SERVICE MERCHANDISE CO INC, 10-K405, 2000-03-16

SERVICE MERCHANDISE CO INC
10-K405, 2000-03-16
MISC GENERAL MERCHANDISE STORES

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
OF 1934 FOR THE FISCAL YEAR ENDED JANUARY 2, 2000.

COMMISSION FILE NO. 1-9223

SERVICE MERCHANDISE COMPANY, INC.

(DEBTORS-IN-POSSESSION AS OF MARCH 27, 1999)
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

<TABLE>
<S> <C>
TENNESSEE 62-0816060
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)

P.O. BOX 24600, NASHVILLE, TN (MAILING
ADDRESS) 37202-4600
7100 SERVICE MERCHANDISE DRIVE, BRENTWOOD, TN
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
</TABLE>

REGISTRANT'S TELEPHONE NUMBER INCLUDING AREA CODE: (615) 660-6000

SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE

SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:

COMMON STOCK ($.50 PAR VALUE)
SERIES A JUNIOR PREFERRED STOCK PURCHASE RIGHTS
9% SENIOR SUBORDINATED DEBENTURES
8 3/8% SENIOR NOTES

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

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

As of February 27, 2000, there were outstanding 99,976,123 shares of the
Registrant's common stock, $.50 par value (the "Common Stock"). The aggregate
market value of the Common Stock held by non-affiliates on February 27, 2000
(based upon the average of the high and low sales prices of such stock as of
such date) was $13,250,644. This calculation assumes that all shares of Common
Stock beneficially held by officers and members of the Board of Directors of the
Registrant are owned by "affiliates," a status which each of the officers and
directors may individually disclaim.

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TABLE OF CONTENTS

<TABLE>
<CAPTION>
PAGE
NO.
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<S> <C> <C>
PART I...................................................................... 2
Item 1. Business.................................................... 2
Item 2. Properties.................................................. 7
Item 3. Legal Proceedings........................................... 10
Item 4. Submission of Matters to a Vote of Security Holders......... 11
PART II..................................................................... 11
Item 5. Market for the Registrant's Common Stock and Related
Stockholder Matters....................................... 11
Item 6. Selected Financial Data..................................... 12
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 13
Item 7A. Quantitative and Qualitative Disclosures about Market
Risk...................................................... 28
Item 8. Financial Statements and Supplementary Data................. 29
Item 9. Changes in and Disagreements With Independent Auditors on
Accounting and Financial Disclosure....................... 63
PART III.................................................................... 63
Item 10. Directors and Executive Officers of the Registrant.......... 63
Item 11. Executive Compensation...................................... 65
Item 12. Security Ownership of Certain Beneficial Owners and
Management................................................ 71
Item 13. Certain Relationships and Related Transactions.............. 73
PART IV..................................................................... 73
Item 14. Exhibits, Financial Statement Schedule, and Reports on Form
8-K....................................................... 73
</TABLE>

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PART I

Except where the context indicates otherwise, the "Company" means Service
Merchandise Company, Inc. and its subsidiaries and the "Registrant" means
Service Merchandise Company, Inc. without reference to its subsidiaries.

ITEM 1. BUSINESS

The Company, with 223 stores in 32 states at January 2, 2000, is one of the
nation's largest retailers of jewelry and offers a selection of brand-name hard
goods and other product lines. During the year ended January 2, 2000 ("fiscal
1999"), the Company repositioned its product offerings to focus on value pricing
and a broad selection of jewelry and hard good products. These remerchandising
efforts were based on perceived customer expectations of entry level price
points and a large selection within each product assortment. The Company also
revised its media strategy during fiscal 1999 to employ TV, radio and print
(including a seasonal sourcebook) campaigns in a coordinated effort to build
awareness, prospect for new customers and drive customer traffic.

On February 21, 2000, the Company's Board of Directors approved its 2000
Business Plan. Key components of the 2000 Business Plan include exiting certain
unprofitable hardlines categories, including toys, juvenile, sporting goods,
most consumer electronics and most indoor furniture. As part of the 2000
Business Plan, the Company plans to eliminate between 5,000 and 6,000 positions
in stages during 2000 and 2001, including approximately 350 distribution center
and 200 corporate positions. The Company announced an initiative to reformat its
existing stores as part of the 2000 Business Plan, which would result in excess
store space becoming available for subleasing or other real estate transactions.
Another important element to the Company's strategy is the convergence of the
Internet and store selling environments. Each store will feature Internet kiosks
that will provide immediate access to the Company's web site,
www.servicemerchandise.com, its bridal and gift registry, and its store
directory. The Company also stated that the plan or plans of reorganization
currently being considered involve a debt conversion of the Company's
prepetition unsecured claims into new common equity of the reorganized Company.
Under such circumstances the existing common stock of the Company would be
cancelled and would result in existing holders of the common stock receiving no
value for their interests. The Company believes the value of the common stock is
highly speculative since it is highly probable that it will be cancelled, and
therefore, worthless if the expected plan of reorganization is consummated.

As a result of the Company's decreased net sales in the fourth quarter of
fiscal 1998 and the resulting negative cash flows from operations, in January
1999 the Company began an effort to effect an out-of-court restructuring plan.
As part of this out-of-court restructuring plan, on January 20, 1999, the
Company entered into a new credit facility with Citibank N.A. (the "Second
Amended and Restated Credit Facility"). The Company also developed a plan to
close up to 132 stores, up to four distribution centers and to reduce corporate
overhead (the "Rationalization Plan"). In March 1999, as part of the
Rationalization Plan, the Company announced the closing of the Dallas
distribution center and the reduction of its workforce at its Nashville
corporate offices by 150 employees.

PROCEEDINGS UNDER CHAPTER 11 OF THE BANKRUPTCY CODE

Before the Company was able to effect an out-of-court restructuring, on
March 15, 1999, five of the Company's vendors filed an involuntary petition for
reorganization under Chapter 11 ("Chapter 11") of title 11 of the United States
Bankruptcy Code (the "Bankruptcy Code") in the United States Bankruptcy Court
for the Middle District of Tennessee (the "Bankruptcy Court") seeking court
supervision of the Company's restructuring efforts. On March 27, 1999, the
Company and 31 of its subsidiaries (collectively, the "Debtors") filed voluntary
petitions with the Bankruptcy Court for reorganization under Chapter 11 under
case numbers 399-02649 through 399-02680 (the "Chapter 11 Cases") and orders for
relief were entered by the Bankruptcy Court. The Chapter 11 Cases have been
consolidated for the purpose of joint administration under Case No. 399-02649.
The Debtors are currently operating their businesses as debtors-in-possession
pursuant to the Bankruptcy Code.

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Actions to collect pre-petition indebtedness are stayed and other
contractual obligations against the Debtors may not be enforced. In addition,
under the Bankruptcy Code, the Debtors may assume or reject executory contracts,
including lease obligations. Parties affected by these rejections may file
claims with the Bankruptcy Court in accordance with the reorganization process.
Substantially all pre-petition liabilities are subject to settlement under a
plan of reorganization to be voted upon by creditors and equity holders and
approved by the Bankruptcy Court. Although the Debtors expect to file a
reorganization plan or plans that provide for emergence from bankruptcy in 2001,
there can be no assurance that a reorganization plan or plans will be proposed
by the Debtors or confirmed by the Bankruptcy Court, or that any such plan(s)
will be consummated. As provided by the Bankruptcy Code, the Debtors initially
had the exclusive right to submit a plan of reorganization for 120 days. On May
25, 1999, the Bankruptcy Court extended the period in which the Company had the
exclusive right to file or advance a plan of reorganization to February 29,
2000. On February 2, 2000, the Bankruptcy Court extended the period in which the
Company has the exclusive right to file or advance a plan of reorganization to
April 30, 2001 and extended the right to solicit acceptance of its plan to June
30, 2001. If the Debtors fail to file a plan of reorganization during such
period or if such plan is not accepted by the required number of creditors and
equity holders, any party in interest may subsequently file its own plan of
reorganization for the Debtors. A plan of reorganization must be confirmed by
the Bankruptcy Court, upon certain findings being made by the Bankruptcy Court
which are required by the Bankruptcy Code. The Bankruptcy Court may confirm a
plan notwithstanding the non-acceptance of the plan by an impaired class of
creditors or equity security holders if certain requirements of the Bankruptcy
Code are met. The plan or plans currently being considered by the Company
involve a debt conversion of the Company's prepetition unsecured claims into new
common equity of the reorganized Company. Under such circumstances the existing
common stock of the Company would be cancelled and would result in existing
holders of the common stock receiving no value for their interests. The Company
believes the value of the common stock is highly speculative since it is highly
probable that it will be cancelled, and therefore, worthless if the expected
plan of reorganization is consummated.

At the first day hearing held on March 29, 1999 before Judge George C.
Paine, the Bankruptcy Court entered first day orders granting authority to the
Debtors, among other things, to pay pre-petition and post-petition employee
wages, salaries, benefits and other employee obligations, to pay vendors and
other providers in the ordinary course for goods and services received from and
after March 15, 1999, and to honor customer service programs, including
warranties, returns, layaways and gift certificates.

The Company entered into an agreement dated March 29, 1999 with Citicorp
USA, Inc., as administrative agent, BankBoston, N.A. as documentation agent and
collateral monitoring agent, and Salomon Smith Barney Inc. as sole arranger and
book manager, for a debtor-in-possession credit facility (the "DIP Facility")
under which the Company may borrow up to $750.0 million, subject to certain
limitations, to fund ongoing working capital needs while it prepares a
reorganization plan. On April 27, 1999, the Bankruptcy Court approved the DIP
Facility. The DIP Facility includes $100.0 million in term loans and a maximum
of $650.0 million in revolving loans. The DIP Facility includes a $200.0 million
sub-facility for standby and trade letters of credit. Interest rates on the DIP
Facility are based on either the Citibank N.A. Alternative Base Rate plus 1.25%
for ABR Loans or 2.25% over LIBOR for Eurodollar Loans. The DIP Facility is
secured by substantially all of the assets of the Company and its subsidiaries,
subject only to valid, enforceable, subsisting and non-voidable liens of record
as of the date of commencement of the Chapter 11 Cases and other liens permitted
under the DIP Facility.

Borrowings under the DIP Facility are limited based on a borrowing base
formula which considers eligible inventories, eligible accounts receivable,
trade letters of credit and mortgage values on eligible real properties,
eligible leasehold interests, available cash equivalents and in-transit cash.
Borrowing availability under the DIP Facility continues unless the Company
breaches both the minimum EBITDA and minimum availability covenants as defined
in the DIP Facility.

On June 10, 1999, the Company filed with the Bankruptcy Court schedules and
statements of financial affairs setting forth, among other things, the assets
and liabilities of the Company as shown by the Company's books and records,
subject to the assumptions contained in certain global notes filed in connection
therewith. Certain of the schedules were amended on March 6, 2000 and all of the
schedules and statements of financial
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affairs are subject to further amendment or modification. Pursuant to order of
the Bankruptcy Court, on or about March 15, 2000, the Company will mail notice
to all known creditors that the deadline for filing proofs of claim with the
Bankruptcy Court is May 15, 2000. Differences between amounts scheduled by the
Company and claims by creditors will be investigated and resolved in connection
with the Company's claims resolution process. That process will not commence
until after the May 15, 2000, bar date and, in light of the number of creditors
of the Company, may take considerable time to complete. Accordingly, the
ultimate number and amount of allowed claims is not presently known and, because
the settlement terms of such allowed claims is subject to a confirmed plan of
reorganization, the ultimate distribution with respect to allowed claims is not
presently ascertainable.

The Company has filed over 200 motions in the Chapter 11 Cases whereby it
was granted authority or approval with respect to various items required by the
Bankruptcy Code and/or necessary for the Company's reorganizational efforts. In
addition to motions pertaining to real estate disposition matters, the Company
has obtained orders providing for, among other things, (i) implementation of
employee retention and incentive programs, (ii) termination or suspension of
certain employee benefit programs, (iii) adequate protection to certain secured
creditors, (iv) implementation of a return to vendor program and other vendor
related programs, (v) the sale of the assets of B.A. Pargh., and (vi) the
extension of time to assume or reject leases.

2000 BUSINESS PLAN

On February 21, 2000, the Company's Board of Directors approved its 2000
Business Plan, which includes the following components: (i) an expansion of
jewelry and jewelry related products; (ii) a more targeted selection of those
categories that have historically performed well and have an affinity to
jewelry, and an exit from certain unprofitable hardlines categories; (iii) the
convergence of the Company's in-store and Internet environment; (iv) the
reduction of selling and warehouse spaces within the Company's stores to adjust
for the new merchandise mix, which allows for the subleasing of excess space;
and (v) the rationalization of the Company's overhead structure, logistics
network and stores/field organization to generate anticipated cost savings. The
execution and success of the 2000 Business Plan is subject to numerous risks and
uncertainties. See "Management Discussion and Analysis of Financial Condition
and Results of Operations -- Safe Harbor Statement Under the Private Securities
Litigation Reform Act of 1995."

Pursuant to the 2000 Business Plan, the Company will feature an expanded
offering of jewelry and jewelry-related products, with the bulk of the expansion
in diamonds. In addition to jewelry, the Company will focus on hardlines
categories that have performed well and which generate cross-selling
opportunities with jewelry. The Company will exit certain unprofitable
categories, including toys, most electronics and sporting goods. As a
MULTI-CHANNEL SPECIALTY RETAILER, the Company has included as part of the 2000
Business Plan the planned convergence of the Internet and store selling
environments. Each store will feature Internet kiosks that will provide
immediate access to the Company's web site, www.servicemerchandise.com, its
bridal and gift registry and its store directory.

The Company's stores will be reconfigured to feature less overall selling
square footage (approximately 18,000 square feet as compared to 27,000 square
feet), but increased square footage for jewelry. The excess store space will be
available for sub-leasing or other real estate transactions. Seventy stores are
scheduled for total refurbishment and upgrade to an expanded jewelry selling
area in 2000 while the balance will undergo a more limited capital improvement
remodel during 2000. Another 83 stores are scheduled for total refurbishment in
2001. Although the Company plans to continue operating substantially all of its
221 stores, in 2000 it will close its distribution centers in Montgomery, New
York and Orlando, Florida. As part of the 2000 Business Plan, the Company will
reduce its workforce at its corporate offices, its distribution centers and
throughout the stores organization resulting in the elimination of 5,000 to
6,000 positions.

To fund the 2000 Business Plan, as well as future operations, and in
anticipation of emergence from Chapter 11 in 2001, the Company has obtained a
commitment from Fleet Retail Finance Inc. ("Fleet") for a new four year $600.0
million credit facility which includes a commitment for post reorganization
financing

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(the "DIP to Exit Facility"). The DIP to Exit Facility, which will be agented by
Fleet and fully underwritten by FleetBoston Robertson Stephens, is subject to
approval by the Bankruptcy Court and, if approved, is intended to replace the
DIP Facility.

The commitment provides that the DIP to Exit Facility will be structured as
a $600.0 million revolver, although Fleet has reserved the right to allocate up
to $85.0 million to a term loan prior to closing. The DIP to Exit Facility
commitment also includes a $150.0 million letter of credit subfacility and
permits subordinated secured financing in amounts up to an additional $50.0
million on terms reasonably satisfactory to Fleet. The DIP to Exit Facility
requires superpriority claim status and a first priority security interest in
all assets subject to existing liens, and contains certain other customary
priority provisions. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Liquidity and Capital Resources."

At this time, it is not possible to predict the outcome of the Chapter 11
Cases or their effect on the Company's business. Reference is made to Item 7.
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," Note B of Notes to Consolidated Financial Statements, and the
Report of Independent Auditors included herein which includes an explanatory
paragraph concerning a substantial doubt as to the Company's ability to continue
as a going concern.

GENERAL

The Company is one of the nation's largest retailers of jewelry and offers
a selection of brand-name hard goods and other product lines. Product offerings
are marketed to customers primarily through direct mail flyers, newspaper
inserts, radio and television advertising. While customers may purchase products
through mail order, telephone order or via the Company's Internet web site,
www.servicemerchandise.com, the majority of purchases occur directly in a
Company store.

The typical store currently consists of approximately 50,000 square feet of
total space (approximately 27,000 square feet selling space and 23,000 square
feet warehouse space) and is situated on a stand-alone lot or as an anchor in a
suburban mall or strip center. The Company operated seven Service Select stores
at January 2, 2000, an 11,000 - 14,000 square foot format that carries a full
line of jewelry and an edited assortment of hardlines. Two of the Service Select
stores were closed in January of 2000. The Company's stores are divided into
thematic product categories. In the Fine Jewelry department, merchandise is
displayed mostly in showcases. In certain other departments, a sample of the
merchandise is displayed, and customers select their purchases via a "pull tag"
system. The pull tag is taken to a cashier, the product is paid for and the
merchandise is delivered to a pick-up station. In self-service departments,
customers select merchandise from a shelf or display and take it to a checkout
counter to complete the purchase. In fiscal 1998, the Company transitioned from
a showroom retailer to a bulked out, self-service retailer. Except for certain
electronics, large fitness equipment and jewelry, almost all product categories
may now be shopped on a self-service basis.

In 1999, the Company negotiated a contract with Household Retail Services
who provided a new private label credit card program. The Bankruptcy Court
approved the new credit card program on August 10, 1999. This program was
introduced to all stores on September 20, 1999 and all accounts required a new
application. None of the previous private label accounts owned by World
Financial Network National Bank were converted to the new private label credit
card program. The credit card program does not provide the Company any
participation in the earnings of the receivables portfolio, but it does provide
an additional method of payment for customers and therefore helps generate
incremental sales.

Virtually every transaction in the store that involves payment, customer
information or inventory is recorded and transmitted, on a daily basis, via
satellite to a central information system at the Company's corporate offices. In
addition, by using the computer, customers may be provided with suggested
alternative items, back-order information, online mail orders, gift registry,
special orders and layaway information.

The Company's computerized daily inventory system tracks the status (on
hand, on order, or in transit), location and history of inventory in the retail
network. The raw data is used in the Company's inventory replenishment system
which tracks inventory positions, sales data and sales forecasts and generates
either

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suggested transfers from distribution centers or suggested purchase order
quantities. The inventory system also records all sales information to produce
daily margin reports with historical comparisons.

The Company's information systems track customers' purchases and facilitate
tailoring the Company's mailing lists to meet specific objectives. The Company
maintains a household database of information on over 24 million households that
is updated with each purchase. This database allows the Company to target
customers based on specific criteria, including the categories purchased, the
frequency of purchases and the value of those purchases.

SEASONALITY AND COMPETITION

The Company's business is highly seasonal, with the Christmas season being
the largest volume-selling period of the year. In preparation for the Christmas
season, the Company significantly increases its merchandise inventories, which
traditionally have been financed by internally generated funds, short-term
borrowings, and terms from vendors. The Company's profitability and cash flows
are primarily dependent upon the large sales volume generated during the fourth
quarter of its fiscal year. Fourth quarter net sales accounted for 37.4% of
total net sales in fiscal 1999.

The Company is engaged in a highly competitive business and competes with
most nationally known jewelry and general retail merchandisers including
department, general merchandise, specialty and discount stores. Many of these
competitors are larger and have greater financial resources than the Company.
The Company considers quality, value, merchandise mix, service, quality of
shopping experience and location to be the most significant competitive factors
in its retailing business.

SUPPLIERS

The Company purchases merchandise from approximately 1,550 suppliers, most
of which are manufacturers. Generally, most merchandise is shipped to the
Company's regional distribution centers and transported to the stores by
commercial contract carriers. In fiscal 1999, the largest vendor accounted for
approximately 5.7% of total cash disbursements for inventory items. On January
27, 1999, the Company announced that it had suspended payment on unpaid invoices
for goods shipped prior to January 8, 1999, totaling approximately $200.0
million related to trade payables for merchandise from vendors. The Company also
announced its intent to pay on a current basis invoices for goods shipped after
January 8, 1999. Prior to the filing of the Chapter 11 Cases, the Company's
ability to purchase merchandise was adversely affected by its lack of cash
reserves and the Company's deteriorating financial performance. Certain vendors
refused to ship merchandise to the Company or would only ship on a cash in
advance basis. As a result of the Chapter 11 Cases and the DIP Facility, the
Company now pays its suppliers for merchandise received post-petition. The
Company believes its ability to acquire merchandise from its suppliers is
adequate to supply its business needs. As of January 2, 2000, accounts payable
totaled $67.3 million, with 62.1% of the Company's $1.45 billion of merchandise
orders purchased on terms.

The Company's direct import program is responsible for sourcing and
repackaging many promotional and seasonal items. Direct import purchases, which
totaled approximately $211.8 million in fiscal 1999, allow the Company to reduce
many traditional cost factors, thereby lowering the cost of merchandise sold in
several product lines.

EMPLOYEES

The number of persons employed by the Company fluctuates seasonally. During
fiscal 1999, the number of active employees varied from approximately 15,000 to
approximately 39,000 including part-time, full-time, and temporary employees. As
of January 2, 2000, the Company had approximately 26,000 part-time, full-time,
and temporary employees, of whom 91.5% were hourly-paid personnel engaged in
non-supervisory activities; the balance consisted of administrative, executive,
distribution center and store management personnel. In February 2000, the
Company began a program to reduce its workforce by 5,000 to 6,000 positions as
part of its 2000 Business Plan. See "Business -- 2000 Business Plan."

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None of the Company's employees are covered by a collective bargaining
agreement. The Company has never experienced a work stoppage due to a labor
disagreement. The Company has experienced a material loss of its workforce
primarily due to the uncertainty surrounding the Company's deteriorating
financial condition and as a result of the filing of the Chapter 11 Cases. The
Company has implemented an employee retention plan, approved by the Bankruptcy
Court, which the Company believes has enhanced its ability to retain employees.

ITEM 2. PROPERTIES

The Company leases and owns retail store facilities, warehouses and office
space. The Company has financed a number of its owned facilities out of
internally generated funds. Some owned facilities have ground leases on a
long-term basis and others are financed by real estate mortgages. The Company's
office is located in Brentwood, Tennessee, and is owned by the Company.

During 1999, the Company implemented a comprehensive review and analysis of
its store operations and determined to close approximately 1/3 of its stores. To
assist in the disposition of the real estate interests associated with the
closed locations, the Company engaged professional appraisers as well as real
estate consultants and brokers. The Company received bids on 77 of the 102
properties offered for sale for an aggregate gross purchase price of
approximately $78.8 million. The sale of those properties was approved by the
Bankruptcy Court on July 14, 1999.

The Company has announced certain strategic real estate initiatives as part
of its 2000 Business Plan. See "Business -- 2000 Business Plan."

DISTRIBUTION CENTERS

The Company operated four distribution centers and one return center
(Bowling Green, Kentucky) as of January 2, 2000. These distribution centers are
located in Florida, New York, and Tennessee, and contain an aggregate of
approximately 2,116,000 square feet as set forth below:

<TABLE>
<CAPTION>
CENTER LOCATION SQ. FEET OWNED/LEASED LEASE TERM
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<S> <C> <C> <C>
Orlando, FL................ 460,000 Leased Primary term extends
through 6/30/00 with
renewal options through
6/30/22
Montgomery, NY............. 800,000 Owned Primary term extends
through 12/31/24
Nashville, TN
(1) Owned................ 588,000 Owned Not applicable
(2) Owned satellite...... 268,000 Owned Not applicable
Bowling Green, KY (Return
Center).................. 180,000 Leased Primary term extends
through 12/31/00 with
renewal options through
12/31/25
</TABLE>

The Company has satisfied its obligation under the sale/leaseback for the
Montgomery, NY distribution center. The transfer of this property from the
industrial development authority to the Company is currently pending.

As part of its 2000 Business Plan, the Company intends to close its
Montgomery, New York, and Orlando, Florida distribution centers and to
consolidate its logistics operations in its Nashville, Tennessee regional
distribution center.

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RETAIL STORES

As of January 2, 2000, the Company operated 223 retail stores (typically
consisting of approximately 50,000 square feet) as follows:

<TABLE>
<CAPTION>
NUMBER OF
STORES
---------
<S> <C>
Owned land and building..................................... 71
Long-term ground lease with an owned building............... 29
Leased...................................................... 148
Stores which have been subleased............................ (1)
Properties available for sale............................... (24)
---
Total....................................................... 223
===
</TABLE>

Most of the leases contain renewal or purchase options. See Note I of Notes
to Consolidated Financial Statements for information concerning the Company's
lease commitments. As part of its 2000 Business Plan, the Company intends to
reformat certain of its stores and to sublease certain excess space in certain
of its reformatted stores. See "Business -- 2000 Business Plan."

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SERVICE MERCHANDISE COMPANY, INC.
STORE LOCATIONS

The numbers in parentheses show the number of stores per state and where
there is more than one store in any city, the number of stores in such city as
of fiscal year-end. As of January 2, 2000 the Company operated 223 stores in 32
states. As of February 27, 2000, the Company operates 221 stores in 32 states:

ALABAMA (6)
Birmingham (2)
Huntsville
Mobile
Montgomery
Tuscaloosa
ARIZONA (3)
Glendale
Mesa (2)
ARKANSAS (1)
Little Rock
CALIFORNIA (2)
San Francisco
San Jose
CONNECTICUT (5)
Danbury
Derby
Manchester
Newington
Orange
DELAWARE (3)
Dover
Wilmington (2)
FLORIDA (42)
Altamonte Springs
Boca Raton
Boynton Beach
Bradenton
Brandon
Casselberry
Coral Springs
Daytona Beach
Fort Myers
Hollywood
Jacksonville (2)
Kissimmee
Lakeland
Largo
Leesburg
Miami (2)
N. Clearwater
N. Miami
Naples
Ocala
Orange Park
Orlando (3)
Pembroke Pines
Pensacola
Pompano Beach
Port Charlotte
Port Richie
Sanford
Sarasota
Spring Hill
St. Petersburg
Stuart
Sunrise
Tallahassee
Tampa (2)
W. Melbourne
W. Palm Beach
GEORGIA (12)
Alpharetta
Augusta
Columbus
Decatur
Douglasville
Duluth
Kennesaw
Macon
Morrow
Savannah
Smyrna
Tucker
ILLINOIS (18)
Arlington Heights
Berwyn
Bloomingdale
Burbank
Crystal Lake
Downers Grove (2)
Joliet
Lansing
Matteson
Naperville
Niles
Norridge
Oaklawn
Orland Park
Schaumburg
Skokie
Waukegan
INDIANA (10)
Castleton
Clarksville
Evansville
Fort Wayne
Greenwood
Indianapolis (2)
Lake
Merrillville
Mishawaka
KANSAS (1)
Overland Park
KENTUCKY (6)
Florence
Lexington
Louisville (2)
Owensboro
Paducah
LOUISIANA (9)
Baton Rouge
Bossier City
Harvey
Houma
Lafayette
Metarie
Monroe
Shreveport
Slidell
MAINE (2)
Augusta
S. Portland
MARYLAND (2)
Baltimore
Columbia
MASSACHUSETTS (6)
Auburn
Burlington
Natick
Saugus
Stoughton
Swansea
MICHIGAN (6)
Novi
Roseville
Southgate
Sterling Heights
Troy
Westland
MISSISSIPPI (3)
Gulfport
Hattiesburg
Jackson
MISSOURI (4)
Crestwood
Florissant
Springfield
St. Peters
NEVADA (1)
Las Vegas
NEW HAMPSHIRE (5)
Dover
Manchester
Nashua
Plaistow
Salem
NEW JERSEY (3)
Hazlet
Paramus
Wayne
NEW YORK (6)
Hartsdale
Lake Grove
Middletown
Patchoque
Poughkeepsie
Woodhaven
NORTH CAROLINA (7)
Cary
Charlotte
Fayetteville
Gastonia
Greensboro
Pineville
Raleigh
OHIO (4)
Cincinnati (3)
Springdale
OKLAHOMA (3)
Oklahoma City
Tulsa
Warr Acres
PENNSYLVANIA (6)
Allentown
Greensburg
Harrisburg
Lancaster
Reading
Wilkes-Barre
SOUTH CAROLINA (3)
Columbia
Greenville
N. Charleston
TENNESSEE (10)
Antioch
Chattanooga
Cookeville
Franklin
Jackson
Johnson City
Knoxville
Madison
Memphis (2)
TEXAS (26)
Arlington
Austin
Baytown
Beaumont
Dallas
Fort Worth
Harlingen
Houston (7)
Lake Jackson
Laredo
Lewisville
Longview
McAllen
Mesquite
N. Richland Hills
Plano
Richardson
San Antonio
Sugar Land
Tyler
VERMONT (1)
Burlington
VIRGINIA (5)
Chantilly
Chesapeake
Fredericksburg
Glen Allen
Midlothian

9
<PAGE> 11

ITEM 3. LEGAL PROCEEDINGS

On March 15, 1999, five of the Company's vendors filed an involuntary
petition for reorganization under Chapter 11 in the Bankruptcy Court seeking
court supervision of the Company's restructuring efforts. On March 27, 1999, the
Company and 31 of its subsidiaries filed voluntary petitions with the Bankruptcy
Court for reorganization under Chapter 11 of the Bankruptcy Code. The Debtors
are currently operating their businesses as debtors-in-possession. The Chapter
11 Cases have been consolidated for the purpose of joint administration under
Case No. 399-02649.

On January 28, 1997, the Company and Service Credit Corp. (the
"Subsidiary"), a wholly-owned subsidiary, entered into an agreement with World
Financial Network National Bank ("WFNNB") for the purpose of providing a private
label credit card to the Company's customers. The contract requires the
Subsidiary to maintain a 3.0% credit risk reserve for the outstanding balances,
which are owned by WFNNB. The purpose of this reserve is to offset future
potential negative spreads and portfolio losses. The negative spreads or losses
may result from potential increased reimbursable contractual program costs. The
3.0% credit risk reserve is held by the Subsidiary, which is not in Chapter 11,
in the form of cash and cash-equivalents. On April 28, 1999, WFNNB advised the
Company that WFNNB has projected that such portfolio losses and negative spreads
will be at least approximately $9.0 million. The Company does not have in its
possession sufficient information to determine the accuracy or validity of
WFNNB's projection. Pending confirmation of the accuracy of WFNNB's projection
and a resolution of the Company's rights and remedies, the Company has made
provision for such potential liability during fiscal 1999 by maintaining an
allowance on the 3.0% credit risk reserve of $9.0 million.

On July 16, 1999, the Company filed a complaint against WFNNB in the
Bankruptcy Court alleging, among other things, breach of contract and violation
of the automatic stay provisions of the Bankruptcy Code by WFNNB with respect to
and in connection with the January 1997 private label credit card program
agreement between the Company, the Subsidiary and WFNNB (the "World Financial
Agreement"). Under the World Financial Agreement, a program was established
pursuant to which, among other things, WFNNB agreed to issue credit cards to
qualifying Company customers for the purchase of goods and services from the
Company. While the ultimate result of this litigation cannot be determined or
predicted with any accuracy at this time, the Company intends to pursue
available remedies against WFNNB.

On August 20, 1999, over the objection of WFNNB, the Bankruptcy Court
authorized the Company to enter into an agreement with Household Bank (SB), N.A.
("Household") for the purpose of offering new private label credit cards to
those customers of the Company who meet Household's credit standards. The
Company's prior private label credit card program with WFNNB was suspended in
March of 1999, and the rights and liabilities of WFNNB, the Company and the
Subsidiary are the subject of the litigation referred to in the preceding
paragraph.

On September 23, 1999, WFNNB filed a motion to dismiss the Company's
complaint and a separate motion seeking to have the complaint litigated in the
United States District Court for the Middle District of Tennessee (the "District
Court"), rather than the Bankruptcy Court. The Company filed timely oppositions
to both motions, and, on October 27, 1999, the District Court denied WFNNB's
motion to have the complaint litigated in the District Court. The Bankruptcy
Court scheduled a hearing on December 6, 1999, to consider WFNNB's motion to
dismiss and the Company's opposition thereto.

On December 6, 1999, the Bankruptcy Court entered an order dismissing the
Company's complaint. On December 16, 1999, the Company filed a motion asking the
Court to clarify the order issued on December 6, 1999, and to grant the Company
leave to file an amended complaint (the "Company's Motion"). On January 11,
2000, WFNNB responded with an objection to the Company's Motion. On February 22,
2000 the Bankruptcy Court entered an order granting the Company's Motion and the
Company filed the amended complaint.

10
<PAGE> 12

and Analysis of Financial Condition and Results of Operations," Note B of Notes
to Consolidated Financial Statements, and the Report of Independent Auditors
included herein which includes an explanatory paragraph concerning a substantial
doubt as to the Company's ability to continue as a going concern. If it is
determined that the liabilities subject to compromise in the Chapter 11 Cases
exceed the fair value of the assets, unsecured claims may be satisfied at less
than 100 percent of their face value and the equity interests of the Company's
shareholders may have no value.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders during the fourth
quarter of fiscal 1999.

PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

During fiscal 1999 and 1998, the Common Stock traded on the New York Stock
Exchange (the "NYSE") under the symbol "SME." On March 17, 1999, the NYSE
notified the Company that it was reviewing the listing status of the Company's
listed securities, including the Common Stock. On December 2, 1999, the NYSE
announced that trading in the Common Stock was suspended effective on that date
and that the NYSE would apply with the SEC for delisting of the Common Stock.
The Common Stock was delisted from the NYSE on January 31, 2000. Subsequent to
December 2, 1999, the Common Stock has been traded on the National Quotation
Bureau, LLC Pink Sheets (the "Pink Sheets") and on the OTC Bulletin Board under
the symbol "SVCDQ". The high and low sales prices for the Common Stock as
reported by the NYSE until December 2, 1999, and the high and low bid prices on
the OTC Bulletin Board and in the Pink Sheets thereafter were as follows:

<TABLE>
<CAPTION>
1999 HIGH LOW
- ---- ----- -----
<S> <C> <C>
First Quarter............................................... $1.13 $0.19
Second Quarter.............................................. $0.47 $0.25
Third Quarter............................................... $0.38 $0.25
Fourth Quarter.............................................. $0.31 $0.08
</TABLE>

<TABLE>
<CAPTION>
1998 HIGH LOW
- ---- ----- -----
<S> <C> <C>
First Quarter............................................... $2.44 $1.63
Second Quarter.............................................. $2.25 $1.63
Third Quarter............................................... $1.94 $1.50
Fourth Quarter.............................................. $1.69 $0.28
</TABLE>

As of February 27, 2000, the closing bid price reported on the OTC Bulletin
Board was $0.14 and the approximate number of holders of the Common Stock was
5,724. The Company has not declared any cash dividends to shareholders for
fiscal 1999 or 1998. The DIP Facility contains certain restrictive covenants,
including a prohibition on the payment of cash dividends.

On February 22, 2000, the Company announced that the plan or plans of
reorganization presently being considered by the Company involve a debt
conversion of the Company's prepetition unsecured claims into new common equity
of the reorganized Company. Under such circumstances, the Common Stock would be
cancelled and would result in existing shareholders of Common Stock receiving no
value for their interests. The Company believes that the value of the Common
Stock is highly speculative since it is highly likely that it will be cancelled,
and therefore, be worthless if the expected plan of reorganization is
consummated.

11
<PAGE> 13

ITEM 6. SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
FISCAL YEAR
--------------------------------------------------------------
1999 1998 1997 1996 1995
---------- ---------- ---------- ---------- ----------
(IN THOUSANDS, EXCEPT PER SHARE, STORE, RATIO AND RATE DATA)
<S> <C> <C> <C> <C> <C>
RESULTS OF OPERATIONS
Net sales(a)............................. $2,230,500 $3,169,525 $3,662,778 $3,955,016 $4,018,525
Earnings (loss) before interest and
income taxes(a)........................ (165,294) (27,145) (63,801) 138,564 162,078
Interest expense -- debt and capitalized
leases................................. 64,835 83,255 78,531 75,636 80,908
Earnings (loss) before extraordinary loss
and cumulative effect of change in
accounting principle(a)................ (229,255) (110,307) (88,957) 39,330 50,325
Net earnings (loss)(a)................... (243,672) (110,307) (91,600) 39,330 50,325
RATIOS & RATES
Gross margin to net sales................ 22.2% 23.8% 23.2% 24.2% 24.3%
Selling, general and administrative
expenses to net sales(a)............... 26.0% 22.4% 19.8% 19.2% 18.7%
Effective tax rate....................... 0.4% 0.1% 37.5% 37.5% 38.0%
Earnings (loss) before extraordinary loss
and cumulative effect of change in
accounting principle to net sales(a)... (10.3)% (3.5)% (2.4)% 1.0% 1.3%
Net earnings (loss) to net sales(a)...... (10.9)% (3.5)% (2.5)% 1.0% 1.3%
PER COMMON SHARE -- BASIC AND DILUTED(b)
Earnings (loss) per share before
extraordinary loss and cumulative
effect of change in accounting
principle -- Basic..................... $ (2.30) $ (1.11) $ (0.89) $ 0.39 $ 0.50
Earnings (loss) per share before
extraordinary loss and cumulative
effect of change in accounting
principle -- Assuming dilution......... (2.30) (1.11) (0.89) 0.39 0.50
Net earnings (loss) per share -- Basic... (2.45) (1.11) (0.92) 0.39 0.50
Net earnings (loss) per share -- Assuming
dilution............................... (2.45) (1.11) (0.92) 0.39 0.50
Weighted -- average common shares:
Basic.................................. 99,721 99,703 99,930 99,209 99,059
Diluted................................ 99,721 99,703 99,930 100,326 100,357
FINANCIAL POSITION
Inventories.............................. $ 642,997 $ 896,303 $ 929,818 $1,052,969 $1,034,467
Notes payable............................ 42,977 156,000 -- -- --
Accounts payable......................... 67,318 228,373 482,235 639,887 679,107
Working capital.......................... 424,878 255,980 586,501 489,597 365,025
Total assets(a).......................... 1,161,944 1,626,895 1,951,461 2,087,452 1,999,008
Long-term obligations(c)................. 101,014 508,385 761,522 682,156 623,286
Shareholders' (deficit) equity........... (17,061) 225,895 336,505 427,094 386,742
RATIOS
Inventory turnover....................... 2.3x 2.6x 2.8x 2.9x 3.0x
Current ratio(a)......................... 2.3x 1.3x 1.7x 1.5x 1.4x
Long-term debt to long-term debt +
equity................................. 120.3% 69.2% 69.4% 61.5% 61.7%
OTHER INFORMATION
Total net sales increase
(decrease)...................... (29.6)% (13.5)% (7.4)% (1.6)% (0.8)%
Comparable store net sales increase
(decrease)(d).......................... (7.8)% (8.9)% (3.1)% (1.9)% (3.3)%
Number of stores......................... 223 350 361 401 410
ADJUSTED EBITDA DATA
Adjusted EBITDA(e)....................... $ (122,867) $ 73,637 $ (4,561) $ 199,189 $ 224,816
Adjusted EBITDA to net sales............. (5.5)% 2.3% (0.1)% 5.0% 5.6%
</TABLE>

12
<PAGE> 14

- ---------------
(a) See Note D to Consolidated Financial Statements for a discussion of the
cumulative effect of a change in accounting principle.

(b) Restated to reflect the adoption of Statement of Financial Accounting
Standards ("SFAS") No. 128.

(d) Adjusted to reflect a comparable number of selling days.

(e) Adjusted EBITDA consists of net earnings before interest, income taxes,
depreciation and amortization. Also included in Adjusted EBITDA is other
amortization classified as selling, general and administrative expenses in
the following amounts: 1999 -- ($136); 1998 -- $630; 1997 -- $992;
1996 -- $966; 1995 -- $964. Certain amounts have been reclassified from
selling, general and administrative expenses to interest expense for both
current and prior periods. Adjusted EBITDA does not reflect restructuring
charges or SFAS No. 121 charges. Adjusted EBITDA is not intended to
represent net earnings, cash flow or any other measure of performance in
accordance with generally accepted accounting principles, but is included
because management believes certain investors find it to be a useful tool
for measuring operating performance. While Adjusted EBITDA and similar
variations thereof are frequently used as a measure of operations and the
ability to meet debt service requirements, these terms are not necessarily
comparable to other similarly titled captions of other companies due to the
potential inconsistencies in the method of calculation.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

This report includes certain forward-looking statements (statements other
than with respect to historical fact, including statements relating to the
Company's 2000 Business Plan, its expected plan of reorganization and its
expected DIP to Exit Facility) based upon management's beliefs, as well as
assumptions made by and data currently available to management. This information
has been, or in the future may be, included in reliance on the "safe harbor"
provisions of the Private Securities Litigation Reform Act of 1995. These
forward-looking statements are based on a variety of assumptions that may not be
realized and are subject to significant business, economic, judicial and
competitive uncertainties and potential contingencies, including those set forth
below, many of which are beyond the Company's control. Actual results may differ
materially from those anticipated in any such forward-looking statements. The
Company undertakes no obligation to update or revise any such forward-looking
statements.

The forward-looking statements and the Company's liquidity, capital
resources and results of operations are subject to a number of risks and
uncertainties including, but not limited to, the following: approval of plans
and activities by the Bankruptcy Court, including the proposed DIP to Exit
Facility, proposed enhancements to the Company's existing employee retention
program including the proposed enhanced severance program, and the Company's
proposed strategic real estate initiatives; the ability of the Company to
continue as a going concern; the ability of the Company to operate pursuant to
the terms of the present DIP Facility and to consummate and operate pursuant to
the terms of the DIP to Exit Facility; the ability of the Company to conduct
successful clearance sales in connection with the 2000 Business Plan; the
ability of the Company to sublease successfully portions of its real estate in
connection with the 2000 Business Plan; the ability of the Company to complete
its store refurbishment program within cost and time expectations; the
successful implementation of the consolidation of its distribution centers;
risks associated with third parties seeking and obtaining Court action to
terminate or shorten the exclusivity period, the time for the Company to accept
or reject executory contracts including its store leases, and for appointment of
a Chapter 11 operation trustee or

13
<PAGE> 15

to convert the Company's reorganization cases to liquidations cases; the ability
of the Company to operate successfully under a Chapter 11 proceeding, achieve
planned sales and margin, and create and have approved a reorganization plan in
the Chapter 11 Cases; potential adverse developments with respect to the
Company's liquidity or results of operations; the ability of the Company to
obtain shipments, negotiate and maintain terms with vendors and service
providers for current orders; the ability to fund and execute the 2000 Business
Plan; the ability of the Company to achieve cost-savings; the ability of the
Company to enter into satisfactory arrangements with third parties with respect
to real estate and internet related strategies; the ability of the Company to
attract, retain and compensate key executives and associates; competitive
pressures from other retailers, including specialty retailers and discount
stores, which may affect the nature and viability of the Company's business
strategy; trends in the economy as a whole which may affect consumer confidence
and consumer demand for the types of goods sold by the Company; the seasonal
nature of the Company's business and the ability of the Company to predict
consumer demand as a whole, as well as demand for specific goods; the ability of
the Company to attract and retain customers; potential adverse publicity; real
estate occupancy and development costs, including the substantial fixed
investment costs associated with opening, maintaining or closing a Company
store; uncertainties with respect to continued public trading in the Company's
securities; the ability to effect conversions to new technological systems; and
the ability to develop, prosecute, confirm and consummate one or more plans of
reorganization with respect to the Chapter 11 cases.

OVERVIEW

The Notes to Consolidated Financial Statements are an integral part of
Management's Discussion and Analysis of Financial Condition and Results of
Operations and should be read in conjunction herewith.

Proceedings Under Chapter 11 of the Bankruptcy Code

On March 15, 1999, five of the Company's vendors filed an involuntary
petition for reorganization under Chapter 11 of the Bankruptcy Code in the
United States Bankruptcy Court for the Middle District of Tennessee seeking
court supervision of the Company's restructuring efforts. On March 27, 1999, the
Company and 31 of its subsidiaries filed voluntary petitions with the Bankruptcy
Court for reorganization under Chapter 11 and orders for relief were entered by
the Bankruptcy Court. The Chapter 11 Cases have been consolidated for the
purpose of joint administration under Case No. 399-02649. The Debtors are
currently operating their businesses as debtors-in-possession pursuant to the
Bankruptcy Code.

Actions to collect pre-petition indebtedness are stayed and other
contractual obligations against the Debtors may not be enforced. In addition,
under the Bankruptcy Code, the Debtors may assume or reject executory contracts,
including lease obligations. Parties affected by these rejections may file
claims with the Bankruptcy Court in accordance with the reorganization process.
Substantially all pre-petition liabilities are subject to settlement under a
plan of reorganization to be voted upon by creditors and equity holders and
approved by the Bankruptcy Court. Although the Debtors expect to file a
reorganization plan or plans that provide for emergence from bankruptcy in 2001,
there can be no assurance that a reorganization plan or plans will be proposed
by the Debtors or confirmed by the Bankruptcy Court, or that any such plan(s)
will be consummated. As provided by the Bankruptcy Code, the Debtors initially
had the exclusive right to submit a plan of reorganization for 120 days. On May
25, 1999, the Bankruptcy Court extended the period in which the Company had the
exclusive right to file or advance a plan of reorganization to February 29,
2000. On February 2, 2000, the Bankruptcy Court extended the period in which the
Company has the exclusive right to file or advance a plan of reorganization to
April 30, 2001 and extended the right to solicit acceptance of its plan to June
30, 2001. If the Debtors fail to file a plan of reorganization during such
period or if such plan is not accepted by the required number of creditors and
equity holders, any party in interest may subsequently file its own plan of
reorganization for the Debtors. A plan of reorganization must be confirmed by
the Bankruptcy Court, upon certain findings being made by the Bankruptcy Court
which are required by the Bankruptcy Code. The Bankruptcy Court may confirm a
plan notwithstanding the non-acceptance of the plan by an impaired class of
creditors or equity security holders if certain requirements of the Bankruptcy
Code are met. The plan or plans currently being considered by the Company
involve a debt conversion of the Company's prepetition on secured claims into
new common equity of the reorganized Company. Under such circum-

14
<PAGE> 16

stances the existing common stock of the Company would be cancelled and would
result in existing holders of the common stock receiving no value for their
interests. The value of the common stock is highly speculative since it is
highly probable that it will be cancelled, and therefore, worthless if the
expected plan of reorganization is consummated.

At the first day hearing held on March 29, 1999 before Judge George C.
Paine, the Bankruptcy Court entered first day orders granting authority to the
Debtors, among other things, to pay pre-petition and post-petition employee
wages, salaries, benefits and other employee obligations, and to pay vendors and
other providers in the ordinary course for goods and services received from
March 15, 1999, and to honor customer service programs, including warranties,
returns, layaways and gift certificates.

The Company has entered into the DIP Facility dated March 29, 1999 with
Citicorp USA, Inc., as administrative agent, BankBoston, N.A. as documentation
agent and collateral monitoring agent, and Salomon Smith Barney Inc. as sole
arranger and book manager, for a debtor-in-possession credit facility under
which the Company may borrow up to $750.0 million, subject to certain
limitations, to fund ongoing working capital needs while it prepares a
reorganization plan. The DIP Facility includes $100.0 million in term loans and
a maximum of $650.0 million in revolving loans. The DIP Facility includes a
$200.0 million sub-facility for standby and trade letters of credit. Interest
rates on the DIP Facility are based on either the LIBOR plus 2.25% for LIBOR
Loans or prime plus 1.25% for ABR Loans. The DIP Facility is secured by
substantially all of the assets of the Company and its subsidiaries, subject
only to valid, enforceable, subsisting and non-voidable liens of record as of
the date of commencement of the Chapter 11 Cases and other liens permitted under
the DIP Facility. On April 27, 1999, the Bankruptcy Court approved the DIP
Facility.

Borrowings under the DIP Facility are limited based on a borrowing base
formula which considers eligible inventories, eligible trade letters of credit,
eligible accounts receivable, mortgage values on eligible real properties,
eligible leasehold interests, available cash equivalents and in-transit cash.
Availability under the DIP Facility continues unless the Company breaches both
the minimum EBITDA and minimum availability covenants, as defined in the DIP
Facility. The Company believes the DIP Facility should provide it with adequate
liquidity to conduct its operations while it prepares a reorganization plan or
until the Company obtains a new credit facility. On February 21, 2000, the
Company signed a commitment letter for a debtor in possession and exit credit
facility. See "Management Discussion and Analysis of Financial Condition and
Results of Operations -- DIP and Exit Credit Facility."

On February 21, 2000, the Company signed a commitment letter with Fleet
Retail Finance Inc. Subject to the expected approval of the Bankruptcy Court and
closing, the Company's anticipated four-year, $600.0 million DIP to exit credit
facility (the "DIP to Exit Facility") will replace the Company's existing $750.0
million DIP Facility (the "DIP Facility"). The DIP to Exit Facility will be
agented by Fleet Retail Finance Inc. ("Fleet"), a co-agent of the DIP Facility,
and fully underwritten by FleetBoston Robertson Stephens Inc.

The Company believes the DIP to Exit Facility will be structured as a
$600.0 million revolver, although Fleet has reserved the right to allocate up to
$85.0 million to a term loan prior to closing. The DIP to Exit Facility also is
expected to include a letter of credit subfacility of $150.0 million and permits
subordinated secured financing in amounts up to an additional $50.0 million on
terms reasonably satisfactory to Fleet. The DIP to Exit Facility is expected to
require superpriority claim status and a first priority security interest in all
assets subject to existing liens, and to contain certain other customary
priority provisions.

The DIP to Exit Facility is expected to be subject to various customary
terms and conditions, and must be closed by the Company no later than May 31,
2000. The DIP to Exit Facility is expected to mature four years from closing but
can be converted to exit financing by the Company at any time during the
four-year term as long as applicable conditions to conversion are satisfied. The
interest rate during the first year of the term is anticipated to be LIBOR plus
250 basis points or prime plus 75 basis points; thereafter, the Company believes
the interest rate on the DIP to Exit Facility will be subject to quarterly
adjustment pursuant to a pricing grid based on availability and/or EBITDA, as
defined in the DIP to Exit Facility, with ranges of 200 to 275 basis points over
LIBOR and 25 to 100 basis points over prime.

15
<PAGE> 17

The Company believes the DIP to Exit Facility will include various
covenants designed to facilitate implementation of the 2000 Business Plan and
the Company's anticipated emergence from Chapter 11 in 2001. To fund capital
expenditures, including the Company's planned two-year store renovation program,
the facility is expected to permit the Company to invest up to $70.0 million of
capital expenditures during 2000 (plus certain incremental amounts based on the
amount of subleased space completed during the fiscal year). In 2001, the DIP to
Exit Facility is expected to permit capital expenditures up to $150.0 million
less actual capital expenditures invested during 2000. During 2002 and 2003, the
Company anticipates that it may invest up to $50.0 million each year with 100
percent carryover of unexpended amounts from prior years. The DIP to Exit
Facility is expected to include a financial covenant test similar to the test in
the current DIP Facility. The Company believes it would not breach this
financial covenant unless unused borrowing availability falls below $50.0
million and the Company fails to meet specified minimum EBITDA performance (as
defined in the DIP to Exit Facility) performance. Expected to be excluded from
the EBITDA calculation are revenues and expenses associated with discontinued
inventory lines, the Orlando and Montgomery distribution centers and the
reduction in force plan (including payroll and severance) except with respect to
non-continuing EBITDA amounts in excess of $100.0 million.

The Company believes there will be no restrictions in the facility on the
Company's ability to sublease and lease store space pursuant to the 2000
Business Plan; lease all or part of the corporate headquarters; sell, pursuant
to sale-leasebacks or outright, the corporate headquarters, the Orlando and/or
Montgomery distribution centers; and/or implement a credit card receivables
securitization program. The Company also believes it will retain the ability to
complete intercompany restructurings, intercompany asset transfers and
intercompany/third-party real estate transactions.

Events of default under the Facility are expected to include customary
default provisions as well as key management provisions that would trigger a
default in the event that both the current Chief Executive Officer and President
ceased to be employed, unless at least one of them is replaced by a person
reasonably satisfactory to Fleet within 90 days and/or the acquisition by any
one person or entity of 50 percent of the voting stock of the Company. Closing
of the facility is subject to customary closing conditions, including at least
$155.0 million of availability at close and no material adverse change in the
financial condition, operations or assets of the Company at the time of closing.
Conversion of the facility to an exit financing is also expected to be based on
customary closing conditions, including the Agent's reasonable satisfaction with
capital structure, plan of reorganization and any materially revised
projections, as well as the achievement by the Company of a specified trailing
12-month EBITDA (which varies depending on time of exit) and certain minimum
availability (which varies from $50.0 to $100.0 million) depending on the time
of exit.

The Company's Consolidated Financial Statements have been prepared on a
going concern basis, which contemplates continuity of operations, realization of
assets and liquidation of liabilities and commitments in the normal course of
business. The filing of the involuntary and voluntary petitions referred to
above, the related circumstances and the losses from operations raise
substantial doubt with respect to the Company's ability to continue as a going
concern. The appropriateness of using the going concern basis is dependent upon,
among other things, confirmation of a plan or plans of reorganization, future
profitable operations and the ability to generate cash from operations and
financing sources sufficient to meet obligations. As a result of the filing of
the Chapter 11 Cases and related circumstances, realization of assets and
liquidation of liabilities is subject to significant uncertainty. While under
the protection of Chapter 11, the Debtors may sell or otherwise dispose of
assets, and liquidate or settle liabilities, for amounts other than those
reflected in the Consolidated Financial Statements. Further, a plan or plans of
reorganization could materially change the amounts reported in the accompanying
Consolidated Financial Statements. The Consolidated Financial Statements do not
include any adjustments relating to recoverability of the value of recorded
asset amounts or the amounts and classification of liabilities that might be
necessary as a consequence of a plan of reorganization.

At this time, it is not possible to predict the outcome of the Chapter 11
Cases or their effect on the Company's business. Additional information
regarding the Chapter 11 Cases is set forth in Item 1. "Business -- Proceedings
Under Chapter 11 of the Bankruptcy Code", Note B of Notes to Consolidated
Financial Statements and the Report of Independent Auditors included herein
which includes an explanatory paragraph concerning a substantial doubt as to the
Company's ability to continue as a going concern. If it is
16
<PAGE> 18

determined that the liabilities subject to compromise in the Chapter 11 Cases
exceed the fair value of the assets, unsecured claims may be satisfied at less
than 100% of their face value and the equity interests of the Company's
shareholders may have no value. The Company believes the DIP Facility or, if
consummated the DIP to Exit Facility should provide the Company with adequate
liquidity to conduct its business while it prepares a reorganization plan.
However, the Company's liquidity, capital resources, results of operations and
ability to continue as a going concern are subject to known and unknown risks
and uncertainties, including those set forth above under "Safe Harbor Statement
Under The Private Securities Litigation Reform Act of 1995."

RESULTS OF OPERATIONS

Fiscal Year Ended January 2, 2000 Compared to Fiscal Year Ended January 3,
1999

The Company's consolidated statements of operations presentation changed in
fiscal 1997 to disclose the financial statement impact of the inventory
liquidations associated with the closed facilities as a result of restructuring
and remerchandising activities. The line item "Closed facilities" represents
activity specifically identifiable to inventory liquidations conducted in
conjunction with (1) the Company's restructuring plan adopted on March 25, 1997
("Restructuring Plan"); (2) the Company's rationalization plan adopted on March
8, 1999 ("Rationalization Plan") and (3) exiting the computer, infant, pet
supply and other merchandise categories and certain components of the wireless
communication and sporting goods categories as part of a remerchandising
program. As of January 2, 2000, primarily all of the aforementioned merchandise
categories have been liquidated. All activity for these items is classified in
"Closed facilities." Prior year amounts reflect operating results for these same
facilities and merchandise classifications. Selling, general and administrative
expenses for closed facilities do not include any allocation of corporate
overhead.

The Company's business is highly seasonal with a significant portion of its
sales occurring in the fourth quarter. Fourth quarter net sales accounted for
37.4% and 40.6% of total net sales in fiscal 1999 and 1998, respectively.

The Company maintains its books using a 52/53 week year ending on the
Sunday closest to the end of the calendar year. There were 52 weeks in the
fiscal years ended January 2, 2000 and December 28, 1997. There were 53 weeks in
the fiscal year ended January 3, 1999. In the fourth quarter of fiscal 1999,
there were 13 reporting weeks. All previous quarters in fiscal years 1999, 1998
and 1997 were also reported on a 13 week basis, other than the fourth quarter of
fiscal 1998, which was reported on a 14 week basis.

Net Sales

Total net sales for the Company were $2.23 billion in fiscal 1999 compared
to $3.17 billion in fiscal 1998. The decline in net sales was primarily due to
the closure of 127 stores as a result of the restructuring and remerchandising
activities and out of stock levels associated with procurement difficulties
encountered prior to the Chapter 11 filings.

Net sales from operations excluding closed facilities were $2.0 billion for
fiscal 1999 compared to $2.3 billion for fiscal 1998, a decrease of $285.0
million or 12.6%. Jewelry comparable store sales increased 1.1%, while hardline
comparable store sales decreased 12.0%. Increases in jewelry sales were offset
by sales decreases in electronics, toys and kids, and fitness/sports.

Net sales from closed facilities were $0.3 billion for fiscal 1999 compared
to $0.9 billion for fiscal 1998. Sales from closed facilities decreased
primarily due to closing 127 under performing stores in fiscal 1999, as compared
to nine under performing stores in fiscal 1998.

Gross Margin

In fiscal 1999, gross margin was $494.6 million as compared to $754.3
million in fiscal 1998. The decrease in gross margin dollars was primarily due
to a decline in sales.

17
<PAGE> 19

Gross margin after cost of merchandise sold and buying and occupancy
expenses and excluding closed facilities was $493.7 million, or 25.1% of net
sales from operations excluding closed facilities for fiscal 1999, compared to
$565.5 million, or 25.1% of net sales from operations excluding closed
facilities for fiscal 1998. The decline in gross margin was primarily due to out
of stock levels associated with procurement difficulties encountered prior to
the Chapter 11 filings, which the Company believes adversely affected sales and
gross margin.

Gross margin for closed facilities, after cost of merchandise sold and
buying and occupancy expenses, was $0.8 million, or 0.3% of sales of these
facilities in fiscal 1999 as compared to gross margin of $188.8 million or 20.7%
in fiscal 1998. The decrease in both gross margin dollars and rate was due to
the volume of inventory liquidation and merchandise discounts offered in
liquidating inventories at the 127 under performing stores closed in fiscal 1999
as compared to nine stores closed in fiscal 1998.

Selling, General and Administrative Expenses

Selling, general and administrative expenses declined $128.3 million in
fiscal 1999 to $580.8 million from $709.1 million in fiscal 1998. The $128.3
million decline was primarily due to store closures, corporate downsizing and
overhead reduction efforts.

Selling, general and administrative expenses were $483.9 million, or 24.6%
of net sales from operations excluding closed facilities for fiscal 1999
compared to $552.0 million, or 24.6% of net sales from operations excluding
closed facilities for fiscal 1998. The decrease was primarily attributable to a
$33.0 million decrease in employment costs and a $35.1 million decrease in other
selling, general and administrative expenses primarily due to corporate
downsizing and overhead reduction efforts.

Selling, general and administrative expenses for closed facilities were
$96.9 million, or 37.3% of net sales from operations for closed facilities for
fiscal 1999 compared to $157.1 million, or 17.2% of net sales from operations
for closed facilities for fiscal 1998. The decrease was primarily attributable
to a $63.5 million decrease in employment costs offset by a $3.3 million
increase in other selling, general and administrative expenses primarily due to
store closures.

Other Income

Other income increased $25.5 million in fiscal 1999 to $38.4 million from
$12.9 million in fiscal 1998. The increase was primarily due to gains on the
sale of owned and leased properties.

Depreciation and Amortization

Depreciation and amortization on owned and leased property and equipment
was $42.6 million for fiscal 1999 as compared to $57.1 million for fiscal 1998,
a decrease of 25.4% primarily due to store closures and lower capital
expenditures. Capital expenditures, excluding capitalized leases, decreased to
$23.0 million in fiscal 1999 as compared to $50.7 million in fiscal 1998.

Reorganization Items

Reorganization items represent expenses incurred by the Company resulting
from the Chapter 11 Cases specific to the reorganization process. For the fiscal
year ended January 2, 2000, the Company recorded net reorganization items
(income) of $1.8 million. Reorganization items include expenses of $18.4 million
for professional fees, $11.8 million related to store closing costs, $9.8
million associated with the loss on disposal of assets, and other administrative
items of $4.2 million, partially offset by income of $46.0 million associated
with the reduction of accrued rent for rejected leases.

Interest Expense

Interest expense on debt and capitalized leases decreased to $64.8 million
in fiscal 1999 from $83.3 million in fiscal 1998. As a result of the filing of
the Chapter 11 Cases, the Company ceased accruing interest on the 8 3/8% Senior
Notes and 9% Senior Subordinated Debentures on March 16, 1999.
18
<PAGE> 20

Extraordinary Item

An extraordinary loss on the early extinguishment of debt was recorded in
the amount of $7.9 million during the first quarter ended April 4, 1999. This
charge related to the write-off of deferred financing charges paid in
conjunction with the Company's prior Amended and Restated Credit Facility and
Second Amended and Restated Credit Facility upon the consummation of the DIP
Facility.

Cumulative Effect of a Change in Accounting Principle

The Company changed its method of accounting for layaway sales during
fiscal 1999. The cumulative effect of the change for periods prior to fiscal
1999 is an increase in net loss of $6.6 million or ($0.07) per share. Layaway
sales for 1999 have been recognized upon delivery of merchandise to the
customer. Layaway sales in prior years were recognized when the initial layaway
deposit was received. The Company changed its method of accounting for layaway
sales in response to the Securities and Exchange Commission's Staff Accounting
Bulletin: No. 101 -- Revenue Recognition In Financial Statements.

Income Tax

The Company recognized an income tax benefit of $0.9 million for fiscal
1999 compared to $0.1 million for fiscal 1998. The Company has recorded a full
valuation allowance on net deferred tax assets because realization of such
assets in the future is uncertain.

Restructuring Plan

On March 25, 1997, the Company adopted a business restructuring plan to
close up to 60 under performing stores and one distribution center (the "1997
Restructuring Plan"). As a result, a pre-tax charge of $129.5 million for
restructuring costs was recorded in the first quarter of fiscal 1997. The
components of the restructuring charge and an analysis of the amounts charged
against the accrual for the fiscal year ended January 2, 2000 are outlined in
the following table:

<TABLE>
<CAPTION>
ACCRUED 1999 ACTIVITY ACCRUED
RESTRUCTURING --------------------------------------- RESTRUCTURING
COSTS AS OF RESTRUCTURING ASSET CHANGE IN COSTS AS OF
JANUARY 3, 1999 COSTS PAID WRITE-DOWNS ESTIMATE JANUARY 2, 2000
--------------- ------------- ----------- --------- ---------------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Lease termination and other real
estate costs.................... $53,161 $(1,780) $ -- $(43,487) $7,894
Property and equipment
write-downs..................... -- -- 2,489 (2,489) --
------- ------- ------ -------- ------
Total.................... $53,161 $(1,780) $2,489 $(45,976) $7,894
======= ======= ====== ======== ======
</TABLE>

Note: The Accrued Restructuring Costs as of January 2, 2000 are included in
liabilities subject to compromise.

The closing of nine stores during the first half of fiscal 1998 brought the
total number of closures, in accordance with the 1997 Restructuring Plan, to 53
stores and one distribution center. Store closures were completed as of May
1998. The Company closed less than 60 stores primarily due to the inability to
negotiate acceptable exit terms from the related lessors.

Restructuring costs paid during the fiscal year ended January 2, 2000,
relate primarily to lease termination and other real estate costs. The Company
paid $1.1 million in contractual rent payments and lease termination fees and
$0.6 million in other real estate costs primarily related to utilities, common
area maintenance fees, real estate taxes and brokerage costs.

In connection with the Chapter 11 Cases, an initial change in estimate of
$46.0 million was made to reflect the reduction allowed under Section 502(b)(6)
of the Bankruptcy Code and recorded as a reorganization item. Amounts had been
accrued according to the remaining leasehold obligations. Section 502(b)(6)
limits a lessor's claim to the rent reserved by such lease, without
acceleration, for the greater of one year, or 15 percent of the remaining lease,
not to exceed three years. Any unpaid rent is included in the

19
<PAGE> 21

claim. Partially offsetting this reduction was a $2.5 million increase in
estimate, resulting in a net change in estimate at January 2, 2000 of $43.5
million related to lease termination and other real estate costs.

The leases remaining on closed locations as of January 2, 2000 vary in
length with expiration dates ranging from January 2000 to October 2018.

As of January 2, 2000, property and equipment associated with the 1997
Restructuring Plan have been written-down to reflect their estimated fair value.
The Company anticipates selling or abandoning substantially all remaining owned
property and equipment associated with the 1997 Restructuring Plan.
Approximately 3,000 employees were terminated pursuant to the 1997 Restructuring
Plan. All such terminations were completed as of May 1998.

Rationalization Plan

In February 1999, the Company announced a rationalization plan to close up
to 132 stores, up to four distribution centers and to reduce corporate overhead
(the "Rationalization Plan"). On March 8, 1999, as part of the Rationalization
Plan and prior to the filing of the involuntary bankruptcy petition, the Board
of Directors approved the adoption of a business restructuring plan to close 106
stores, to close the Dallas distribution center and to reduce the Company's
workforce at its Nashville corporate offices by 150 employees. As a result, a
pre-tax charge of $99.5 million for restructuring costs was recorded in the
first quarter of 1999. On March 29, 1999 and in connection with the Chapter 11
Cases, store leases under this plan were approved for rejection by the
Bankruptcy Court. The components of the restructuring charge and the amounts
charged against the accrual through fiscal year ended January 2, 2000 are
outlined in the following table.

<TABLE>
<CAPTION>
1999 ACTIVITY
INITIAL CHARGE ------------------------------------ ACCRUED
RECORDED IN ASSET CHANGE IN COSTS AS OF
MARCH 1999 COSTS PAID WRITE-DOWNS ESTIMATE JANUARY 2, 2000
-------------- ---------- ----------- --------- ---------------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Lease termination and other real
estate costs....................... $62,469 $ (9,297) $ -- $(14,857) $38,315
Property and equipment write-downs... 24,452 -- (19,298) (5,154) --
Employee severance................... 12,533 (9,237) -- (2,818) 478
------- -------- -------- -------- -------
Total....................... $99,454 $(18,534) $(19,298) $(22,829) $38,793
======= ======== ======== ======== =======
</TABLE>

Note: The Accrued Costs as of January 2, 2000 are included in liabilities
subject to compromise.

The stores planned for closure included both owned and leased properties.
Lease termination and other real estate costs consist principally of the
remaining rental payments required under the closing stores' and distribution
center's lease agreements under Section 502(b)(6) of the Bankruptcy Code, net of
any actual or reasonably probable sublease income. Section 502(b)(6) limits the
lessor's claim to the rent reserved by such lease, without acceleration, for the
greater of one year, or 15 percent of the remaining term of the lease, not to
exceed three years. Any unpaid rent is included in the claim. The Company
experienced lower than expected expenses in lease terminations, dispositions of
closed stores and severance payments during the fiscal year ended January 2,
2000. As a result, the Company reduced its estimate for these costs by $23.0
million.

Restructuring costs paid during the fiscal year ended January 2, 2000,
relate primarily to lease termination and other real estate costs. The Company
incurred $2.3 million in contractual rent payments and lease termination fees,
$7.0 million in other real estate costs primarily related to utilities, common
area maintenance fees, real estate taxes and brokerage costs, and $9.2 million
in severance costs.

After taking into effect the above asset write-downs, the Company's
carrying value of the property and equipment associated with the Rationalization
Plan closures is $1.8 million as of January 2, 2000. This entire amount is
classified as available for sale as all store closures are now complete. Assets
available for sale are considered current assets and are included with "Prepaid
expenses and other assets." The Company anticipates selling substantially all
owned property and equipment associated with the closed stores.

20
<PAGE> 22

The employee severance provision was recorded for the planned termination
of approximately 4,400 employees associated with the closures, as well as the
reduction of corporate overhead. Substantially all such terminations were
completed as of December 1999.

Fiscal Year Ended January 3, 1999 Compared to Fiscal Year Ended December 28,
1997

Net loss for fiscal 1998 was $110.3 million, or $1.11 per share, compared
to net loss of $91.6 million, or $0.92 per share, for the year ended December
28, 1997 ("fiscal 1997"). The increase in net loss was primarily a result of
decreased net sales and a $43.1 million impairment loss with respect to certain
fixed assets.

Net Sales

Net sales were $3.17 billion for fiscal 1998 compared to $3.66 billion for
fiscal 1997. The decrease of $493.3 million or 13.5%, was the result of an 8.9%
decline in comparable store sales and a decline in net sales from closed
facilities of $311.1 million due to the closure of 53 under performing stores
during 1997 and 1998. Net sales from operations excluding closed facilities were
$2.26 billion for fiscal 1998 compared to $2.44 billion for fiscal 1997, a
decrease of $182.2 million or 7.5%. Comparable store sales declined 8.9%.
Jewelry comparable store sales increased 3.6%. Improvements in gold sales,
jewelry special sales events and warranty sales were offset by sales declines in
watches, diamonds and precious and semi-precious stones.

Hardline comparable store sales were down 13.6%. Sales improvements in
decorative home, seasonal, telephone, home furnishing and photo categories were
offset by sales declines in sporting and fitness, toys, small appliances,
housewares, audio and home office equipment.

Net sales from closed facilities were $913.9 million for fiscal 1998
compared to $1.2 billion for fiscal 1997. Sales from closed facilities for
fiscal 1998 decreased from fiscal 1997 due to store closures.

Gross Margin

In fiscal 1998, gross margin was $754.3 million as compared to $851.0
million in fiscal 1997. The decrease in gross margin dollars was primarily due
to the overall decline in sales.

Gross margin after cost of merchandise sold and buying and occupancy
expenses and excluding closed facilities decreased to $565.5 million, or 25.1%
of net sales from operations excluding closed facilities for fiscal 1998,
compared to $620.1 million, or 25.4% of net sales from operations excluding
closed facilities for fiscal 1997. The reduced gross margin rate reflects a
$14.7 million write-down lowering discontinued inventory items to their net
realizable value and competition induced price mark-downs, partially offset by a
shift to a higher margin merchandise assortment.

Gross margin after cost of merchandise sold and buying and occupancy
expenses, for closed facilities was $188.8 million, or 20.7% of sales from
closed facilities for fiscal 1998 as compared to $230.9 million, or 18.9% of
sales from closed facilities for fiscal 1997. The decrease in gross margin was
due to store closures.

Selling, General and Administrative Expenses

Selling, general and administrative expenses declined $20.5 million in
fiscal 1998 to $709.1 million from $729.6 million in fiscal 1997. The $20.5
million decline was primarily due to store closures and favorable results from
the private label credit card.

Selling, general and administrative expenses of operations excluding closed
facilities were $552.0 million, or 24.5% of sales from operations excluding
closed facilities for fiscal 1998 compared to $516.6 million, or 21.2% of sales
from operations excluding closed facilities for fiscal 1997. The increase in
selling, general and administrative expenses was primarily attributable to an
increase in legal and consulting expenses of operations excluding closed
facilities as a result of restructuring and remerchandising activities incurred
primarily in the third and fourth quarters of fiscal 1998. This increase as a
percent of sales was partially offset by income of $19.6 million recognized from
the private label credit card program.

21
<PAGE> 23

Selling, general and administrative expenses for closed facilities were
$157.1 million for fiscal 1998 compared to $213.0 million in fiscal 1997. The
closing of the 44 underperforming stores completed in July 1997 resulted in the
decreased selling, general and administrative costs for fiscal 1998.

Depreciation and Amortization

Depreciation and amortization on owned and leased property and equipment
was $57.1 million for fiscal 1998 as compared to $58.2 million for fiscal 1997,
a decrease of 2.0%. Capital expenditures, excluding capitalized leases,
increased to $50.7 million in fiscal 1998 as compared to $40.8 million in fiscal
1997. The Company closed a net 11 stores in fiscal 1998 as compared to closing a
net 40 stores (including the 44 under performing stores) in fiscal 1997.

Interest Expense

Interest expense on debt and capitalized leases increased to $83.3 million
in fiscal 1998 from $78.5 million in fiscal 1997. Interest expense for the year
increased primarily due to the term loan being outstanding for the full year
partially offset by lower average borrowings against the revolver under the
Amended and Restated Credit Facility.

Income Tax

The Company recognized an income tax benefit of $0.1 million for fiscal
1998 compared to $53.4 million for fiscal 1997. The decrease in the benefit was
primarily due to the recording of a full valuation allowance against deferred
tax assets of $48.1 million. The effective income tax rate was reduced to 0.1%
for fiscal 1998 compared to 37.5% for fiscal 1997.

Restructuring Plan

The closing of nine stores during the first half of fiscal 1998 brought the
total number of closures in accordance with the 1997 Restructuring Plan to 53
stores and one distribution center. Store closures related to the 1997
Restructuring Plan were completed in May 1998. Impairment charges recognized on
the nine stores closed in fiscal 1998 were $5.2 million. The components of the
restructuring charges and an analysis of the amounts charged against the accrual
during fiscal 1998 are outlined in the following table:

<TABLE>
<CAPTION>
ACCRUED 1998 ACTIVITY ACCRUED
RESTRUCTURING --------------------------------------- RESTRUCTURING
COSTS AS OF RESTRUCTURING ASSET CHANGE IN COSTS AS OF
DECEMBER 28, 1997 COSTS PAID WRITE-DOWNS ESTIMATE JANUARY 3, 1999
----------------- ------------- ----------- --------- ---------------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Lease termination and
other real estate
costs................. $73,511 $(13,737) $ -- $ (6,613) $53,161
Property and equipment
write-downs........... -- -- 5,706 (5,706) --
Employee severance...... 531 (155) -- (376) --
Other exit costs........ 2,200 -- -- (2,200) --
------- -------- ------ -------- -------
Total......... $76,242 $(13,892) $5,706 $(14,895) 53,161
======= ======== ====== ======== =======
Less: Current
portion..... (7,864)
-------
$45,297
=======
</TABLE>

The 1997 Restructuring Plan adopted by the Company in 1997 was for the
closure of up to 60 stores and one distribution center. The Company closed less
than 60 stores primarily due to the inability to negotiate acceptable exit terms
from the related lessors. Restructuring costs paid during fiscal 1998 relate
primarily to lease termination and other real estate costs. Lease termination
and other real estate costs consist principally of the remaining rental payments
required under the closing stores' lease agreements, net of any actual or
reasonably probable sublease income, as well as early termination costs. The
leases remaining on closed
22
<PAGE> 24

locations as of January 3, 1999 vary in length with expiration dates ranging
from February 1999 to December 2030.

Changes in estimates are representative of conditions existing as of
January 3, 1999. Due to favorable lease termination experience in the second
half of fiscal 1998 and favorable experience related to the sale of property and
equipment associated with the store closures, restructure reserves of $14.9
million were reversed in the fourth quarter of fiscal 1998.

The 1997 Restructuring Plan was based on an analysis of individual store
performance based on cash flow return on committed capital, suitability within
marketing demographic profiles and strategic geographic positioning. After the
effect of charges and costs related specifically to the closings, the immediate
ongoing impact of the closings on net income was insignificant as the stores
closed were near break-even contributors.

During the second quarter of fiscal 1997, the Company also began
implementing certain remerchandising strategies, including the exit of the low
margin computer business and certain components of the wireless communication
business. Additional remerchandising decisions were executed in the first
quarter of fiscal 1998 with the exit of infant and pet supply categories and
certain components of the sporting goods business.

In the third quarter of fiscal 1998, the Company completed the
remerchandising portion of the Restructuring Plan.

Impaired Assets

In the fourth quarter of fiscal 1998, the Company recorded a non-cash
impairment loss of $43.1 million related to a write-down of the Company's fixed
assets. The Company performed a long-lived asset impairment analysis due to
projected cash flow losses combined with current operating and cash flow losses
at certain store locations.

Assets are evaluated for impairment on an individual store basis which
management believes is the lowest level for which there are identifiable cash
flows. Projected future cash flows (undiscounted and without interest) were
compared to the carrying amount of assets at each location. If the carrying
amount of the assets exceeded the projected future cash flows, an impairment
loss was recognized. Impaired assets were written-down to their estimated fair
value. Fair value was based on sales of similar assets or other estimates of
fair value such as discounting estimated future cash flows. Considerable
management judgment is necessary to estimate fair value. Accordingly, actual
results could vary significantly from such estimates.

LIQUIDITY AND CAPITAL RESOURCES

On March 27, 1999, the Debtors filed the Chapter 11 Cases which will affect
the Company's liquidity and capital resources in fiscal 2000. See Item 1.
"Business -- Proceedings Under Chapter 11 of the Bankruptcy Code."

Availability under the Company's bank credit facility, and trade credit and
terms from vendors provided the resources required to support operations,
seasonal working capital requirements and capital expenditures during fiscal
1999. The Company's business is highly seasonal with the Company's inventory
investment and related short-term borrowing requirements reaching a peak prior
to the Christmas season. Historically, positive cash flow from operations has
been generated principally in the latter part of the fourth quarter of each
fiscal year, in line with the seasonal nature of the Company's business.

Net cash provided (used) by operations was $192.6 million for fiscal 1999
as compared to ($291.4) million for fiscal 1998 and ($21.4) million for fiscal
1997. Cash flow from operations increased for fiscal 1999 compared to fiscal
1998 primarily as a result of: (i) reduced disbursements as a result of the
bankruptcy filing and the concomitant reclassification of pre-petition
liabilities to liabilities subject to compromise; (ii) cash generated from the
liquidation of inventory as a result of store closings; and (iii) improved
vendor terms, resulting in higher post petition accounts payable balances. Cash
flow from operations decreased for fiscal 1998 compared to fiscal 1997 as a
result of: (i) decreased earnings attributable in part to cash payments related
to restructuring and remerchandising activities; (ii) reductions in accounts
payable due to decreased

23
<PAGE> 25

purchase volumes as a result of the store closings, a negotiated contraction in
payment terms in exchange for revised economics with certain vendors, aggressive
use of anticipation discounts or cash in advance payments at year-end and
changes in merchandise mix which changed the average terms. These factors were
partially offset by inventory liquidations associated with the closing stores.

Net cash provided (used) by investing activities was $39.8 million, ($36.2)
million, and ($23.3) million for fiscal 1999, 1998, and 1997, respectively. Cash
provided in fiscal 1999 by investing activities resulted primarily from proceeds
from the sale of real estate assets offset by capital spending.

Net cash provided (used) by financing activities was ($304.6) million,
$97.1 million and $78.9 million for fiscal 1999, 1998, and 1997, respectively.
Cash provided in fiscal 1997 from financing activities reflected a $200 million
term loan obtained in connection with the completion of the Company's $900.0
million, five-year Amended and Restated Credit Facility in the third quarter of
fiscal 1997. This was partially offset by the retirement of $86.2 million of
Senior Notes due 2001 and $17.4 million of debt issuance costs incurred
primarily for the Amended and Restated Credit Facility. Additionally, the
Company paid $15.8 million in mortgage payments including both prepayments and
regularly scheduled payments. In fiscal 1998, cash provided by financing
activities reflected $156.0 million in net short-term borrowings. In fiscal
1999, cash used in financing activities of $304.6 million went towards paying
down the Company's total debts.

Capital Expenditures

Capital expenditures in fiscal 1999 and 1998 related primarily to
information systems improvements, capital maintenance, remodeling of certain
stores and new store construction. In fiscal 1999, the Company opened one store
and closed 128 stores, including 106 under performing stores as part of the
Rationalization Plan, as compared to the opening of six stores and closing of 17
stores in fiscal 1998. In fiscal 1997, the Company opened five stores and closed
45 stores.

Planned capital expenditures for fiscal 2000 are expected to be
approximately $65.0 million and are expected to be directed primarily to store
remodels, capital maintenance, and information systems improvements. The Company
expects to fund these planned expenditures primarily with borrowings under the
DIP to Exit Facility and with cash flows from operations including proceeds from
inventory clearance sales related to exited categories, subject to Bankruptcy
Court approval.

Capital Structure

The Company's principal sources of liquidity during fiscal 1999 were
borrowings under the DIP Facility, which included a $100.0 million term loan and
a revolving credit facility with a maximum commitment level of $650.0 million
and terms from vendors. At January 2, 2000, the Company had $42.9 million in
revolving loans outstanding under the DIP Facility. The Company had $156.0
million in revolving loans outstanding on January 3, 1999.

Average short-term borrowings for fiscal 1999 increased to $157.2 million
as compared to $55.0 million for fiscal 1998, due primarily to reductions in
term loan amounts. Short-term borrowings under the revolver portion of the DIP
Facility reached a maximum of $382.2 million during fiscal 1999 as compared to
$298.8 million in fiscal 1998.

Total debt as a percentage of total capital for fiscal 1999 was 102.9% as
compared to 79.8% in fiscal 1998 and 70.2% in fiscal 1997. The 1999 figure
exceeds 100% as a result of the shareholder's equity deficit.

On December 15, 1998, the Company announced that it had not made the
approximately $13.5 million interest payment due December 15, 1998 on its 9%
Subordinated Debentures. The related indenture provides for a 30 day grace
period. The Company stated that it would evaluate available alternatives during
that period. The Company obtained a 30 day waiver with respect to any cross
default under the Amended and Restated Credit Facility with respect to the
failure to make the December 15, 1998 interest payment. The non-payment of the
interest on the 9% Subordinated Debentures was a default under the Amended and
Restated Credit Facility and the Company's operating performance, absent a
waiver, would have resulted in a breach of the fixed-charge coverage ratio
covenants in agreements with First American National Bank and the Canadian
24
<PAGE> 26

Imperial Bank of Commerce. On January 14, 1999, the Company made the
approximately $13.5 million interest payment on the 9% Subordinated Debentures.

As a first step in an effort to effect an out-of-court restructuring plan,
on January 20, 1999, the Company completed the Second Amended and Restated
Credit Facility, a $750.0 million, 30 month, asset-based credit facility
replacing the Amended and Restated Credit Facility. The Second Amended and
Restated Credit Facility included $150.0 million in term loans and a maximum of
$600.0 million in revolving loans. Financial covenants were subject to amendment
pending the finalization of the Company's business plan. The Second Amended and
Restated Credit Facility included a $200.0 million sub-facility for standby and
trade letters of credit. Interest rates on the Second Amended and Restated
Credit Facility were based on either Prime Rate + 1.50% or Eurodollar + 2.75%.
The Second Amended and Restated Credit Facility was secured by all material
unencumbered assets of the Company, including inventory but excluding previously
mortgaged property and leasehold interests.

Borrowings under the Second Amended and Restated Credit Facility were
limited based on a borrowing base formula which considered eligible inventories,
eligible accounts receivable and mortgage values on eligible real properties,
and limitations contained in the Company's public senior subordinated debt
indenture. The Second Amended and Restated Credit Facility contained certain
restrictive covenants, the most restrictive of which included: (a) maintenance
of an EBITDA amount, (b) restrictions on dividends and the incurrence of
additional indebtedness, (c) restrictions on incurring and assuming liens on
property or assets, (d) restrictions on mergers, consolidations, and sales of
assets, and (e) a capital spending maximum of $50.0 million annually.
Additionally, the Second Amended and Restated Credit Facility required
borrowings outstanding under the revolving loans to be less than an amount to be
specified at a later date for a period of 30 consecutive days each year. From
the date of its completion through the filing of the Chapter 11 Cases and
completion of the DIP Facility, availability under the Second Amended and
Restated Credit Facility was the Company's primary source of liquidity.

On March 29, 1999, the Company entered into the DIP Facility which replaced
the Second Amended and Restated Credit Facility and which the Company believed
would provide liquidity for the Company's operations while it prepared a
reorganization plan. However, there can be no assurance that the Company will be
able to access liquidity from the DIP Facility or from any other source, or that
such liquidity will be sufficient to meet the Company's needs. On April 27,
1999, the Bankruptcy Court approved the DIP Facility. The DIP facility
terminates no later than June 30, 2001.

Performance against covenants under the DIP Facility is set forth below:

<TABLE>
<CAPTION>
COVENANT THRESHOLD ACTUAL
- -------- ------------- --------------
<S> <C> <C>
A. 1999 Capital Expenditures.......................... $50.0 million $25.6 million
B. Minimum Availability (February 24, 2000)........... $50.0 million $233.2 million
OR
Minimum EBITDA (Period ended January 2, 2000)...... $26.0 million $56.7 million
</TABLE>

Note: EBITDA is calculated as defined in the Second Amendment to the DIP
Facility.

25
<PAGE> 27

The Company believes there will be no restrictions in the DIP to Exit
Facility on the Company's ability to sublease and lease store space pursuant to
the 2000 Business Plan; lease all or part of the corporate headquarters; sell,
pursuant to sale-leasebacks or outright, the corporate headquarters, the Orlando
and/or Montgomery distribution centers; and/or implement a credit card
receivables securitization program. The Company also believes it will retain the
ability to complete intercompany restructurings, intercompany asset transfers
and intercompany/third-party real estate transactions.

Events of default under the Facility are expected to include customary
default provisions as well as key management provisions that would trigger a
default in the event that both the current Chief Executive Officer and President
ceased to be employed, unless at least one of them is replaced by a person
reasonably satisfactory to Fleet within 90 days and/or the acquisition by any
one person or entity of 50 percent of the voting stock of the Company. Closing
of the DIP to Exit Facility is subject to customary closing conditions,
including at least $155.0 million of availability at close and no material
adverse change in the financial condition, operations or assets of the Company
at the time of closing. Conversion of the DIP to Exit Facility to an exit
financing is also expected to be based on customary closing conditions,
including the Agent's reasonable satisfaction with capital structure, plan of
reorganization and any materially revised projections, as well as the
achievement by the Company of a specified trailing 12-month EBITDA (which varies
depending on time of exit) and certain minimum availability (which varies from
$50.0 to $100.0 million) depending on the time of exit.

There can be no assurance that the Company will be able to access liquidity
from the DIP Facility, or consummate and access liquidity from the DIP to Exit
Facility, or from any other source, or that such liquidity will be sufficient to
meet the Company's needs. See "Management Discussion and Analysis of Financial
Conditions and Results of Operations -- Safe Harbor Statement Under the Private
Securities Litigation Reform Act of 1995."

Inflation

The Company does not believe inflation has had a material impact on the
Company's net sales or net earnings (loss) during the last three fiscal years.

26
<PAGE> 28

EFFECT OF NEW ACCOUNTING PRONOUNCEMENTS

In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for
Derivative Instruments and Hedging Activities." This pronouncement was to be
effective for all fiscal quarters of fiscal years beginning after June 15, 1999.
In June 1999, the FASB issued SFAS No. 137, "Accounting for Derivative
Instruments and Hedging Activities -- Deferral of the Effective Date of FASB
Statement No. 133." This pronouncement postpones the effective date of SFAS No.
133 to all fiscal quarters of fiscal years beginning after June 15, 2000. The
Company is currently in the process of analyzing the impact of the adoption of
this Statement.

YEAR 2000 UPDATE

The Year 2000 issue was primarily the result of computer programs using a
two-digit format, as opposed to four digits, to indicate the year. As a result,
such computer systems would be unable to interpret dates beyond the year 1999,
which could have caused a system failure or other computer errors leading to a
disruption in the operation of such systems. In 1997, the Company developed a
strategic plan to update its information systems in order to meet business
needs. As a result of this plan, several major processing systems were replaced
or significantly upgraded during 1998 and 1999, and are, for the most part, Year
2000 compliant, including certain point of sale systems, human resources and
financial reporting systems. The Company's plan devoted the necessary resources
to identify and modify systems potentially impacted by Year 2000, or implement
new systems to become Year 2000 compliant in a timely manner. In 1999, the
Company executed its year 2000 plan as systems potentially impacted by Year 2000
were identified and, if necessary, were modified. In addition, the Company
developed contingency plans for key operational areas that could have been
impacted by the Year 2000 problem. Total expenditures for the Year 2000 plan
were approximately $2.6 million. The Company did not incur any significant Year
2000 issues during, or after, the move into the new calendar year.

27
<PAGE> 29

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

The Company's operations are subject to market risks primarily from changes
in interest rates. The Company has immaterial exposure to exchange rate risk.
The Company has managed its interest rate risk by entering into interest rate
swap agreements and balancing its debt portfolio with both fixed and floating
rate borrowings. As of January 2, 2000, the Company was a party to interest rate
swaps covering $125.0 million in principal amount of indebtedness and expiring
in December 2000. These swaps exchange the Company's floating interest rate
exposure on $125.0 million in debt for fixed interest rate exposure. The Company
will pay a weighted average fixed rate of 5.97% on the $125.0 million notional
amount rather than the three-month LIBOR rate, which was 6.18% as of January 2,
2000. The fair value of the interest rate swap agreements was ($2.3) million as
of January 2, 2000. The following table summarizes as of January 2, 2000, the
amount of fixed interest rate indebtedness and the amount of variable rate
indebtedness that will become due in the stated period. See Note L to the
Consolidated Financial Statements.

CONTRACTUAL MATURITY DATES OF TERM LOAN AND LONG-TERM DEBT AS OF 1/2/00
(INCLUDING CURRENT PORTION)

<TABLE>
<CAPTION>
2000 2001 2002 2003 2004 THEREAFTER TOTAL FAIR VALUE
------- -------- ------- -------- -------- ---------- -------- ----------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Fixed Rate Debt............ $ 5,612 $ 18,382 $ 4,926 $155,389 $158,472 $47,867 $390,648 $109,838
Average interest rate...... 8.91% 8.92% 8.92% 8.91% 8.83% 8.39%
Variable Rate Debt......... 27,667 98,500 12,192 -- -- -- 138,359 137,837
-------- --------
Average interest rate...... 7.94% 7.93% 7.03% --% --% --%
Total Debt........ $33,279 $116,882 $17,118 $155,389 $158,472 $47,867 $529,007 $247,675
======== ========
</TABLE>

EXPECTED MATURITY DATES OF TERM LOAN AND LONG-TERM DEBT AS OF 1/3/99
(INCLUDING CURRENT PORTION)

<TABLE>
<CAPTION>
1999 2000 2001 2002 2003 THEREAFTER TOTAL FAIR VALUE
------- ------- ------- -------- -------- ---------- -------- ----------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Fixed Rate Debt............. $ 3,903 $ 4,417 $18,623 $ 5,074 $155,884 $217,591 $405,492 $164,171
Average interest rate....... 8.96% 8.96% 8.97% 8.97% 9.07% 9.05%
Variable Rate Debt.......... 20,138 17,333 3,962 220,008 0 20,300 281,741 272,010
-------- --------
Average interest rate....... 7.09% 7.19% 7.53% 8.26% 3.72% 3.72%
Total Debt......... $24,041 $21,750 $22,585 $225,082 $155,884 $237,891 $687,233 $436,181
======== ========
</TABLE>

On March 27, 1999, the Debtors filed the Chapter 11 Cases. As a result of
the filing of the Chapter 11 Cases, principal or interest payments may not be
made on any pre-petition debt until a plan of reorganization defining the
repayment terms has been approved by the Bankruptcy Court.

28
<PAGE> 30

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
FISCAL YEAR ENDED
----------------------------------------
JANUARY 2, JANUARY 3, DECEMBER 28,
2000 1999 1997
---------- ---------- ------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C>
Net sales:
Operations excluding closed facilities.................... $1,970,611 $2,255,595 $2,437,792
Closed facilities......................................... 259,889 913,930 1,224,986
---------- ---------- ----------
2,230,500 3,169,525 3,662,778
Cost of merchandise sold and buying and occupancy expenses:
Operations excluding closed facilities.................... 1,476,883 1,690,113 1,817,709
Closed facilities......................................... 259,065 725,143 994,053
---------- ---------- ----------
1,735,948 2,415,256 2,811,762
---------- ---------- ----------
Gross margin after cost of merchandise sold and buying and
occupancy expenses:
Operations excluding closed facilities.................... 493,728 565,482 620,083
Closed facilities......................................... 824 188,787 230,933
---------- ---------- ----------
494,552 754,269 851,016
---------- ---------- ----------
Selling, general and administrative expenses:
Operations excluding closed facilities.................... 483,911 552,016 516,612
Closed facilities......................................... 96,853 157,069 213,018
---------- ---------- ----------
580,764 709,085 729,630
---------- ---------- ----------
Other income, net........................................... (38,402) (12,927) (2,571)
Restructuring charge (credit)............................... 76,743 (14,895) 129,510
Impairment of assets........................................ -- 43,079 --
Depreciation and amortization:
Operations excluding closed facilities.................... 40,063 43,034 41,877
Closed facilities......................................... 2,501 14,038 16,371
---------- ---------- ----------
42,564 57,072 58,248
---------- ---------- ----------
Reorganization items (income)............................... (1,823) -- --
---------- ---------- ----------
Loss before interest, income tax, extraordinary item, and
cumulative effect of a change in accounting principle..... (165,294) (27,145) (63,801)
Interest expense (contractual interest $87,360 for the year
ended January 2, 2000).................................... 64,835 83,255 78,531
---------- ---------- ----------
Loss before income tax, extraordinary item, and cumulative
effect of a change in accounting principle................ (230,129) (110,400) (142,332)
Income tax benefit.......................................... (874) (93) (53,375)
---------- ---------- ----------
Loss before extraordinary item and cumulative effect of a
change in accounting principle............................ (229,255) (110,307) (88,957)
Extraordinary loss from early extinguishment of debt........ (7,851) -- (2,643)
Cumulative effect of a change in recording layaway sales.... (6,566) -- --
---------- ---------- ----------
Net loss.................................................... $ (243,672) $ (110,307) $ (91,600)
========== ========== ==========
Loss Per Common Share -- basic and diluted:
Loss before extraordinary item and cumulative effect of a
change in accounting principle............................ $ (2.30) $ (1.11) $ (0.89)
Extraordinary loss from early extinguishment of debt........ (0.08) -- (0.03)
Cumulative effect of a change in recording layaway sales.... (0.07) -- --
---------- ---------- ----------
Net loss.................................................... $ (2.45) $ (1.11) $ (0.92)
========== ========== ==========
Pro forma amounts assuming the new layaway sales recognition
is applied retroactively:
Loss before extraordinary item.............................. $ (229,255) $ (109,078) $ (84,888)
Loss per common share -- basic and diluted.................. $ (2.30) $ (1.09) $ (0.85)
Net loss.................................................... $ (237,106) $ (109,078) $ (87,531)
Loss per common share -- basic and diluted.................. $ (2.38) $ (1.09) $ (0.88)
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.
29
<PAGE> 31

SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
JANUARY 2, JANUARY 3,
2000 1999
---------- ----------
(IN THOUSANDS,
EXCEPT PER SHARE DATA)
<S> <C> <C>
ASSETS
Current Assets:
Cash and cash equivalents................................. $ 61,591 $ 133,749
Accounts receivable, net of allowance of $19,474 and
$2,999, respectively................................... 13,171 38,098
Refundable income taxes................................... -- 10,769
Inventories............................................... 642,997 896,303
Prepaid expenses and other assets......................... 29,135 24,379
---------- ----------
TOTAL CURRENT ASSETS.............................. 746,894 1,103,298
Net property and equipment -- owned......................... 353,078 439,710
Net property and equipment -- leased........................ 14,636 21,297
Other assets and deferred charges........................... 47,336 62,590
---------- ----------
TOTAL ASSETS...................................... $1,161,944 $1,626,895
========== ==========
LIABILITIES AND SHAREHOLDERS' (DEFICIT) EQUITY
Liabilities Not Subject To Compromise
Current Liabilities:
Notes payable............................................. $ 42,977 $ 156,000
Accounts payable.......................................... 67,318 228,373
Accrued expenses.......................................... 181,860 224,813
State and local sales taxes............................... 28,737 1,726
Accrued restructuring costs............................... 38 7,864
Borrowings classified as current.......................... 1,000 220,041
Current maturities of capitalized lease obligations....... 86 8,501
---------- ----------
TOTAL CURRENT LIABILITIES......................... 322,016 847,318
Long Term Liabilities:
Accrued restructuring costs............................... -- 45,297
Long-term debt............................................ 98,500 467,192
Capitalized lease obligations............................. 2,514 41,193
---------- ----------
TOTAL LONG-TERM LIABILITIES....................... 101,014 553,682
Liabilities Subject To Compromise........................... 755,975 --
---------- ----------
TOTAL LIABILITIES................................. 1,179,005 1,401,000
---------- ----------
Commitments and contingencies (Note R)
SHAREHOLDERS' (DEFICIT) EQUITY
Preferred stock, $1 par value, authorized, 4,600 shares,
undesignated as to rate and other rights, none
issued................................................. -- --
Series A Junior Preferred Stock, $1 par value, authorized
1,100 shares, none issued.............................. -- --
Common stock, $.50 par value, authorized 500,000 shares,
issued and outstanding 100,012 and 100,340 shares,
respectively........................................... 50,006 50,170
Additional paid-in capital................................ 6,424 7,680
Deferred compensation..................................... (708) (1,975)
Accumulated other comprehensive loss...................... -- (869)
Retained (deficit) earnings............................... (72,783) 170,889
---------- ----------
TOTAL SHAREHOLDERS' (DEFICIT) EQUITY.............. (17,061) 225,895
---------- ----------
TOTAL LIABILITIES AND SHAREHOLDERS' (DEFICIT)
EQUITY.......................................... $1,161,944 $1,626,895
========== ==========
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.
30
<PAGE> 32

SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' (DEFICIT) EQUITY

<TABLE>
<CAPTION>
ACCUMULATED
COMMON STOCK OTHER
----------------- ADDITIONAL COMPREHENSIVE RETAINED
COMMON PAR PAID-IN DEFERRED INCOME (DEFICIT)
SHARES VALUE CAPITAL COMPENSATION (LOSS) EARNINGS TOTAL
------- ------- ---------- ------------ ------------- --------- ---------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE DECEMBER 29, 1996.......... 99,758 $49,879 $ 5,670 $(1,251) $ -- $ 372,796 $ 427,094
Net loss......................... -- -- -- -- -- (91,600) (91,600)
Exercise of stock options........ 57 29 75 -- -- -- 104
Shares issued under restricted
stock awards................... 621 310 2,393 (2,703) -- -- --
Amortization of deferred
compensation................... -- -- -- 948 -- -- 948
Cancellation/forfeiture of
restricted stock............... (60) (30) (230) 219 -- -- (41)
------- ------- ------- ------- ----- --------- ---------
BALANCE DECEMBER 28, 1997.......... 100,376 50,188 7,908 (2,787) -- 281,196 336,505
Comprehensive loss:
Net loss....................... -- -- -- -- -- (110,307) (110,307)
Minimum pension liability
adjustment................... -- -- -- -- (869) -- (869)
---------
Comprehensive net loss......... (111,176)
Shares issued under restricted
stock awards................... 50 25 83 (108) -- -- --
Amortization of deferred
compensation................... -- -- -- 625 -- -- 625
Cancellation/forfeiture of
restricted stock............... (86) (43) (311) 295 -- -- (59)
------- ------- ------- ------- ----- --------- ---------
BALANCE JANUARY 3, 1999............ 100,340 50,170 7,680 (1,975) (869) 170,889 225,895
Comprehensive loss:
Net loss....................... -- -- -- -- -- (243,672) (243,672)
Minimum pension liability
adjustment................... -- -- -- -- 869 -- 869
---------
Comprehensive net loss......... (242,803)
Amortization of deferred
compensation................... -- -- -- 356 -- -- 356
Cancellation/forfeiture of
restricted stock............... (328) (164) (1,256) 911 -- -- (509)
------- ------- ------- ------- ----- --------- ---------
BALANCE JANUARY 2, 2000............ 100,012 $50,006 $ 6,424 $ (708) $ -- $ (72,783) $ (17,061)
======= ======= ======= ======= ===== ========= =========
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.
31
<PAGE> 33

SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
FISCAL YEAR ENDED
--------------------------------------
JANUARY 2, JANUARY 3, DECEMBER 28,
2000 1999 1997
---------- ---------- ------------
(IN THOUSANDS)
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss.................................................. $(243,672) $(110,307) $ (91,600)
Adjustments to reconcile net loss to net cash
Provided (used) by operating activities:
Extraordinary loss from early extinguishment of debt... 7,851 -- --
Cumulative effect of a change in accounting
principle -- layaway sales........................... 6,566 -- --
Depreciation and amortization(a)....................... 57,059 63,820 62,345
Deferred income tax.................................... -- 24,303 (39,663)
Provision for write-off of bad debts................... 17,810 (457) --
Net gain on sale of property and equipment............. (19,567) (12,927) (2,571)
Provision for write-down of restricted cash............ 8,819 -- --
Write-down of property and equipment due to asset
impairment........................................... -- 43,079 --
Write-down of property and equipment due to
restructuring........................................ 16,809 -- 32,915
Reorganization items................................... (1,823) -- --
Reversal of restructuring charges...................... -- (14,895) --
Write-off of debt issue costs.......................... -- -- 2,208
Changes in assets and liabilities:
Accounts receivable.................................. (6,358) 5,489 18,324
Inventories.......................................... 256,800 33,515 123,151
Prepaid expenses and other assets.................... 3,644 (7,576) (1,368)
Accounts payable..................................... 28,822 (253,862) (157,652)
Accrued expenses..................................... 19,178 (36,872) (9,866)
Accrued restructuring costs.......................... 29,932 (13,892) 76,242
Income tax........................................... 10,769 (10,769) (33,898)
--------- --------- ---------
NET CASH PROVIDED (USED) BY OPERATING ACTIVITIES:.... 192,639 (291,351) (21,433)
--------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Additions to property and equipment -- owned.............. (22,957) (50,676) (40,838)
Proceeds from sale of property and equipment.............. 49,434 44,845 19,574
Proceeds from sale of property and
equipment -- reorganization............................ 4,592 -- --
Restricted cash and other assets, net..................... 8,769 (30,358) (2,006)
--------- --------- ---------
NET CASH PROVIDED (USED) BY INVESTING ACTIVITIES:.... 39,838 (36,189) (23,270)
--------- --------- ---------
</TABLE>

32
<PAGE> 34
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

CONSOLIDATED STATEMENTS OF CASH FLOWS -- (CONTINUED)

- ---------------
(a) Includes other amortization classified as either selling, general and
administrative expense or interest expense of $14,495 for fiscal 1999,
$6,748 for fiscal 1998, $4,058 for fiscal 1997, and $39 of discount
amortization classified as interest expense in fiscal 1997.

The accompanying notes are an integral part of these consolidated financial
statements.
33
<PAGE> 35

SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE YEARS ENDED JANUARY 2, 2000

A. DESCRIPTION OF THE BUSINESS

The Company is one of the nation's largest retailers of jewelry and offers
a selection of brand-name hard goods and other product lines. The major
categories of goods offered by the Company are fine jewelry, kitchen and dining,
home accents and furniture, looking healthy/staying healthy, season to season,
travel and adventure, electronics and kid essentials. Customer purchases
typically take place in a Company store, by telephone, or via the internet. The
Company is engaged in a highly competitive business and competes with most
nationally known jewelry and general retail merchandisers, including department,
general merchandise, specialty and discount stores. As of January 2, 2000, the
Company operated 223 stores in 32 states.

B. PROCEEDINGS UNDER CHAPTER 11 OF THE BANKRUPTCY CODE

Proceedings Under Chapter 11 of the Bankruptcy Code

On March 15, 1999, five of the Company's vendors filed an involuntary
petition for reorganization under Chapter 11 ("Chapter 11") of title 11 of the
United States Bankruptcy Code (the "Bankruptcy Code") in the United States
Bankruptcy Court for the Middle District of Tennessee (the "Bankruptcy Court")
seeking court supervision of the Company's restructuring efforts. On March 27,
1999, the Company and 31 of its subsidiaries (collectively, the "Debtors") filed
voluntary petitions with the Bankruptcy Court for reorganization under Chapter
11 under case numbers 399-02649 through 399-02680 (the "Chapter 11 Cases") and
orders for relief were entered by the Bankruptcy Court. The Chapter 11 Cases
have been consolidated for the purpose of joint administration under Case No.
399-02649. The Debtors are currently operating their businesses as
debtors-in-possession pursuant to the Bankruptcy Code.

Under the Bankruptcy Code, actions to collect pre-petition indebtedness are
stayed and other contractual obligations against the Debtors may not be
enforced. In addition, under the Bankruptcy Code the Debtors may assume or
reject executory contracts, including lease obligations. Parties affected by
these rejections may file claims with the Bankruptcy Court in accordance with
the reorganization process. Substantially all pre-petition liabilities are
subject to settlement under a plan of reorganization to be voted upon by
creditors and equity holders and approved by the Bankruptcy Court. Although the
Debtors expect to file a reorganization plan or plans that provide for emergence
from bankruptcy in 2000 or 2001, there can be no assurance that a reorganization
plan or plans will be proposed by the Debtors or confirmed by the Bankruptcy
Court, or that any such plan(s) will be consummated. As provided by the
Bankruptcy Code, the Debtors initially had the exclusive right to submit a plan
of reorganization for 120 days. On May 25, 1999, the Company received Court
approval to extend the period in which the Company has the exclusive right to
file or advance a plan of reorganization in its Chapter 11 case. The order
extended the Company's exclusive right to file a plan from July 23, 1999 to
February 29, 2000, and extended the Company's exclusive right to solicit
acceptances of its plan from September 21, 1999 to May 1, 2000. In January 2000,
the Company pursued a second extension of the exclusivity period prior to its
expiration. On February 2, 2000, the Company received Court approval to extend
the period in which the Company has the exclusive right to file or advance a
plan from February 29, 2000 to April 30, 2001 and extend the Company's right to
solicit acceptances of its plan from May 1, 2000 to June 30, 2001. If the
Debtors fail to file a plan of reorganization during such period or extension
thereof or if such plan is not accepted by the required number of creditors and
equity holders, any party in interest may subsequently file its own plan of
reorganization for the Debtors. A plan of reorganization must be confirmed by
the Bankruptcy Court, upon certain findings being made by the Bankruptcy Court
which are required by the Bankruptcy Code. The Bankruptcy Court may confirm a
plan notwithstanding the non-acceptance of the plan by an impaired class of
creditors or equity security holders if certain requirements of the Bankruptcy
Code are met. A plan of reorganization could also result in holders of the
Common Stock receiving no value for their

34
<PAGE> 36
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

interests. Because of such possibilities, the value of the Common Stock is
highly speculative, and may have no value.

C. FINANCIAL STATEMENT PRESENTATION AND GOING CONCERN MATTERS

The accompanying consolidated financial statements have been prepared on a
going concern basis of accounting and in accordance with AICPA Statement of
Position ("SOP") 90-7 "Financial Reporting by Entities in Reorganization Under
the Bankruptcy Code."

The Company's recent losses and the Chapter 11 Cases raise substantial
doubt about the Company's ability to continue as a going concern. The
consolidated financial statements do not include any adjustments relating to
recoverability and classification of recorded asset amounts or the amount and
classification of liabilities that might be necessary should the Company be
unable to continue as a going concern. The ability of the Company to continue as
a going concern and appropriateness of using the going concern basis is
dependent upon, among other things, (i) the Company's ability to comply with its
debtor-in-possession financing agreements, (ii) confirmation of a plan of
reorganization under the Bankruptcy Code, (iii) the Company's ability to achieve
profitable operations after such confirmation, and (iv) the Company's ability to
generate sufficient cash from operations to meet its obligations.

As described in Note B, the Company intends to submit a plan for
reorganization to the Bankruptcy Court. Management believes that the plan of
reorganization, as it is being developed and subject to approval of the
Bankruptcy Court, along with cash provided by the debtor-in-possession facility
and operations, will provide sufficient liquidity to allow the Company to
continue as a going concern; however, there can be no assurance that the sources
of liquidity will be available or sufficient to meet the Company's needs. A plan
of reorganization could materially change the amounts currently recorded in the
consolidated financial statements. The consolidated financial statements do not
give effect to any adjustment to the carrying value of assets or amounts and
classifications of liabilities that might be necessary as a result of the
Chapter 11 Cases.

The Company continues to develop its fiscal 2000 business plans, which may
include additional store closings, changes in merchandise assortments, changes
in its distribution networks and overhead costs; and is considering various
options with respect to the Restated Retirement Plan, the ESP and the Savings
and Investment Plan, which may include reinstatement, amendments, termination or
substitution of such plans, among other things.

D. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of consolidation: The consolidated financial statements include
the accounts of the Company and its subsidiaries, all of which are wholly-owned.
All significant intercompany transactions and balances have been eliminated.

35
<PAGE> 37
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Fiscal year: The Company maintains its books using a 52/53 week year
ending on the Sunday closest to the end of the calendar year. There were 52
weeks in the fiscal years ended January 2, 2000 and December 28, 1997. There
were 53 weeks in the fiscal year ended January 3, 1999.

Use of estimates: The preparation of the consolidated financial
statements, in conformity with generally accepted accounting principles,
requires management to make estimates and assumptions that affect the amounts
reported in the consolidated financial statements and related notes to the
consolidated financial statements. Changes in such estimates may affect amounts
reported in future periods.

Cash and cash equivalents: Cash and cash equivalents include cash on hand
and short-term, highly liquid investments which generally include commercial
paper and institutional money market funds with an original maturity date less
than 30 days. These investments are valued at cost, which approximates market,
and have a weighted-average interest rate of 5.8% for the fiscal year ended
January 3, 1999. There were no investments recorded at January 2, 2000.

Accounts receivable: Accounts receivable includes primarily trade
accounts, vendor allowances and receivables for income earned on the private
label credit card.

Inventories: Inventories are valued at the lower of cost or market. Cost
is determined utilizing the first-in, first-out method and includes certain
buying and warehousing costs.

Advertising: The Company generally expenses the costs of producing and
distributing advertising the first time the advertising takes place. Net
advertising expense was $110.6 million, $133.0 million and $135.0 million for
fiscal 1999, 1998 and 1997, respectively. Advertising costs of $5.6 million and
$10.6 million were included in prepaid expenses at January 2, 2000 and January
3, 1999, respectively.

Property and equipment -- owned: Owned property and equipment are stated
at cost. Depreciation and amortization are provided principally on the
straight-line method over a period of five to 10 years for furniture, fixtures
and equipment and 30 years for buildings. Leasehold improvements are depreciated
over the lesser of the life of the asset or the real estate lease term.

Property and equipment -- capitalized leases: Capitalized leases are
recorded at the lower of fair value of the leased property or the present value
of the minimum lease payments at the inception of the lease. Amortization of
leased property is computed using the straight-line method over the lesser of
the life of the leased asset or the term of the lease.

Deferred charges and other assets: Deferred charges consist primarily of
debt issuance costs and deferred finance charges which are amortized over the
life of the related debt. This amortization is classified as interest expense.
Other assets include restricted cash required by the World Financial Network
National Bank private label credit card agreement.

Derivative financial instruments: As part of a strategy to maintain an
acceptable level of exposure to the risk of interest rate fluctuation, the
Company has developed a targeted mix of fixed-rate versus variable rate debt.
The Company utilizes interest rate swaps to manage this mix. All outstanding
interest rate swaps have been designated as hedges of debt instruments. The
Company recognizes interest differentials as adjustments to interest expense in
the period they occur. Gains and losses on terminations of interest rate swaps
would be deferred and amortized to interest expense over the shorter of the
original term of the agreements or the remaining life of the associated
outstanding debt. The counterparties to these instruments are major financial
institutions. The fair value of the Company's interest rate swap agreements is
based on dealer quotes. These values represent the amounts the Company would
receive or pay to terminate the agreements taking into consideration current
interest rates. These counterparties expose the Company to credit risk in the
event of non-performance; however, the Company does not anticipate
non-performance by the other parties. The Company does not hold or issue
derivative financial instruments for trading purposes.
36
<PAGE> 38
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Impairment of assets: The Company reviews long-lived assets for impairment
whenever events or changes in circumstances indicate that net book value of the
asset may not be recoverable in accordance with the SFAS No. 121, "Accounting
for Impairment of Long-Lived Assets to Be Disposed Of." The impact of SFAS No.
121 for fiscal 1998 is disclosed in Note G in these consolidated financial
statements.

Stock-based compensation: The Company accounts for stock-based employee
compensation in accordance with Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees," and related interpretations. The pro
forma impact of the fair value method of accounting for stock-based employee
compensation is disclosed in Note M to these consolidated financial statements
in accordance with SFAS No. 123, "Accounting for Stock-Based Compensation."

Store opening costs: Costs of opening new stores are charged to operations
as incurred.

Income tax: The Company reports income taxes in accordance with SFAS No.
109, "Accounting for Income Taxes." Under SFAS No. 109, the asset and liability
method is used for computing future income tax consequences of events, which
have been recognized in the Company's consolidated financial statements or
income tax returns. Deferred income tax expense or benefit is the change during
the year in the Company's deferred income tax assets and liabilities.

Net earnings (loss) per common share: Net earnings (loss) per common share
for all periods have been computed in accordance with SFAS No. 128, "Earnings
Per Share." Basic net earnings (loss) per common share is computed by dividing
net earnings (loss) by the weighted average number of common shares outstanding
during the year. Diluted net earnings (loss) per common share is computed by
dividing net earnings (loss) by the weighted-average number of common shares
outstanding during the year plus incremental shares that would have been
outstanding upon the assumed vesting of dilutive restricted stock and the
assumed exercise of dilutive stock options. See Note N for a reconciliation of
basic and diluted earnings (loss) per share.

Comprehensive income (loss): Comprehensive income (loss) is reported in
accordance with SFAS No. 130, "Reporting Comprehensive Income." Other
comprehensive income (loss) includes minimum pension liability adjustments. See
Note P for reporting of minimum pension liabilities.

Cumulative effect of a change in accounting principle: The Company changed
its method of accounting for layaway sales. Layaway sales for 1999 have been
recognized upon delivery of merchandise to the customer. Layaway sales in prior
years were recognized when the initial layaway deposit was received. The Company
changed its method of accounting for layaway sales in response to the Securities
and Exchange Commission's Staff Accounting Bulletin: No. 101 -- Revenue
Recognition In Financial Statements. The amount of cash received upon initiation
of the layaway is recorded as a deposit liability within accrued expenses. The
cumulative effect of the change for periods prior to fiscal 1999 is an increase
in net loss of $6,566 or ($0.07) per share. The pro forma amounts shown on the
Consolidated Statement of Operations have been adjusted for the effect of
retroactive application on sales and cost of sales. See Note U.

Retirement Plans and Other Postretirement Benefits: The Company reports
all information on its retirement plans and other postretirement benefits in
accordance with SFAS No. 132, "Employers' Disclosure

37
<PAGE> 39
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

about Pensions and Other Postretirement Benefits". All periods reported have
been stated in accordance with SFAS 132. See Note P.

Segment Reporting: The Company adopted SFAS No. 131, "Disclosures about
Segments of an Enterprise and Related Information" in 1998. See Note T.

Reclassification: Certain reclassifications have been made to fiscal 1998
and 1997 to conform to the fiscal 1999 presentation.

E. RESTRUCTURING PLANS

1997 Restructuring Plan

On March 25, 1997, the Company adopted a business-restructuring plan to
close up to 60 under performing stores and one distribution center (the "1997
Restructuring Plan"). As a result, a pre-tax charge of $129.5 million for
restructuring costs was recorded in the first quarter of fiscal 1997. The
components of the restructuring charge and an analysis of the amounts charged
against the accrual for the fiscal year ended January 2, 2000 are outlined in
the following table:

<TABLE>
<CAPTION>
ACCRUED 1999 ACTIVITY ACCRUED
RESTRUCTURING --------------------------------------- RESTRUCTURING
COSTS AS OF RESTRUCTURING ASSET CHANGE IN COSTS AS OF
JANUARY 3, 1999 COSTS PAID WRITE-DOWNS ESTIMATE JANUARY 2, 2000
--------------- ------------- ----------- --------- ---------------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Lease termination and
other real estate
costs................... $53,161 $(1,780) $ -- $(43,487) $7,894
Property and equipment
write-downs............. -- -- 2,489 (2,489) --
------- ------- ------ -------- ------
Total........... $53,161 $(1,780) $2,489 $(45,976) $7,894
======= ======= ====== ======== ======
</TABLE>

Note: The Accrued Restructuring Costs as of January 2, 2000 are included in
liabilities subject to compromise.

Restructuring costs paid during the fiscal year ended January 2, 2000,
relate primarily to lease termination and other real estate costs. The Company
incurred $1.1 million in contractual rent payments and lease termination fees
and $0.6 million in other real estate costs primarily related to utilities,
common area maintenance fees, real estate taxes and brokerage costs.

The leases remaining on closed locations as of January 2, 2000 vary in
length with expiration dates ranging from January 2000 to October 2018.

38
<PAGE> 40
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Rationalization Plan

<TABLE>
<CAPTION>
1999 ACTIVITY
INITIAL CHARGE ------------------------------------ ACCRUED
RECORDED IN ASSET CHANGE IN COSTS AS OF
MARCH 1999 COSTS PAID WRITE-DOWNS ESTIMATE JANUARY 2, 2000
-------------- ---------- ----------- --------- ---------------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Lease termination and other
real estate costs.......... $62,469 $ (9,297) $ -- $(14,857) $38,315
Property and equipment write-
downs...................... 24,452 -- (19,298) (5,154) --
Employee severance........... 12,533 (9,237) -- (2,818) 478
------- -------- -------- -------- -------
Total.............. $99,454 $(18,534) $(19,298) $(22,829) $38,793
======= ======== ======== ======== =======
</TABLE>

Note: The Accrued Costs as of January 2, 2000 are included in liabilities
subject to compromise.

The stores planned for closure included both owned and leased properties.
Lease termination and other real estate costs consist principally of the
remaining rental payments required under the closing stores' and distribution
center lease agreements under Section 502(b)(6) of the Bankruptcy Code, net of
any actual or reasonably probable sublease income. Section 502(b)(6) limits the
lessor's claim to the rent reserved by such lease, without acceleration, for the
greater of one year, or 15 percent of the remaining term of the lease, not to
exceed three years. Any unpaid rent is included in the claim. The Company
experienced lower than expected expenses in lease terminations, dispositions of
closed stores and severance payments during the fiscal year ended January 2,
2000. As a result, the Company reduced its estimate for these costs by $23.0
million.

After taking into effect the above asset write-downs, the Company's
carrying value of the property and equipment associated with the Rationalization
Plan closures is $1.8 million as of January 2, 2000. This entire amount is
classified as available for sale as all store closures are now complete. Assets
available for sale are considered current assets and are included with "Prepaid
expenses and other assets". The Company anticipates selling substantially all
owned property and equipment associated with the closures.

39
<PAGE> 41
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

F. PROPERTY AND EQUIPMENT

Property and equipment consist of the following:

<TABLE>
<CAPTION>
JANUARY 2, JANUARY 3,
2000 1999
---------- ----------
(IN THOUSANDS)
<S> <C> <C>
Owned assets:
Land........................................................ $ 84,039 $ 97,161
Buildings................................................... 297,761 386,071
Furniture, fixtures and equipment........................... 293,368 399,221
Leasehold improvements...................................... 70,622 108,375
Construction in progress.................................... -- 66
Other....................................................... 1,990 2,484
--------- ---------
747,780 993,378
Less: Accumulated depreciation and amortization............. (394,702) (553,668)
--------- ---------
Owned assets, net........................................... $ 353,078 $ 439,710
========= =========
Capitalized leases:
Real estate................................................. $ 55,710 $ 93,251
Furniture, fixtures and equipment........................... 1,598 7,046
--------- ---------
57,308 100,297
Less: Accumulated amortization.............................. (42,672) (79,000)
--------- ---------
Capitalized leases, net..................................... $ 14,636 $ 21,297
========= =========
</TABLE>

G. IMPAIRED ASSETS

In the fourth quarter of fiscal 1998, the Company recorded a non-cash
impairment loss of $43.1 million related to a write-down of the Company's fixed
assets. The Company performed a long-lived impairment analysis due to projected
cash flow losses combined with current operating and cash flow losses at certain
store locations.

40
<PAGE> 42
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

estimate fair value. Accordingly, actual results could vary significantly from
such estimates. The following table is a summary of the impairment charges
recognized:

<TABLE>
<CAPTION>
1998
IMPAIRMENT
AMOUNT
--------------
(IN THOUSANDS)
<S> <C>
Land........................................... $ 3,196
Buildings...................................... 6,501
Furniture and Fixtures......................... 16,470
Leasehold Improvements......................... 12,011
Capital Lease Assets........................... 4,901
-------
Total................................ $43,079
=======
</TABLE>

H. BORROWINGS

This note contains information regarding the Company's short-term
borrowings and long-term debt as of January 2, 2000. As a result of the filing
of the Chapter 11 Cases, no principal or interest payments were made on any
pre-petition unsecured debt after March 15, 1999. Any plan of reorganization
defining the repayment terms must be approved by the Bankruptcy Court.

From September 1997 through January 20, 1999, the Company had a five-year,
$900.0 million, fully committed asset-based credit facility (the "Amended and
Restated Credit Facility"). The Amended and Restated Credit Facility included
$200.0 million in term loans and up to a maximum of $700.0 million in revolving
loans including a $175.0 million sub-facility for letters of credit. The Amended
and Restated Credit Facility was set to mature on September 10, 2002. Interest
rates on the Amended and Restated Credit Facility were subject to change based
on a financial performance-based grid and could not exceed a rate of LIBOR +
2.25% on revolving loans and LIBOR + 2.50% on the term loan. There was a
commitment fee of 0.375% on the undrawn portion of the revolving loans. Term
loan borrowings under the Amended and Restated Credit Facility were $196.0
million as of January 3, 1999. Short-term borrowings were $156.0 million under
the Amended and Restated Credit Facility at January 3, 1999.

On January 20, 1999, the Company completed a $750.0 million, 30-month
asset-based credit facility (the "Second Amended and Restated Credit Facility")
which replaced the Amended and Restated Credit Facility. The Second Amended and
Restated Credit Facility included $150.0 million in term loans and a maximum of
$600.0 million in revolving loans. The Second Amended and Restated Credit
Facility included a $200.0 million sub-facility for standby and trade letters of
credit. Interest rates on the Second Amended and Restated Facility were based on
either Prime Rate + 1.5% or LIBOR + 2.75%.

On March 29, 1999, the Company entered into a 27-month, $750.0 million
fully committed asset-based debtor-in-possession credit facility (the "DIP
Facility") which replaced the Second Amended and Restated Credit Facility. The
Bankruptcy Court approved the DIP Facility on an interim basis on March 29, 1999
and granted final approval on April 27, 1999. The DIP Facility, which matures on
June 30, 2001, includes $100.0 million in term loans and up to a maximum of
$650.0 million in revolving loans including a $200.0 million sub-facility for
letters of credit. Interest rate spreads on the DIP Facility are LIBOR + 2.25%
on Eurodollar loans and Prime Rate + 1.25% on Alternate Base Rate loans.
Short-term borrowings related to the DIP Facility were $43.0 million as of
January 2, 2000. Outstanding borrowings under the term loan of the DIP Facility
were $99.5 million as of January 2, 2000. There is a commitment fee of 0.375% on
the undrawn portion of the revolving loans under the DIP Facility.

41
<PAGE> 43
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The DIP Facility is secured by all material unencumbered assets of the
Company and its subsidiaries, including inventory, but excluding previously
mortgaged property. Borrowings under the DIP Facility are limited based on a
borrowing base formula which considers eligible inventories, eligible accounts
receivable, mortgage values on eligible real properties, eligible leasehold
interests, available cash equivalents and in-transit cash. The DIP Facility had
an initial borrowing base reserve of $125.0 million which was reduced by $75.0
million on April 27, 1999, the date of final approval of the 1999 Operating Plan
by the DIP Facility lenders. The remaining borrowing base reserve of $50.0
million was eliminated during the third quarter upon adoption of financial
covenants for the DIP Facility. Availability under the facility continues unless
the Company breaches both the financial covenants for the DIP facility. As of
January 2, 2000, the Company was in compliance with its financial covenants.

Borrowings consists of the following:

<TABLE>
<CAPTION>
JANUARY 2, JANUARY 3,
2000 1999
---------- ----------
(IN THOUSANDS)
<S> <C> <C>
9% Senior Subordinated Debentures, payable in equal
installments in 2003 and 2004............................. $300,000 $ 300,000
Term loan, repaid in 1999................................... -- 196,000
DIP facility term loan, variable interest rate at January 2,
2000 of 8.08% payable in varying amounts to 2001.......... 99,500 --
8 3/8% Senior Notes due 2001................................ 13,799 13,799
First Mortgage Secured Notes, variable interest rate at
January 2, 2000 of 6.64%, payable in varying amounts from
1998 to 2002.............................................. 38,858 62,707
Real Estate Mortgage Financing Notes, weighted-average fixed
interest rate at January 2, 2000 of 9.12%, payable in
mortgage installments to 2011............................. 58,591 69,264
Mortgage notes payable, weighted-average fixed interest rate
at January 2, 2000 of 8.08%, payable in varying amounts to
2022...................................................... 18,259 21,163
Industrial Revenue Bonds, fixed and variable interest rates,
weighted-average interest rate at January 2, 2000 of 3.5%,
payable in varying amounts to 2024........................ -- 24,300
-------- ---------
529,007 687,233
Less: Borrowings not subject to compromise classified as
noncurrent................................................ (98,500) --
Less: Borrowings not subject to compromise classified as
current................................................... (1,000) (220,041)
-------- ---------
Long-term debt subject to compromise........................ $429,507 $ 467,192
======== =========
</TABLE>

42
<PAGE> 44
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The future scheduled contractual principal payments for the Company's
borrowings (which are subject to being restructured in connection with the
Chapter 11 Cases) were as follows as of January 2, 2000:

<TABLE>
<CAPTION>
CONTRACTUAL
PRINCIPAL PAYMENTS
------------------
(IN THOUSANDS)
<S> <C>
Fiscal Year
2000...................................... $ 33,279
2001...................................... 116,882
2002...................................... 17,118
2003...................................... 155,389
2004...................................... 158,472
Thereafter................................ 47,867
--------
Total........................... $529,007
========
</TABLE>

During fiscal 1997, the Company retired $86.2 million of the Company's
$100.0 million 8 3/8% Senior Notes due 2001. As a result of this early
retirement, the Company recorded an extraordinary loss of $2.0 million after
tax, or $0.02 per share. Additionally, a non-cash extraordinary loss of $0.6
million, or $0.01 per share, was recorded to write-off deferred financing
charges associated with the replacement of the Company's $525.0 million Reducing
Revolving Credit Facility with the $950.0 million Amended and Restated Credit
Facility of September, 1997. The Company ceased accruing interest on the 8 3/8%
Senior Notes on March 16, 1999, in accordance with SOP 90-7.

The 9% Senior Subordinated Debentures are subordinated to all senior
indebtedness of the Company, as defined, and are callable, at the Company's
option, at a premium of 104.5%, which decreases annually until reaching par in
December 2000. Interest on the debentures is payable semi-annually in June and
December. The Company delayed its interest payment due December 15, 1998. The
payment was made January 14, 1999. The non-payment of the interest was a default
under the Amended and Restated Credit Facility and the Company's operating
performance, absent a waiver, would have resulted in a breach of the
fixed-charge coverage ratio covenants in agreements with First American National
Bank and the Canadian Imperial Bank of Commerce. A waiver was granted to the
Company by those parties to waive the default until January 15, 1999. The
default was cured upon payment. The Company ceased accruing interest on the 9%
Senior Subordinated Debentures on March 16, 1999, in accordance with SOP 90-7.

Mortgages are collateralized by property and equipment having a net book
value of approximately $22.3 million at January 2, 2000.

The Company has commercial and standby letters of credit under the DIP
Facility used to secure corporate obligations. The commercial letters of credit
have contractual amounts totaling $50.4 million and $57.4 million at January 2,
2000 and January 3, 1999, respectively. The standby letters of credit have
contractual amounts totaling $27.2 million and $49.0 million at January 2, 2000
and January 3, 1999, respectively.

I. LEASE COMMITMENTS

The Company has both capital and operating lease agreements for stores and
other facilities as well as for certain furniture, fixtures and equipment. Under
most of these lease agreements, the Company pays taxes, insurance and
maintenance costs. Initial lease terms for stores generally range from 10 to 25
years with renewal periods for an additional five years. Certain store leases
provide for additional contingent rental payments based on a percentage of sales
in excess of specified minimum amounts.

43
<PAGE> 45
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Future minimum lease payments as of January 2, 2000 (inclusive of leases at
closed stores that have not yet been terminated) are as follows:

<TABLE>
<CAPTION>
CAPITALIZED LEASES
-------------------------
FURNITURE,
FIXTURES
AND OPERATING
REAL ESTATE EQUIPMENT LEASES
----------- ---------- ---------
(IN THOUSANDS)
<S> <C> <C> <C>
Fiscal Year
2000............................................... $ 7,987 $243 $ 33,303
2001............................................... 7,184 139 33,594
2002............................................... 6,607 -- 31,895
2003............................................... 6,154 -- 30,692
2004............................................... 5,168 -- 28,234
Thereafter......................................... 17,275 -- 148,282
-------- ---- --------
Total minimum payments............................. 50,375 382 $306,000
========
Less: Imputed interest and executory costs......... (18,991) (16)
-------- ----
Present value of net minimum lease payments........ 31,384 366
Less: Long-term capitalized lease obligations not
subject to compromise............................ (2,514) --
Less: Current maturities not subject to
compromise....................................... (86) --
-------- ----
Capitalized lease obligations subject to
compromise....................................... $ 28,784 $366
======== ====
</TABLE>

Minimum sublease rentals, not deducted from above, to be received in the
future under noncancellable operating subleases aggregated $2.8 million at
January 2, 2000. Minimum lease rentals to be received in the future on
noncancellable leases of owned properties aggregated $6.4 million at January 2,
2000.

Capitalized real estate and equipment leases are at effective interest
rates of approximately 12.9% and 7.7%, respectively, as of January 2, 2000.

Rental expense, net of lease income on owned properties and sublease income
on leased properties, consists of the following:

<TABLE>
<CAPTION>
FISCAL YEAR
-----------------------------
1999 1998 1997
------- ------- -------
(IN THOUSANDS)
<S> <C> <C> <C>
Minimum rentals....................................... $49,028 $71,537 $74,163
Contingent rentals.................................... -- 962 1,237
Sublease rental income................................ (2,485) (3,353) (3,792)
Owned properties rental income........................ (2,527) (3,768) (3,962)
------- ------- -------
Net rental expense.................................... $44,016 $65,378 $67,646
======= ======= =======
</TABLE>

J. LIABILITIES SUBJECT TO COMPROMISE

"Liabilities subject to compromise" refers to certain liabilities incurred
prior to the commencement of the Chapter 11 Cases. These liabilities consist
primarily of amounts outstanding under long-term debt and also include accounts
payable, accrued interest, accrued restructuring costs, and other accrued
expenses. These amounts represent the Company's estimate of known or potential
claims to be resolved in connection with the

44
<PAGE> 46
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Chapter 11 Cases. Such claims remain subject to future adjustments. Adjustments
may result from (1) negotiations; (2) actions of the Bankruptcy Court; (3)
further development with respect to disputed claims; (4) future rejection of
additional executory contracts or unexpired leases; (5) the determination as to
the value of any collateral securing claims; (6) proofs of claim; or (7) other
events. The Bankruptcy Court set May 15, 2000 as the last date for parties to
file proofs of claim with respect to pre-petition obligations. Payment terms for
these amounts, which are considered long-term liabilities at this time, will be
established in connection with the Chapter 11 Cases.

The Company has received approval from the Bankruptcy Court to pay certain
pre-petition and post-petition employee wages, salaries, benefits and other
employee obligations, to pay vendors and other providers in the ordinary course
for goods and services received after March 15, 1999, and to honor customer
service programs, including warranties, returns, layaways and gift certificates.

The principal categories of claims classified as liabilities subject to
compromise under reorganization proceedings are identified below.

<TABLE>
<CAPTION>
JANUARY 2, 2000
---------------
(IN THOUSANDS)
<S> <C>
Accounts payable............................................ $189,877
Accrued expenses............................................ 60,754
Accrued restructuring costs:
1997 Restructuring Plan................................... 7,894
1999 Rationalization Plan................................. 38,793
Long-term debt.............................................. 429,507
Capitalized lease obligations............................... 29,150
--------
Total............................................. $755,975
========
</TABLE>

Contractual interest expense not recorded on certain pre-petition debt
totaled $22.5 million for the year ended January 2, 2000.

K. REORGANIZATION ITEMS

Expenses and income directly incurred or realized as a result of the
Chapter 11 Cases have been segregated from the normal operations and are
disclosed separately. The major components are as follows:

<TABLE>
<CAPTION>
FISCAL YEAR ENDED
JANUARY 2, 2000
-----------------
(IN THOUSANDS)
<S> <C>
Reduction of accrued rent for rejected leases............... $(45,981)
Professional fees........................................... 18,364
Store closing costs......................................... 11,754
Loss on disposal of assets.................................. 9,827
Other administrative items.................................. 4,213
--------
Total reorganization items (income) expense................. $ (1,823)
========
</TABLE>

Reduction of accrued rent for rejected leases:

In connection with the Chapter 11 Cases, the 1997 Restructuring Plan was
adjusted to reflect the reduction allowed under Section 502(b)(6) of the
Bankruptcy Code. An amount had been accrued according to the remaining leasehold
obligation. Section 502(b)(6) limits the lessor's claim to the rent reserved by
such

45
<PAGE> 47
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

leases, without acceleration, for the greater of one year, or 15 percent, not to
exceed three years, of such leases, plus any unpaid rent.

Professional fees:

"Professional fees" relates to legal, accounting and other professional
costs.

Store closing costs:

Subsequent to the announcement of the Rationalization Plan and commencement
of the Chapter 11 Cases, the Company identified an additional 18 stores for
closure. The costs associated with these closing stores include rent, common
area maintenance, utilities, asset write-downs and severance. The rent amount
has been adjusted to reflect the reduction allowed under Section 502(b)(6) of
the Bankruptcy Code. Income was recorded for a change in the estimated closing
costs as a result of the Company's favorable experience disposing of selected
stores during the fiscal year ended January 2, 2000.

Loss on disposal of assets:

"Loss on disposal of assets" consists of losses associated with the sale of
real property and the sale of certain assets of one of the Company's
subsidiaries, B.A. Pargh Co., Inc.

Other administrative items:

"Other administrative items" consists of administrative items, directly
attributable to the Chapter 11 Cases.

L. FAIR VALUE OF FINANCIAL INSTRUMENTS

The fair value of financial instruments has been estimated by the Company
using available market information as of January 2, 2000 and January 3, 1999,
and valuation methodologies considered appropriate to the circumstances.

<TABLE>
<CAPTION>
JANUARY 2, 2000 JANUARY 3, 1999
---------------------- ----------------------
CARRYING ESTIMATED CARRYING ESTIMATED
AMOUNT FAIR VALUE AMOUNT FAIR VALUE
-------- ---------- -------- ----------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
Assets:
Cash and cash equivalents............. $ 61,591 $ 61,591 $133,749 $133,749
Liabilities:
9% Senior Subordinated Debentures..... 300,000 27,750 300,000 64,125
Term Loan............................. 99,500 99,500 196,000 196,000
Mortgages............................. 115,708 119,149 153,134 145,529
Industrial Revenue Bonds.............. -- -- 24,300 24,300
Notes payable to banks................ -- -- 156,000 156,000
8 3/8% Senior Notes................... 13,799 1,276 13,799 6,227
</TABLE>

Cash and cash equivalents:

The carrying amount approximates fair value due to the short maturity of
these instruments (less than three months).

46
<PAGE> 48
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

9% Senior Subordinated Debentures and 8 3/8% Senior Notes:

Fair value is based on quoted market prices from the New York Stock
Exchange at January 3, 1999. Fair value at January 2, 2000 based on indicative
price reported by the Daily Bankruptcy Review.

Notes payable to banks, Term Loan and Mortgages:

Fair value is based on management's estimate of the present value of
estimated future cash flows discounted at the current market rate for financial
instruments with similar characteristics and maturities.

Industrial Revenue Bonds:

The carrying value approximates the fair value. Due to the variable rate
nature of the instruments, the interest rate paid by the Company is equivalent
to the current market rate demanded by investors; therefore, the instruments
trade at par.

Derivatives:

As of January 2, 2000, the Company was party to interest rate swaps
covering $125.0 million in principal amount of indebtedness and expiring in
December 2000. These swaps exchange the floating interest rate exposure on the
$125.0 million of debt for fixed interest rate exposure. The Company will pay a
weighted average fixed rate of 5.97% on the $125.0 million notional amount
rather than the three-month LIBOR rate, which was 6.18% as of January 2, 2000.
As of January 2, 2000, these instruments had no carrying value. The fair value
of interest rate swap agreements are estimated based on quotes from dealers of
these instruments and represent the estimated amounts the Company would expect
to pay or receive to terminate the agreements. The fair value of the Company's
interest rate swap agreements was $0.4 million and ($2.3) million as of January
2, 2000 and January 3, 1999, respectively.

M. STOCK OPTIONS AND AWARDS

Under the Company's employee stock incentive plans, the Compensation
Committee of the Board of Directors ("Compensation Committee") has authority to
grant the following types of awards: (a) stock options; (b) stock appreciation
rights; (c) restricted stock; (d) deferred stock; (e) stock purchase rights
and/or (f) other stock-based awards. Awards are exercisable subject to terms and
conditions as determined by the Compensation Committee with no awards
exercisable ten years after the date of grant.

In fiscal 1991, the Board of Directors adopted the 1991 Directors' Equity
Plan for nonemployee directors. Under the Second Amended and Restated Directors'
Plan eligible directors annually receive stock options exercisable for 3,000
shares of the Company's common stock. The plan was amended in fiscal 1998 and
1997 to increase the number of shares covered by option grants to directors and
to permit participating nonemployee directors to receive all or any portion of
their quarterly retainer in the form of an option to purchase shares of the
Company's common stock, respectively. The stock options are granted with an
exercise price equal to the fair market value of the Company's common stock as
of the date of grant, are exercisable in 20% installments beginning one year
from the date of grant and expire ten years from the grant date. An aggregate of
296,875 shares of the Company's common stock is authorized to be issued under
this plan.

During fiscal 1995, the Company amended and restated the 1989 Employee
Stock Incentive Plan ("Stock Incentive Plan") to increase the number of shares
issuable, to extend the term during which awards may be made under the Stock
Incentive Plan and to limit the amount of stock-based awards that may be granted
to any single officer or key employee under that plan. Options are generally
granted with a three to five-year vesting requirement. At January 2, 2000, there
were approximately 5.1 million shares of unissued common stock reserved for
issuance under the Company's Stock Incentive Plan.
47
<PAGE> 49
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

On October 16, 1998, the Company repriced options granted between August 1,
1989 and September 30, 1998 with grant prices ranging from $1.59 per share to
$10.13 per share. For each option exchanged, one new option was issued with an
exercise price of $1.25 per share. A total of 6.4 million options were repriced
and are exercisable in equal one-third installments beginning one year from the
date of grant. The repriced options expire five years from the grant date.

Stock options: A summary of the status of the Company's two fixed stock
option plans for fiscal 1999, 1998 and 1997, and changes during those years is
presented below:

<TABLE>
<CAPTION>
FISCAL YEAR
--------------------------------------------------------------------
1999 1998 1997
-------------------- -------------------- --------------------
WEIGHTED- WEIGHTED- WEIGHTED-
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
FIXED OPTIONS SHARES PRICE SHARES PRICE SHARES PRICE
- ------------- ------- --------- ------- --------- ------- ---------
(SHARES IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Outstanding, beginning of
year...................... 7,909 $1.96 9,126 $4.65 5,759 $5.35
Granted..................... 5 0.38 7,282 1.31 5,034 3.92
Exercised................... -- -- -- -- (57) 1.91
Forfeited or canceled....... (4,003) 1.82 (8,499) 4.30 (1,610) 5.54
------- ------- -------
Outstanding, end of year.... 3,911 2.11 7,909 1.96 9,126 4.65
======= ======= =======
Options exercisable at
year-end.................. 1,791 3.09 1,176 5.41 2,970 5.22
Weighted-average fair value
of options granted during
the year.................. $0.41 $0.52 $2.19
</TABLE>

The following table summarizes information about fixed stock options
outstanding at January 2, 2000:

<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
--------------------------------------- -------------------------
WEIGHTED-
NUMBER AVERAGE WEIGHTED- NUMBER WEIGHTED-
OUTSTANDING REMAINING AVERAGE EXERCISABLE AVERAGED
AT JANUARY 2, CONTRACTUAL EXERCISE AT JANUARY 2, EXERCISE
RANGE OF EXERCISE PRICES 2000 LIFE PRICE 2000 PRICE
- ------------------------ ------------- ----------- --------- ------------- ---------
(SHARES IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
$0.07 - 2.19 3,222 4.00 $1.23 1,123 $1.19
2.20 - 4.75 326 5.82 4.11 306 4.12
4.76 - 6.50 89 6.42 4.98 88 4.98
6.51 - 10.13 274 2.58 9.11 274 9.11
----- -----
$0.07 - 10.13 3,911 4.11 2.11 1,791 3.09
===== =====
</TABLE>

Had the fair value of options granted under these plans beginning in 1995
been recognized as compensation expense on a straight-line basis over the
vesting period of the grant in accordance with SFAS

48
<PAGE> 50
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

No. 123, the Company's net loss and net loss per share would have been adjusted
to the pro forma amounts indicated below:

<TABLE>
<CAPTION>
FISCAL YEAR
-------------------------------------
1999 1998 1997
---------- ---------- ---------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C>
Net loss
As reported.................................... $(243,672) $(110,307) $(91,600)
Pro forma...................................... $(247,707) $(115,121) $(94,285)
Net loss per share -- basic and diluted
As reported.................................... $ (2.45) $ (1.11) $ (0.92)
Pro forma...................................... $ (2.48) $ (1.15) $ (0.94)
</TABLE>

The pro forma effect on net loss for fiscal 1999, 1998 and 1997 is not
representative of the pro forma effect on net earnings (loss) in future years
because it does not take into consideration pro forma compensation expense
related to grants made prior to 1995. The fair value of each option grant is
estimated on the date of grant using the Black-Scholes option-pricing model with
the following weighted-average assumptions applied to options granted:

<TABLE>
<CAPTION>
FISCAL YEAR
-------------------------------------------
1999 1998 1997
------------ ------------ -----------
<S> <C> <C> <C>
Dividend yield............................. N/A N/A N/A
Expected volatility........................ 58% 48% 47%
Risk-free interest rate range.............. 4.5% to 4.6% 4.2 to 5.8% 5.9 to 6.8%
Expected life.............................. 6 Years 3 to 6 Years 6 Years
</TABLE>

Restricted stock awards: Periodically, the Company issues shares of
restricted stock under provisions of the Stock Incentive Plan. A total of
288,334 restricted shares remained outstanding at January 2, 2000. These
remaining shares will vest at various dates through the year 2002. During the
vesting periods, none of such shares may be sold, transferred, pledged or
assigned. During the restriction period, holders of the shares may exercise full
voting rights and receive all dividends with respect to those shares.

Restricted stock activity for the last three fiscal years was as follows:

<TABLE>
<CAPTION>
FISCAL YEAR
----------------------
1999 1998 1997
---- ----- -----
(SHARES IN THOUSANDS)
<S> <C> <C> <C>
Outstanding, beginning of year.............................. 626 675 512
Granted..................................................... 0 51 621
Vested...................................................... (9) (26) (398)
Forfeited or canceled....................................... (329) (74) (60)
---- ----- -----
Outstanding, end of year.................................... 288 626 675
==== ===== =====
Weighted-average fair value of restricted stock granted
during the year........................................... N/A $1.15 $4.35
</TABLE>

No deferred compensation was recorded during fiscal 1999 in connection with
restricted stock awards, compared to $0.1 million in fiscal 1998. Deferred
compensation amortization relating to restricted stock awards of $0.4 million in
fiscal 1999, $0.6 million in fiscal 1998 and $0.9 in 1997 was charged to
operations.

Service Merchandise Foundation option: The Service Merchandise Foundation
("Foundation"), a private charitable foundation, was formed in 1990. As a
charitable contribution, the Company granted the

49
<PAGE> 51
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Foundation an option to purchase approximately 1.9 million shares of common
stock at $2.20 per share, the then current market price. The option is
exercisable in whole or in part from the date of grant until October 15, 2000.
Under applicable Internal Revenue Service rulings, the stock option may not be
exercised directly by the Foundation. The Foundation may sell all or a part of
the option to unrelated not-for-profit entities, which may then exercise the
option directly. The option is not treated as granted and outstanding until such
time as the Foundation sells all or part of it.

N. EARNINGS PER SHARE

The following table reconciles weighted-average shares used in the earnings
per share calculation for fiscal 1999, 1998 and 1997, respectively:

<TABLE>
<CAPTION>
INCOME SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNT
----------- ------------- ---------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C>
FOR THE YEAR ENDED JANUARY 2, 2000:
Basic EPS -- before extraordinary item and
cumulative effect of a change in accounting
principle................................... $(229,255) 99,721 $(2.30)
======
Effect of dilutive securities:
None........................................ -- --
--------- ------
Diluted EPS -- before extraordinary item and
cumulative effect of a change in accounting
principle................................... $(229,255) 99,721 $(2.30)
========= ====== ======
FOR THE YEAR ENDED JANUARY 3, 1999:
Basic EPS...................................... $(110,307) 99,703 $(1.11)
======
Effect of dilutive securities:
None........................................ -- --
--------- ------
Diluted EPS.................................... $(110,307) 99,703 $(1.11)
========= ====== ======
FOR THE YEAR ENDED DECEMBER 28, 1997:
Basic EPS -- before extraordinary item......... $ (88,957) 99,930 $(0.89)
======
Effect of dilutive securities:
None........................................ -- --
--------- ------
Diluted EPS -- before extraordinary item....... $ (88,957) 99,930 $(0.89)
========= ====== ======
</TABLE>

The following table includes options to purchase shares of common stock
which were outstanding at the end of the respective fiscal year but were not
included in the computation of diluted earnings per share because the options'
exercise prices were greater than the average market price of the common shares.
Fiscal 1999,

50
<PAGE> 52
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

1998 and 1997 include all options to purchase shares of common stock and
restricted stock, as they were anti-dilutive in the computation of diluted
earnings per share.

<TABLE>
<CAPTION>
NUMBER SHARES
OUTSTANDING AT RANGE OF
YEAR RANGE OF GRANT DATES YEAR-END RANGE OF PRICES EXPIRATION DATES
- ---- -------------------- -------------- --------------- -------------------
<S> <C> <C> <C> <C>
1999 08/01/8 - 01/04/99 4.2 million $0.07 - $10.13 01/15/00 - 01/04/99
1998 08/01/89 - 12/29/98 8.5 million $0.07 - $10.38 08/01/99 - 12/29/98
1997 04/23/88 - 11/03/97 9.8 million $2.20 - $10.38 04/23/98 - 11/03/97
</TABLE>

During fiscal 1999 and 1998, the Common Stock traded on the New York Stock
Exchange (the "NYSE") under the symbol "SME." On March 17, 1999, the NYSE
notified the Company that it was reviewing the listing status of the Company's
listed securities, including the Common Stock. On December 2, 1999, the NYSE
announced that trading in the Common Stock was suspended effective on that date
and that the NYSE would apply with the SEC for delisting of the Common Stock.
Subsequent to December 2, 1999, the Common Stock has been traded on the National
Quotation Bureau, LLC Pink Sheets (the "Pink Sheets") and on the OTC Bulletin
board under the symbol "SVCDQ".

O. SHAREHOLDERS' RIGHTS PLAN

Under the 1998 Shareholder Rights Plan, Series A Junior Preferred Stock
Purchase Rights (the "Rights") were issued for each outstanding share of Common
Stock to shareholders of record at the close of business on February 9, 1998.
Each Right entitles the registered holders to purchase from the Company one
one-hundredth of a share (a "Unit") of Series A Junior Preferred Stock, par
value $1 per share (the "Preferred Stock"), at a purchase price of $10 per Unit,
subject to adjustment. Initially, the Rights will attach to all certificates
representing shares of outstanding Common Stock, and no separate Rights
Certificates will be distributed. The Rights will separate from the Common
Stock, and the Distribution Date will occur, upon the earlier of (i) 10 days
following public announcement ("Stock Acquisition Date") that a person or group
of affiliated persons (other than the Company, or certain of its affiliates) (an
"Acquiring Person") has acquired, obtained the right to acquire, or otherwise
obtained beneficial ownership of 15% or more of the then outstanding shares of
Common Stock, or (ii) 10 days (or such date as may be determined by the Board of
Directors prior to any person becoming an "Acquiring Person") following the date
that a tender offer or exchange offer that would result in a person or group
beneficially owning 15% or more of the then outstanding shares of Common Stock
is first published or sent or given to shareholders. The Rights are not
exercisable until the Distribution Date and will expire at the close of business
on the tenth anniversary of the Rights Agreement unless earlier redeemed by the
Company as described below. If any person becomes the beneficial owner of 15% of
the Common Stock or if a 15% or more shareholder engages in certain self-dealing
transactions or a merger with the Company where the Company is not the surviving
corporation, each Right will entitle the shareholder, under alternative
circumstances, to buy either securities of the Company or securities of an
acquiring company (depending on the form of the transaction) at an exercise
price that will be half of the market value of such securities at the time. At
any time until ten days following the Stock Acquisition Date, a majority of the
Board of Directors may redeem the Rights in whole, but not in part, at a price
of $.01 per Right, payable, at the election of such majority of Board of
Directors, in cash or shares of Common Stock.

P. RETIREMENT PLANS

The Company has a defined benefit pension plan (the "Restated Retirement
Plan") in which all employees of the Company are eligible to participate upon
reaching age 21 and completing one year of qualified service, as defined in the
Restated Retirement Plan. Benefits are based on years of service and

51
<PAGE> 53
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

employee compensation. Contributions to the Restated Retirement Plan had been
intended to provide not only for benefits attributed to service to date, but
also for benefits expected to be earned in the future. The Company's funding
policy had been to contribute at least the amount required by the Employee
Retirement Income Security Act of 1974, but no more than the maximum tax
deductible amount. In fiscal 1999, 1998, and 1997 the Company made contributions
of approximately $20.0 thousand, $3.4 million, and $4.8 million, respectively,
to the Restated Retirement Plan.

The assets held by the Restated Retirement Plan primarily include common
stock, long-term corporate bonds and long-term government bonds.

The Company maintains a non-qualified supplemental retirement plan, the
Executive Security Plan (the "ESP"), which covers certain management employees
hired or promoted to their job level prior to February 18, 1989. The ESP
provides salary continuation and or death benefits equal to two times the
participant's annual salary at retirement or at age 65. Employees who complete
20 years of service and terminate employment prior to attaining retirement age
are entitled to a death benefit up to age 65, at which time they can elect
salary continuation and/or a death benefit. Salary continuation benefits are
paid from the general assets of the Company.

On August 31, 1999, the Bankruptcy Court approved a motion by the Company
to amend the Restated Retirement Plan and the ESP. The amendment to the Restated
Retirement Plan ceased the accrual of benefits, disallowed new enrollments to
the Plan and vested benefits already accrued under the Plan effective September
30, 1999. The amendment to the ESP, covering approximately 165 former and
current management associates, ceased the accrual of benefits and suspended
payments effective September 30, 1999. Those actions to cease the accrual of
benefits under the Restated Retirement Plan and the ESP, as well as the
reduction in employees as a result of the 1999 Rationalization Plan, resulted in
curtailment (gains) and losses of ($11.5) million and $1.8 million,
respectively.

The following valuation results are based on actuarial assumptions and
methods mandated by SFAS No. 132 and SFAS No. 87 "Employers Accounting for
Pensions."

<TABLE>
<CAPTION>
RESTATED EXECUTIVE
RETIREMENT PLAN SECURITY PLAN
------------------- -------------------
1999 1998 1999 1998
-------- ------- ------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
CHANGE IN BENEFIT OBLIGATION
Benefit obligation at beginning of year........... $ 72,719 $65,394 $10,944 $ 10,099
Service cost...................................... 4,356 5,568 58 176
Interest cost..................................... 4,490 4,333 178 722
Actuarial loss.................................... (1,896) 7,308 (1,294) 543
Benefits paid..................................... (18,408) (9,884) (200) (596)
Curtailment....................................... (11,462) -- -- --
-------- ------- ------- --------
Benefit obligation at end of year................. $ 49,799 $72,719 $ 9,686 $ 10,944
======== ======= ======= ========
CHANGE IN PLAN ASSETS
Fair value of plan assets at beginning of year.... $ 74,599 $73,445 $ -- $ --
Actual return on plan assets...................... 6,401 7,646 -- --
Employer contribution............................. 20 3,392 200 596
Benefits paid..................................... (18,408) (9,884) (200) (596)
-------- ------- ------- --------
Fair value of plan assets at end of year.......... $ 62,612 $74,599 $ -- $ --
</TABLE>

52
<PAGE> 54
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

<TABLE>
<CAPTION>
RESTATED EXECUTIVE
RETIREMENT PLAN SECURITY PLAN
------------------- -------------------
1999 1998 1999 1998
-------- ------- ------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
======== ======= ======= ========
RECONCILIATION OF FUNDED STATUS
Funded status..................................... $ 12,813 $ 1,880 $(9,686) $(10,944)
Amounts not recognized............................ (4,217) (4,642) -- --
Unrecognized net actuarial loss (gain)............ 706 12,786 (1,373) 1,721
Unrecognized prior service cost................... -- (663) -- --
Unrecognized transition obligation................ -- (1,897) 2,546 2,910
-------- ------- ------- --------
Net amount recognized............................. $ 9,302 $ 7,464 $(8,513) $ (6,313)
======== ======= ======= ========
AMOUNTS RECOGNIZED ON THE BALANCE SHEET
Prepaid benefit cost.............................. $ 9,302 $ 7,464 $ -- $ --
Accrued benefit liability......................... -- -- (9,686) (10,092)
Intangible asset.................................. -- -- 1,173 2,910
Accumulated and other comprehensive loss*......... -- -- -- 869
-------- ------- ------- --------
Net amount recognized............................. $ 9,302 $ 7,464 $(8,513) $ (6,313)
======== ======= ======= ========
*Change in other comprehensive loss
Intangible asset.................................. $ -- $ -- $ (240) $ 240
Accrued pension benefit cost...................... -- -- (629) 629
-------- ------- ------- --------
Total other comprehensive (income) loss........... $ -- $ -- $ (869) $ 869
======== ======= ======= ========
</TABLE>

<TABLE>
<CAPTION>
RESTATED RETIREMENT PLAN
-----------------------------
1999 1998 1997
------- ------- -------
(IN THOUSANDS)
<S> <C> <C> <C>
NET PERIODIC PENSION COST
Service Cost................................................ $ 4,356 $ 5,568 $ 6,049
Interest Cost............................................... 4,490 4,332 4,850
Expected return on assets................................... (6,424) (6,282) (6,099)
Amortization of net transition amount....................... (284) (379) (379)
Amortization of prior service cost.......................... (98) (162) (165)
Recognized net loss......................................... -- -- 239
Gain due to curtailment..................................... (3,857) -- (273)
------- ------- -------
Net periodic pension cost................................... $(1,817) $ 3,077 $ 4,222
======= ======= =======
</TABLE>

53
<PAGE> 55
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

<TABLE>
<CAPTION>
EXECUTIVE SECURITY PLAN
--------------------------
1999 1998 1997
------ ------ ------
(IN THOUSANDS)
<S> <C> <C> <C>
NET PERIODIC PENSION COST
Service Cost................................................ $ 58 $ 176 $ 198
Interest Cost............................................... 178 722 702
Amortization of net transition amount....................... 364 364 364
Recognized net loss......................................... -- 31 --
Curtailments................................................ 1,800 -- --
------ ------ ------
Net periodic pension cost................................... $2,400 $1,293 $1,264
====== ====== ======
</TABLE>

<TABLE>
<CAPTION>
RESTATED RETIREMENT PLAN AND
EXECUTIVE SECURITY PLAN
-----------------------------
<S> <C> <C> <C>
WEIGHTED AVERAGE ACTUARIAL ASSUMPTIONS
Discount rate............................................... 7.75% 6.75% 7.25%
Expected long-term rate of return on assets................. 9.50% 9.50% 9.50%
Future salary increases..................................... 3.50% 3.50% 4.00%
</TABLE>

Q. EMPLOYEE SAVINGS PLAN

The Service Merchandise Company, Inc. Savings and Investment Plan (the
"Plan") is a voluntary salary deferral plan under Section 401(k) of the Internal
Revenue Code. All employees of the Company (other than seasonal and temporary
employees) are eligible to participate upon reaching age 21 and completing one
qualifying year of service, as defined in the Plan. Eligible employees may elect
to defer from 1% to 15% of their compensation, subject to certain limitations.
The Company will match, based on earnings performance, up to 50% of the first 6%
of employees' salary deferrals. Deferrals and matching contributions are
invested in securities and investments as permitted by the Plan and directed by
each employee.

Company contributions to the Plan were $0.0, $0.6 million and $1.3 million
for fiscal 1999, 1998 and 1997, respectively. The Company match percentage
equaled 0.0% in fiscal 1999, 10% in fiscal 1998 and 20% in fiscal 1997.

54
<PAGE> 56
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

R. INCOME TAXES

Deferred income tax assets and liabilities at January 2, 2000 and January
3, 1999 are comprised of the following:

<TABLE>
<CAPTION>
JANUARY 2, JANUARY 3,
2000 1999
---------- ----------
(IN THOUSANDS)
<S> <C> <C>
Deferred income tax assets:
Financial accruals.......................................... $ 41,088 $ 42,220
Capitalized leases.......................................... 5,488 8,511
Tax credit and loss carryover............................... 97,388 12,304
Capitalized legal fees...................................... 11,656 1,739
--------- --------
Deferred income tax asset................................... 155,620 64,774
--------- --------
Deferred income tax liabilities:
Depreciation................................................ (10,402) (13,473)
Layaway sales............................................... -- (1,884)
Pension liability........................................... (3,086) (2,315)
Inventory................................................... (7,338) (4,606)
Other....................................................... (349) (743)
--------- --------
Deferred income tax liability............................... (21,175) (23,021)
--------- --------
Net deferred income tax asset............................... $ 134,445 $ 41,753
========= ========
Net current deferred income tax asset....................... $ 16,830 $ 20,182
Net long-term deferred income tax asset..................... 117,615 21,571
--------- --------
134,445 41,753
Valuation Allowance......................................... (134,445) (41,753)
--------- --------
Net Deferred income tax asset............................... $ -- $ --
========= ========
</TABLE>

The Company has recorded a full valuation allowance on net deferred tax
assets as realization of such assets in future years is uncertain.

The provision for income taxes, net of tax benefit of $1.6 million in
fiscal 1997 on the extraordinary loss from early extinguishment of debt,
consists of the following:

<TABLE>
<CAPTION>
FISCAL YEAR
--------------------------------
1999 1998 1997
-------- -------- --------
<S> <C> <C> <C>
Current income taxes:
Federal............................................ $ (564) $(19,134) $(11,896)
State and local.................................... (310) (423) (759)
-------- -------- --------
(874) (19,557) (12,655)
Deferred benefit -- tax attributes................. (80,234) (12,304) (40,720)
Deferred benefit -- other.......................... (10,217) (9,985) --
Valuation allowance................................ 90,451 41,753 --
-------- -------- --------
Total income tax benefit........................... $ (874) $ (93) $(53,375)
======== ======== ========
</TABLE>

55
<PAGE> 57
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

At January 2, 2000, the Company had federal net operating loss carry
forwards of $255.4 million and state net operating loss carry forwards of $279.1
million, which expire beginning in 2019 and 2001, respectively.

A reconciliation of the provision for income taxes to the federal statutory
rate is as follows:

<TABLE>
<CAPTION>
FISCAL YEAR
----------------------
1999 1998 1997
----- ----- ----
<S> <C> <C> <C>
Statutory federal tax rate.................................. 35.0% 35.0% 35.0%
State and local income taxes, net of federal benefit........ 1.3% 1.3% 1.3%
Valuation allowance......................................... (37.0)% (37.8)% --
Other....................................................... 1.1% 1.6% 1.2%
----- ----- ----
Effective tax rate.......................................... 0.4% 0.1% 37.5%
===== ===== ====
</TABLE>

S. OTHER COMMITMENTS AND CONTINGENCIES

56
<PAGE> 58
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

litigated in the District Court. The Bankruptcy Court scheduled a hearing on
December 6, 1999, to consider WFNNB's motion to dismiss and the Company's
opposition thereto.

The Company was involved in litigation, investigations and various legal
matters during the fiscal year ended January 2, 2000, which are being defended
and handled in the ordinary course of business. While the ultimate results of
these matters cannot be determined or predicted, management believes that they
will not have a material adverse effect on the Company's results of operations
or financial position. Any potential liability may be affected by the Chapter 11
Cases.

T. SEGMENT REPORTING

The Company manages its business on the basis of one reportable segment.
See Note A for a brief description of the Company's business. As of January 2,
2000, all of the Company's operations are located within the United States. The
following data is presented in accordance with SFAS No. 131 for all periods
presented.

<TABLE>
<CAPTION>
YEARS ENDED
----------------------------------------
JANUARY 2, JANUARY 3, DECEMBER 28,
2000 1999 1997
---------- ---------- ------------
CLASSES OF SIMILAR PRODUCTS (IN THOUSANDS)
- ---------------------------
<S> <C> <C> <C>
Net sales:
Hardlines........................................... $1,445,230 $2,249,628 $2,725,837
Jewelry............................................. 785,270 919,897 936,941
---------- ---------- ----------
Total net sales............................. $2,230,500 $3,169,525 $3,662,778
========== ========== ==========
</TABLE>

U. QUARTERLY FINANCIAL INFORMATION -- UNAUDITED

The Company has historically incurred a net loss throughout the first three
quarters of the year due to the seasonality of its business. The results of
operations for the first three quarters are not necessarily indicative of the
operating results for the entire fiscal year.

A change in accounting principle regarding layaway sales was adopted during
the thirteen weeks ended January 2, 2000. The restated amounts below reflect the
effect of the retroactive application of the change as of January 4, 1999.

57
<PAGE> 59
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

<TABLE>
<CAPTION>
13 WEEKS ENDED
--------------------------------------------------
APRIL 4, JULY 4, OCTOBER 3, JANUARY 2,
1999 1999 1999 2000
--------- --------- ---------- ----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C>
Net sales as originally reported.............. $ 510,509 $ 518,264 $366,485
Effect of change in accounting for layaway
sales....................................... 1,186 414 (2,021)
--------- --------- --------
Net sales as restated......................... $ 511,695 $ 518,678 $364,464 $835,663
========= ========= ======== ========
Gross margin as originally reported(a)........ $ 96,801 $ 87,219 $ 80,399
Effect of change in accounting for layaway
sales....................................... 487 173 (841)
--------- --------- --------
Gross margin as restated...................... $ 97,288 $ 87,392 $ 79,558 $230,314
========= ========= ======== ========
Net earnings (loss) as originally reported.... $(168,338) $(100,594) $ 3,967
Effect of change in accounting for layaway
sales....................................... 487 173 (841)
Extraordinary loss............................ 7,851 -- --
--------- --------- --------
Net earnings (loss) before cumulative effect
of change in accounting principle and
extraordinary loss as restated.............. (160,000) (100,421) 3,126 $ 28,040
Extraordinary loss............................ (7,851) -- -- --
Cumulative effect of change in accounting for
layaway sales............................... (6,566) -- -- --
--------- --------- -------- --------
Net earnings (loss) as restated............... $(174,417) $(100,421) $ 3,126 $ 28,040
========= ========= ======== ========
Per common share -- basic and diluted
Net earnings (loss) as originally reported.... $ (1.69) $ (1.01) $ 0.04
Effect of change in accounting for layaway
sales....................................... 0.01 -- (0.01)
Extraordinary loss............................ 0.08 -- --
--------- --------- --------
Earnings (loss) before cumulative effect and
extraordinary loss as restated.............. (1.60) (1.01) 0.03 $ 0.28
Extraordinary loss............................ (0.08) -- -- --
--------- --------- -------- --------
Cumulative effect of change in accounting for
layaway sales............................... (0.07) -- -- --
--------- --------- -------- --------
Net earnings (loss) as restated............... $ (1.75) $ (1.01) $ 0.03 $ 0.28
========= ========= ======== ========
</TABLE>

58
<PAGE> 60
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

<TABLE>
<CAPTION>
14 WEEKS
13 WEEKS ENDED ENDED
------------------------------------------- ----------
MARCH 29, JUNE 28, SEPTEMBER 27, JANUARY 3,
1998 1998 1998 1999
--------- -------- ------------------ ----------
<S> <C> <C> <C> <C>
Net sales............................... $594,182 $685,112 $604,987 $1,285,244
======== ======== ======== ==========
Gross margin(a)......................... $143,101 $163,564 $138,254 $ 309,350
======== ======== ======== ==========
Net loss................................ $(24,101) $ (6,337) $(38,098) $ (41,771)
======== ======== ======== ==========
Per common share -- basic and diluted
Net loss................................ $ (0.24) $ (0.06) $ (0.38) $ (0.42)
======== ======== ======== ==========
Pro forma amounts assuming the new
layaway sales recognition is applied
retroactively:
Net sales............................... $593,990 $687,221 $603,622 $1,287,647
======== ======== ======== ==========
Gross margin............................ $143,020 $164,434 $137,689 $ 310,354
======== ======== ======== ==========
Net loss................................ $(24,181) $ (5,467) $(38,663) $ (40,767)
======== ======== ======== ==========
Per common share -- basic and diluted
Net loss................................ $ (0.24) $ (0.05) $ (0.39) $ (0.41)
======== ======== ======== ==========
</TABLE>

- ---------------
(a) Gross margin after cost of merchandise sold and buying and occupancy
expenses.

V. SUBSEQUENT EVENTS

Subsequent Event -- 2000 Business Plan

On February 21, 2000, the Company's Board of Directors approved its 2000
Business Plan. Key components of the 2000 Business Plan include exiting certain
unprofitable hardlines categories, including toys, juvenile, sporting goods,
most consumer electronics and most indoor furniture. As part of the 2000
Business Plan, the Company plans to eliminate between 5,000 and 6,000 positions
in stages during 2000 and 2001, including approximately 350 distribution center
and 200 corporate positions. The Company announced an initiative to reformat its
existing stores as part of the 2000 Business Plan, which would result in excess
store space becoming available for subleasing or other real estate transactions.
Another important element to the Company's strategy is the convergence of the
Internet and store selling environments. Each store will feature Internet kiosks
that will provide immediate access to the Company's web site,
www.servicemerchandise.com, its bridal and gift registry, and its store
directory. The Company also stated that the plan or plans of reorganization
currently being considered involve a debt conversion of the Company's
prepetition unsecured claims into new common equity of the reorganized company.
Under such circumstances, the Company's existing common stock is highly
speculative and is likely worthless if the current plan of reorganization under
consideration is consummated.

Subsequent Event -- DIP and exit credit facility

On February 21, 2000, the Company signed a commitment letter with Fleet
Retail Finance Inc. Following the expected approval of the Bankruptcy Court and
closing, the Company's new four-year, $600.0 million DIP and exit credit
facility (the "Facility") will replace the Company's existing $750.0 million DIP
facility (the "DIP facility"). The Facility will be agented by Fleet Retail
Finance Inc. ("Fleet"), a co-agent of the DIP facility, and fully underwritten
by FleetBoston Robertson Stephens Inc.

59
<PAGE> 61
SERVICE MERCHANDISE COMPANY, INC. AND SUBSIDIARIES
(DEBTORS-IN-POSSESSION)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The Facility is presently structured as a $600.0 million revolver, although
Fleet has reserved the right to allocate up to $85.0 million to a term loan
prior to closing. The Facility also includes a letter of credit subfacility of
$150.0 million and permits subordinated secured financing in amounts up to an
additional $50.0 million on terms reasonably satisfactory to Fleet. The Facility
requires superpriority claim status and a first priority security interest in
all assets subject to existing liens, and contains certain other customary
priority provisions.

The Facility is subject to various customary terms and conditions, and must
be closed by the Company no later than May 31, 2000. The Facility will mature
four years from closing but can be converted to exit financing by the Company at
any time during the four-year term as long as applicable conditions to
conversion are satisfied. The interest rate during the first year of the term is
LIBOR plus 250 basis points or prime plus 75 basis points; thereafter, the
interest rate on the Facility is subject to quarterly adjustment pursuant to a
pricing grid based on availability and/or EBITDA, as defined in the Facility,
with ranges of 200 to 275 basis points over LIBOR and 25 to 100 basis points
over prime.

The Facility includes various covenants designed to facilitate
implementation of the 2000 Business Plan and the Company's anticipated emergence
from Chapter 11 in 2001. To fund capital expenditures, including the Company's
planned two-year store renovation program, the facility will permit the Company
to invest up to $70.0 million of capital expenditures during 2000 (plus certain
incremental amounts based on the amount of subleased space completed during the
fiscal year). In 2001, the Facility will permit capital expenditures up to
$150.0 million less actual capital expenditures invested during 2000. During
2002 and 2003, the Company may invest up to $50.0 million each year with 100
percent carryover of unexpended amounts from prior years. The Facility will
include a financial covenants test similar to the test in the current DIP
Facility. The Company would not breach this financial covenant unless unused
borrowing availability falls below $50.0 million and the Company fails to meet
specified minimum EBITDA performance (as defined in the Facility) performance.
Excluded from the EBITDA calculation are revenues and expenses associated with
discontinued inventory lines, the Orlando and Montgomery distribution centers
and the reduction in force plan (including payroll and severance) except with
respect to non-continuing EBITDA amounts in excess of $100.0 million.

There are no restrictions in the Facility on the Company's ability to
sublease and lease store space pursuant to the 2000 Business Plan; lease all or
part of the corporate headquarters; sell, pursuant to sale-leasebacks or
outright, the corporate headquarters, the Orlando and/or Montgomery distribution
centers; and/or implement a credit card receivables securitization program. The
Company also retains the ability to complete intercompany restructurings,
intercompany asset transfers and intercompany/third-party real estate
transactions.

Events of default under the Facility include customary default provisions
as well as key management provisions that would trigger a default in the event
that both the current Chief Executive Officer and President ceased to be
employed, unless at least one of them is replaced by a person reasonably
satisfactory to Fleet within 90 days and/or the acquisition by any one person or
entity of 50 percent of the voting stock of the Company. Closing of the Facility
is subject to customary closing conditions, including at least $155.0 million of
availability at close and no material adverse change in the financial condition,
operations or assets of the Company at the time of closing. Conversion of the
Facility to an exit financing is also based on customary closing conditions,
including the Agent's reasonable satisfaction with capital structure, plan of
reorganization and any materially revised projections, as well as the
achievement by the Company of a specified trailing 12-month EBITDA (which varies
depending on time of exit) and certain minimum availability (which varies from
$50.0 to $100.0 million) depending on the time of exit.

60
<PAGE> 62

SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
(IN THOUSANDS)

<TABLE>
<CAPTION>
COL. A COL. B COL. C COL. D COL. E
ADDITIONS
BALANCE AT CHARGED TO CHARGED TO
BEGINNING OF COSTS AND OTHER ACCOUNTS DEDUCTIONS BALANCE AT
DESCRIPTION PERIOD EXPENSES (DESCRIBE) (DESCRIBE)(A) END OF PERIOD
- ----------- ------------ ---------- -------------- ------------- -------------
<S> <C> <C> <C> <C> <C>
INVENTORY VALUATION ALLOWANCE INCLUDED UNDER THE
BALANCE SHEET CAPTION "INVENTORY"
Year ended January 2, 2000........................ $25,017 $ -- -- $(11,992) $ 13,025
Year ended January 3, 1999........................ $16,945 $50,144 -- $(42,072) $ 25,017
Year ended December 28, 1997...................... $10,048 $44,226 -- $(37,329) $ 16,945
DEFERRED TAX ASSET VALUATION ALLOWANCE INCLUDED
UNDER THE BALANCE SHEET CAPTION "DEFERRED INCOME
TAXES"
Year ended January 2, 2000........................ $41,753 $92,692 -- $ -- $134,445
Year ended January 3, 1999........................ $ -- $41,753 -- $ -- $ 41,753
Year ended December 28, 1997...................... $ -- $ -- -- $ -- $ --
ALLOWANCE FOR DOUBTFUL ACCOUNTS INCLUDED UNDER THE
BALANCE SHEET CAPTION "ACCOUNTS RECEIVABLE"
Year ended January 2, 2000........................ $ 2,999 $15,751 -- $ (724) $ 19,474
Year ended January 3, 1999........................ $ 3,456 $ 4,541 -- $ (4,998) $ 2,999
Year ended December 28, 1997...................... $ 4,593 $ 4,388 -- $ (5,525) $ 3,456
ALLOWANCE FOR UNCOLLECTIBLE VENDOR DEBITS INCLUDED
UNDER THE BALANCE SHEET CAPTION "ACCOUNTS PAYABLE"
Year ended January 2, 2000........................ $ 4,300 $ 1,447 -- $ -- $ 5,747
Year ended January 3, 1999........................ $ -- $ 4,300 -- $ -- $ 4,300
Year ended December 28, 1997...................... $ -- $ -- -- $ -- $ --
</TABLE>

61
<PAGE> 63

INDEPENDENT AUDITORS' REPORT

To the Board of Directors and Shareholders
Service Merchandise Company, Inc.
Brentwood, Tennessee

We have audited the accompanying consolidated balance sheets of Service
Merchandise Company, Inc. and subsidiaries (Debtors-in-Possession) as of January
2, 2000 and January 3, 1999, and the related consolidated statements of
operations, changes in shareholders' (deficit) equity, and cash flows for each
of the three fiscal years in the period ended January 2, 2000. Our audits also
included the financial statement schedule listed in the Index at Item 14. These
financial statements and this financial statement schedule are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements and financial statement schedule based on
our audits.

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

In our opinion, such consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Service Merchandise Company, Inc. and subsidiaries (Debtors-in-Possession) as of
January 2, 2000 and January 3, 1999, and the results of their operations and
cash flows for each of the three fiscal years in the period ended January 2,
2000, in conformity with generally accepted accounting principles. Also, in our
opinion, such financial statement schedule, when considered in relation to the
basic consolidated financial statements taken as a whole, presents fairly, in
all material respects the information set forth therein.

As discussed in Note D to the consolidated financial statements, in 1999
the Company changed its method of recording layaway sales.

As discussed in Note B, the Company has filed for reorganization under
Chapter 11 of the Federal Bankruptcy Code. The accompanying financial statements
do not purport to reflect or provide for the consequences of the bankruptcy
proceedings. In particular, such financial statements do not purport to show (a)
as to assets, their realizable value on a liquidation basis or their
availability to satisfy liabilities, (b) as to prepetition liabilities, the
amounts that may be allowed for claims or contingencies, or the status and
priority thereof, (c) as to stockholder accounts, the effect of any changes that
may be made in the capitalization of the Company, or (d) as to operations, the
effect of any changes that may be made in its business.

The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern. The Company has
experienced recurring losses and has a deficiency in net assets. These matters
raise substantial doubt about its ability to continue as a going concern. The
consolidated financial statements do not include adjustments that might result
from the outcome of this uncertainty.

DELOITTE & TOUCHE LLP

Nashville, Tennessee
February 4, 2000
(February 21, 2000 as to Note V)

62
<PAGE> 64

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH INDEPENDENT AUDITORS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

No reportable items.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

DIRECTORS OF THE REGISTRANT

The following is a list of directors, their ages, positions and business
experience as of the date hereof:

<TABLE>
<CAPTION>
NAME AND POSITION AGE EXPERIENCE
- ----------------- --- ----------
<S> <C> <C>
Raymond Zimmerman 67 Chairman of the Board since January 1999;
Chairman of the Board Chairman of the Board from October 1981
through January 1998; Chief Executive
Officer from October 1981 to April 1997;
President from July 1984 to November 1994
and from 1981 to October 1983. Board
member of The Limited Stores, Columbus,
Ohio.
S. Cusano 46 Chief Executive Officer since March 1999;
Chief Executive Officer Executive Vice President and Chief
Financial Officer from April 1997 to March
1999; Vice President and Chief Financial
Officer from July 1993 to April 1997;
Group Vice President -- Finance from
December 1991 to July 1993.
Charles Septer 48 President and Chief Operating Officer
President and Chief Operating Officer since March 1999; Senior Vice President,
Jewelry Merchandising since 1988.
Richard P. Crane, Jr. 60 Practicing Attorney, Partner, Musick,
Peeler & Garrett, Los Angeles, California;
Board member of North American Gaming,
Inc.
R. Maynard Holt, J.D. 60 R. Maynard Holt, Business Consulting &
Insurance, Nashville, Tennessee.
Charles V. Moore 60 President and Board member of Trainer,
Wortham & Company, Inc., Investment
Counselors, New York, New York.
Harold Roitenberg 73 President of Roitenberg Investments, Inc.,
Minneapolis, Minnesota; Board member of
Damark International, Inc.
</TABLE>

EXECUTIVE OFFICERS OF THE REGISTRANT

The following is a list of executive officers, their ages, positions and
business experience during the past five years as of the date hereof:

<TABLE>
<CAPTION>
NAME AND POSITION(1) AGE EXPERIENCE
- -------------------- --- ----------
<S> <C> <C>
S. Cusano 46 Chief Executive Officer since March 1999;
Chief Executive Officer Executive Vice President and Chief
Financial Officer from April 1997 to March
1999; Vice President and Chief Financial
Officer from July 1993 to April 1997;
Group Vice President -- Finance from
December 1991 to July 1993.
Charles Septer 48 President and Chief Operating Officer
President and Chief Operating Officer since March 1999; Senior Vice President,
Jewelry Merchandising since 1988.
</TABLE>

63
<PAGE> 65

<TABLE>
<CAPTION>
NAME AND POSITION(1) AGE EXPERIENCE
- -------------------- --- ----------
<S> <C> <C>
C. Steven Moore 37 Chief Administrative Officer since March
Chief Administrative Officer, Senior Vice 1999, Senior Vice President since February
President, General Counsel and Corporate 9, 1999; Corporate Secretary since August
Secretary 1996; Vice President and General Counsel
since August 1996; Senior Corporate
Attorney from November 1994 to August
1996; Corporate Attorney from May 1992 to
November 1994.
Thomas L. Garrett, Jr. 46 Senior Vice President and Chief Financial
Senior Vice President and Chief Financial Officer since March 1999; Vice President
Officer and Treasurer since July 1996; Treasurer,
Magma Copper Company from July 1992 to May
1996.
Gary Sease 56 Senior Vice President, Logistics since
Senior Vice President, Logistics September 1996; Senior Vice President,
Operations Services of American National
Can Company from September 1992 to
September 1996.
Jerry E. Foreman 45 Senior Vice President, Merchandising since
Senior Vice President, Hardlines June 1999; President and Chief Operating
Merchandising, E-Commerce Officer of Ingram Industries Subsidiary,
Retailer Services, Inc. from January 1996
to June 1999; President and Chief
Operating Officer, Ingram Merchandising
Inc. from March 1995 to January 1996;
Service Merchandise Co., Inc. from 1976 to
1995, most recently Vice President of
Merchandising.
Kenneth A. Conway 43 Vice President and Controller since June
Vice President and Controller 1999; Vice President -- Controller and
Assistant Secretary, PETsMART, Inc. from
September 1992 to June 1999; Controller
and Assistant Secretary, STOR Furnishings
International, Inc. from April 1987 to
September 1992; Senior Accountant, Price
Waterhouse from June 1982 to April 1987.
R. John Pindred 33 Vice President and Treasurer since April
Vice President and Treasurer 1999; Director of Commercial Development,
Koch Industries from December 1997 to
April 1999; Vice President of Financial
Planning and Analysis, Service Merchandise
Co. from August 1996 to December 1997;
Manager of Price Risk, BHP Copper from
April 1991 to August 1996; Mill
Metallurgist, Noranda Minerals from
January 1990 to April 1991.
</TABLE>

- ---------------
(1) All Executive Officers serve at the pleasure of the Board of Directors.

SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

Section 16(a) of the Securities Exchange Act of 1934, as amended, requires
the Company's directors, the Company's executive officers and persons who
beneficially own more that ten percent of the Common Stock to file reports of
ownership and changes in ownership with the SEC. Such directors, officers and
greater than ten percent shareholders are required by SEC regulations to furnish
the Company with copies of all Section 16(a) forms they file.

Based solely on the Company's review of the copies of such forms furnished
to the Company, or written representations from certain reporting persons, the
Company believes that during fiscal 1999 its directors, officers and greater
than ten percent beneficial owners were in compliance with all applicable filing
requirements.

64
<PAGE> 66

ITEM 11. EXECUTIVE COMPENSATION

This item contains information with respect to compensation paid to the
Company's Seven Named Officers and its Directors.

SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION
AWARDS
ANNUAL COMPENSATION -----------------------
------------------------------------------ SECURITIES
OTHER RESTRICTED UNDERLYING
ANNUAL STOCK OPTIONS/ ALL OTHER
NAME AND PRINCIPAL POSITION SALARY BONUS COMPENSATION AWARDS SARS COMPENSATION
DURING FISCAL 1999 YEAR ($) ($) ($)(1) ($)(2) (#) ($)(3)
--------------------------- ---- -------- ---------- ------------ ---------- ---------- ------------
<S> <C> <C> <C> <C> <C> <C> <C>
S. Cusano............................. 1999 $650,000 $1,685,467(4) -- -- 31,738
Chief Executive Officer 1998 406,906 -- -- -- 579,500 4,050
1997 369,616 25,000 -- 31,250(9) 425,000 2,300
Charles Septer........................ 1999 500,000 969,334(5) -- -- -- 1,268
President and Chief Operating 1998 366,296 -- -- -- 402,153 2,818
Officer 1997 349,860 -- -- -- 240,000 2,757
C. Steven Moore....................... 1999 350,000 410,175(6) -- -- -- 809
Senior Vice President, Chief 1998 190,000 -- -- -- -- 390
Administrative Officer, 1997 160,000 -- -- -- -- 283
General Counsel and Secretary
Thomas L. Garrett, Jr................. 1999 315,000 379,780(7) -- -- -- 662
Senior Vice President and 1998 262,501 -- -- -- -- 26,656
Chief Financial Officer 1997 250,000 -- -- -- -- 390
Gary Sease............................ 1999 318,270 306,494(8) -- -- -- 802
Senior Vice President 1998 324,861 -- -- -- 290,000 5,765
Logistics 1997 309,000 50,000 -- -- -- 12,173
Gary M. Witkin(9)..................... 1999 742,630 -- -- -- -- 2,337,885(10)
President and CEO 1998 756,911 -- 30,000 -- 999,999 8,794
1997 773,614 108,150 30,000 -- 1,000,000 5,474
Bettina Whyte(11)..................... 1999 --(12) -- -- -- -- --
CEO
</TABLE>

- ---------------
(1) Mr. Witkin received a non-accountable expense allowance of $30,000 in fiscal
1998 and 1997.

(2) The value of outstanding restricted stock awards as of January 2, 2000 are
as follows:

<TABLE>
<CAPTION>
NUMBER OF
NAME SHARES VALUE
---- --------- -----
<S> <C> <C>
S. Cusano................................................... 3,334 283
C. Steven Moore............................................. 20,000 1,700
Thomas Garrett.............................................. 20,000 1,700
</TABLE>

Dividends are payable on restricted stock when and if it is paid on unrestricted
stock. No dividends were paid in the reported fiscal years.

65
<PAGE> 67

(3) Represents estimated Company contributions in benefits derived from payments
by the Company for group life insurance. The amount of such benefits for
1999 is set forth in the following table:

<TABLE>
<CAPTION>
GROUP TERM
LIFE INSURANCE
--------------
<S> <C>
S. Cusano................................................... $1,638
Charles Septer.............................................. $1,268
C. Steven Moore............................................. $ 809
Thomas L. Garrett, Jr....................................... $ 662
Gary Sease.................................................. $ 802
Gary M. Witkin.............................................. $ 156
Bettina Whyte............................................... $ 0
</TABLE>

(4) Mr. Cusano's Bonus includes $1,288,000 paid pursuant to an amendment to his
severance agreement with the Company effective February 1, 1999. Mr. Cusano
also received $195,000 under the Company's employee retention program and
earned $195,000 under the same program which was paid on January 31, 2000.
Mr. Cusano also earned $7,467 under the Company's 1999 Incentive Bonus
Program which is to be paid by March 31, 2000.

(5) Mr. Septer's Bonus includes $500,000 paid pursuant to his employment
agreement dated March 23, 1999. Mr. Septer also received $150,000 under the
Company's employee retention program and earned $150,000 under the same
program which was paid on January 31, 2000. Mr. Septer also earned $169,334
under the Company's 1999 Incentive Bonus Program which is to be paid by
March 31, 2000.

(6) Mr. Moore's Bonus includes $31,175 paid pursuant to the Company's 1998
Incentive Bonus Program. Mr. Moore also received $78,750 under the Company's
employee retention program and earned $78,750 under the same program which
was paid on January 31, 2000. Mr. Moore also earned $221,500 under the
Company's 1999 Incentive Bonus Program which is to be paid by March 31,
2000.

(7) Mr. Garrett's Bonus includes $76,435 paid pursuant to the Company's 1998
Incentive Bonus Program. Mr. Garrett also received $59,063 under the
Company's employee retention program and earned $59,063 under the same
program which was paid on January 31, 2000. Mr. Garrett also earned $185,220
under the Company's 1999 Incentive Bonus Program which is to be paid by
March 31, 2000.

(8) Mr. Sease's Bonus includes $59,676 paid pursuant to the Company's employee
retention program and $59,676 earned under the same program which was paid
on January 31, 2000. Mr. Sease also earned $187,143 under the Company's 1999
Incentive Bonus Program which is to be paid by March 31, 2000.

(9) Mr. Witkin resigned as President and CEO on January 4, 1999.

(10) Includes $2,317,890 payment provided in the agreement with the Company
dated January 7, 1999 in connection with his resignation as President and
CEO.

(11) Ms. Whyte served as the Company's CEO from February 8, 1999 through March
23, 1999 pursuant to the Company's agreement.

(12) Ms. Whyte is a principal in J. Alix and Associates and received no direct
compensation from the Company for her services as the Company's CEO. During
fiscal 1999, the Company paid J. Alix and Associates $2,093,446 for
services rendered by all J. Alix personnel assigned to the Company's
engagement and expenses of $120,613.

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<PAGE> 68

OPTIONS/SAR EXERCISE AND YEAR-END VALUE TABLE

The following table provides information as to options exercised or held by
the Seven Named Officers during fiscal 1999. None of the Named Officers has been
granted SARs.

<TABLE>
<CAPTION>
NUMBER OF SECURITIES VALUE OF UNEXERCISED
UNDERLYING UNEXERCISED IN-THE-MONEY
OPTIONS/SARS AT OPTION/SARS AT
SHARES ACQUIRED VALUE FISCAL YEAR-END(#) FISCAL YEAR-END(#)
NAME ON EXERCISE REALIZED EXERCISABLE/UNEXERCISABLE(1) EXERCISABLE/UNEXERCISABLE(1)
- ---- --------------- -------- ---------------------------- ----------------------------
<S> <C> <C> <C> <C>
S. Cusano................ -- -- 193,167/386,333 $0/$0
Charles Septer........... -- -- 134,051/268,102 $0/$0
C. Steven Moore.......... -- -- 10,335/20,670 $0/$0
Thomas L. Garrett,
Jr. ................... -- -- 41,667/83,333 $0/$0
Gary Sease............... -- -- 96,667/193,333 $0/$0
Gary M. Witkin........... -- -- 0/0 $0/$0
Bettina Whyte............ -- -- 0/0 $0/$0
</TABLE>

- ---------------
(1) The number of unexercised options and/or SARs available at fiscal year-end,
whether exercisable or Unexercisable, includes out-of-the money options, and
the value of unexercised options and/or SARs available at fiscal year-end
does not include out-of-the money options.

DIRECTOR COMPENSATION

In fiscal 1999, directors not otherwise employed as officers of the Company
received an annual fee of $23,000. In addition, Directors were paid $1,250 per
in-person Board meeting and $300 per telephonic Board meeting. Mr. Holt,
Chairman of the Audit Committee and member of the Compensation Committee,
received an additional $5,250 for the year for his committee service. Mr. Moore,
Chairman of the Compensation Committee, received an additional $1,000 for the
year for his committee service. Mr. Roitenberg, member of the Audit and
Compensation Committees, received an additional $1,250 for the year for his
committee service. Mr. Crane, member of the Audit Committee, received an
additional $1,000 for the year for his committee service.

Under the Directors' Deferred Compensation Plan, implemented in 1991,
directors have the option of deferring receipt of their fees until a period
following their service as a director or until retirement age.

Under the Second Amended and Restated Directors' Equity Plan each
nonemployee director receives on the date of the Annual Meeting of Shareholders,
options to purchase 3,000 shares of Common Stock at an exercise price equal to
the fair market value of such shares on the date of grant. The options expire 10
years from the date of grant and are exercisable in installments of twenty
percent each year beginning one year from the date of grant. The options become
immediately exercisable on a director's death or disability or on the date a
"change in control" is deemed to occur under the Amended and Restated 1989
Employee Stock Incentive Plan. See "Change in Control Provisions Under the
Company's Stock Incentive Plans." The Second Amended and Restated Directors'
Equity Plan provides nonemployee directors the option to apply their cash
retainer payment to acquire options to purchase shares of Common Stock of the
Company. During 1999 no options were granted to any of the Directors under this
plan.

From January 29, 1998 until his resignation on January 7, 1999, James E.
Poole served as Chairman of the Board. The Company and Mr. Poole entered into an
agreement providing that so long as Mr. Poole served as Chairman of the Board he
was to receive $10,000 per month as compensation. The agreement also provided
for certain compensation upon death, disability or removal from office,
secretarial assistance and reimbursement of reasonable expenses. In connection
with his resignation as Chairman of the Board and his retirement from the Board
of Directors, the Company paid Mr. Poole $250,000.

67
<PAGE> 69

SEVERANCE AND INDEMNIFICATION AGREEMENTS; EMPLOYMENT AGREEMENTS; CHANGE IN
CONTROL PROVISIONS

During fiscal 1999, the Company had severance agreements with each of the
Named Officers currently employed by the Company. The severance agreements were
entered into in December 1998, and with respect to Mr. Garrett, March 1999, and
replaced severance agreements previously in place with the Named Officers (other
than Mr. Garrett). Mr. Cusano's severance agreement was subsequently amended as
described below, and Mr. Cusano, Mr. Septer and Mr. Moore subsequently entered
into employment agreements as described below, which replaced each of their
severance agreements.

The severance agreements in place during fiscal 1999 with Messrs. Sease and
Garrett and the employment agreements of Messrs. Cusano, Septer and Moore
described below provide for the payment of compensation in the form of salary
continuation in the amount of two times the officer's maximum annual base salary
plus bonuses paid in the preceding twelve months and continuation of certain
healthcare benefits, if the employment of the Named Officer is terminated for
any reason other than the officer's death, disability, or for cause. If the
Named Officer is terminated or deemed to be terminated within two years of a
Change in Control, he will be entitled to salary continuation in the amount of
three times the officer's maximum annual base salary. A Change in Control under
these agreements is the same as that used in the Company's Stock Incentive Plan
described below. Under the terms of these agreements, the employment of a Named
Officer is deemed terminated for cause if he engages in (i) willful misconduct
materially injurious to the Company; (ii) acts of dishonesty or fraud; (iii)
willful violations of obligations not to compete with the Company or disclose
confidential information. If the employment of a Named Officer is terminated for
death or for cause, he will be entitled only to his base salary through the date
of termination. If the employment is terminated by reason of disability, the
officer will be entitled only to his base salary through the date of termination
and such amounts as he is entitled to receive under the Company's disability
insurance policies. The agreements provide that these Named Officers will not
engage in various activities competitive with the business of the Company for a
period of two year from the date of any termination giving rise to salary
continuation payments. The assumption by the Company of these employment and
severance agreements was approved by the Bankruptcy Court on May 25, 1999 with
the modifications that, (i) excluded from the definition of Change in Control is
an event (that would otherwise be a Change in Control) that occurs in connection
with the substantial consummation of a plan of reorganization and (ii) the
period of non-competition is increased to two years.

Gary M. Witkin entered into an agreement with the Company January 7, 1999
pursuant to which he resigned as President, Chief Executive Officer, and as a
director. The agreement provides for (i) the payment to Mr. Witkin of
$2,317,890, (ii) continuation of health care coverage for the shorter of two
years or his eligibility for coverage with another employer, (iii) the transfer
of title to his Company provided automobile. The agreement requires Mr. Witkin
to cooperate with the Company in litigation and related proceedings. Mr. Witkin
is obligated under the agreement to maintain certain matters in confidence and
not to compete with the Company.

On January 8, 1999, the Company entered into a retention agreement (the "JA
Agreement") with Jay Alix & Associates ("Jay Alix"), pursuant to which Jay Alix
assumed management responsibility for the Company. Under the JA Agreement,
Bettina M. Whyte was the principal responsible for the overall engagement. On
February 8, 1999, she was designated Chief Executive Officer by the Board. She
resigned on March 23, 1999. The JA Agreement contains standard indemnification
provisions, including indemnification provisions for the benefit of Ms. Whyte.

Effective February 1, 1999, the Company entered into an agreement (the
"February Agreement") with S. Cusano, then the Executive Vice President and
Chief Financial Officer, amending and restating his severance agreement with the
Company. Under the terms of this restated agreement, Mr. Cusano resigned
effective May 20, 1999, but agreed to continue as Executive Vice President and
Chief Financial Officer through the effective date of his resignation. The
agreement provides for (i) the payment to Mr. Cusano of $1,288,000 in
installments payable through May 20, 1999, in addition to his regular pay while
employed with the Company, (ii) the vesting of all unvested stock options held
by him on May 20, 1999, (iii) the immediate transfer of title to his Company
provided automobile, (iv) the continuation of health care benefits for the
shorter of two years or his eligibility for coverage with another employer, and
(v) the payment of Mr. Cusano's

68
<PAGE> 70

attorney's fees. The Company has the right to terminate him at any time. If he
is terminated for Cause (defined as (a) the willful engaging in misconduct
materially injurious to the Company, (b) acts of dishonesty or fraud, or (c) the
willful violation of obligations not to compete with the Company or disclose
confidential information) the Company can stop further payments and recoup prior
incentive payments made. If his employment is terminated for death or for cause,
he will be entitled only to his base salary through the date of termination. If
the employment is terminated by reason of disability, the officer will be
entitled only to his base salary through the date of termination, and such
amounts as he is entitled to receive under the Company's disability insurance
policies. The agreement provides that Mr. Cusano will not compete with the
Company during the term of the Agreement.

On March 23, 1999, the Company appointed Mr. Cusano as Chief Executive
Officer. In connection therewith, the Company and Mr. Cusano entered into an
employment agreement with an initial term of three years which renews
automatically for additional one year terms unless either party gives
appropriate notice to the other party. The agreement provides for a base salary
of $650,000 with the opportunity to receive an annual incentive bonus. Any such
annual incentive bonus would be subject to offset by up to one-third of the
amounts paid to Mr. Cusano pursuant to the February Agreement between the
Company and Mr. Cusano.

In connection with his appointment as President and Chief Operating
Officer, on March 23, 1999, the Company and Mr. Septer entered into an
employment agreement with an initial term of three years which renews
automatically for additional one year terms unless either party gives
appropriate notice to the other party. The agreement provides for a base salary
of $500,000. The agreement provides that Mr. Septer will be paid a bonus of
$250,000 on each of March 26, 1999 and April 23, 1999 (the "Special Bonus") and
that he will be entitled to receive an annual incentive bonus pursuant to the
Company's annual bonus plan offset by up to one-third of the amount of the
Special Bonus.

In connection with his appointment as Senior Vice President, Chief
Administrative Officer and General Counsel, on March 23, 1999, the Company and
Mr. Moore entered into an employment agreement with an initial term of three
years which renews automatically for additional one year terms unless either
party gives appropriate notice to the other party. The agreement provides for a
base salary of $350,000 with the opportunity to receive an annual incentive
bonus.

On May 5, 1999, the Bankruptcy Court approved the Company's employee
retention program which includes a stay bonus program (the "Stay Bonus Program")
applicable to the Named Officers, among others. Pursuant to the Stay Bonus
Program, for fiscal year 1999, Mr. Cusano earned $390,000, Mr. Septer earned
$300,000, Mr. Moore earned $157,500, Mr. Garrett earned $118,125, and Mr. Sease
earned $119,350.

The Company also has indemnification agreements with each of its directors
and Named Officers providing for contractual rights of indemnification to the
fullest extent permitted by Tennessee law.

CHANGE IN CONTROL PROVISIONS UNDER THE COMPANY'S STOCK INCENTIVE PLANS

Under the Stock Incentive Plan, any stock options and SAR's which are not
then exercisable will become fully exercisable and vested upon a change in
control or a potential change in control. Similarly, a change in control or a
potential change in control will result in the lapsing of restrictions
applicable to restricted stock and other stock-based awards and such shares and
awards being deemed fully vested. Stock options, SARs, limited SARs, restricted
stock and other stock-based awards will, in such instances, unless otherwise
determined by the Compensation Committee in is sole discretion, be cashed out on
the basis of the change in control price as defined in the plan. A change in
control occurs if (i) any person becomes a beneficial owner directly or
indirectly of 20% or more of the total voting stock of the Company (subject to
certain exceptions); (ii) as a result of, or in connection with, any cash tender
or exchange offer, merger or other business combination or similar transaction,
less than a majority of the combined voting power of the then outstanding
securities of the Company is held in the aggregate by the holders of Company
securities entitled to vote generally in the election of directors immediately
prior to such transaction; or (iii) during any period of two consecutive years,
individuals who at the beginning of such period constitute the Board of
Directors cease for any reason to constitute at least a majority thereof. A
potential change in control means (i) approval by the shareholders of an
aggregate which, if completed, would constitute a change in control, or (ii) the
acquisition

69
<PAGE> 71

by a person of 5% or more of the total voting stock of the Company and the
adoption by the Board of a resolution that a potential change in control, as
defined in the plan, has occurred.

Options and shares of restricted stock granted under the Second Amendment
and Restated Directors' Equity Plan become immediately vested on the date a
"change in control" is deemed to occur under the Stock Incentive Plan.

PENSION PLAN

The Company's pension plan (the "Pension Plan") which is qualified under
Section 401(a) of the Internal Revenue Code of 1986, as amended (the "Code"),
includes all full-time employees who are at least age twenty-one with one year
of qualified service as defined by the Pension Plan. Directors who are not
officers or employees of the Company do not participate. In 1996, the Pension
Plan was changed to a traditional final average compensation plan, with monthly
benefits on years of service. Participants in the Pension Plan as of January 1,
1998 are provided certain minimum benefits reflecting the provisions of the
prior Pension Plan based on compensation received during 1998.

The following table shows the estimated annual pension benefits payable to
a covered participant at normal retirement age, based on selected compensation
and years of service compensations:

<TABLE>
<CAPTION>
YEARS OF SERVICE
-----------------------------------------------
REMUNERATION 15 20 25 30 35
- ------------ ------- ------- ------- ------- -------
<S> <C> <C> <C> <C> <C>
$125,000 $19,958 $26,610 $33,263 $39,915 $46,568
150,000 25,583 34,110 42,638 51,165 59,693
175,000 27,833 37,110 46,388 55,665 64,943
200,000 27,833 37,110 46,388 55,665 64,943
225,000 27,833 37,110 46,388 55,665 64,943
250,000 27,833 37,110 46,388 55,665 64,943
300,000 27,833 37,110 46,388 55,665 64,943
400,000 27,833 37,110 46,388 55,665 64,943
450,000 27,833 37,110 46,388 55,665 64,943
500,000 27,833 37,110 46,388 55,665 64,943
</TABLE>

Compensation covered by the plan generally includes all compensation earned
by a participant, including elective deferrals to qualified plans but excluding
severance payments, expense reimbursements and allowances, and other non-wage
items. However, for purposes of determining benefits, compensation covered by
the plan is limited to $160,000. As a result, covered compensation for each of
the Named Officers is limited to $160,000 by Section 401 (a)(17) of the Code. In
addition, annual benefits payable from the plan are limited to $130,000 by
Section 415 of the Code. These limitations are indexed periodically for
inflation.

The estimated credited years of service covered by the plan for each of the
persons named in the compensation table are:

<TABLE>
<CAPTION>
AS OF DECEMBER 31, 1999 AS OF AGE 65
----------------------- ------------
<S> <C> <C>
S. Cusano.......................................... 8 27
Charles Septer..................................... 18 35
C. Steven Moore.................................... 3 35
Thomas L. Garrett, Jr.............................. 3 22
Gary Sease......................................... 3 12
Gary M. Witkin..................................... N/A N/A
Bettina Whyte...................................... N/A N/A
</TABLE>

On August 31, 1999, the Bankruptcy Court approved a motion by the Company
to amend the Pension Plan. The amendment ceased the accrual of benefits,
disallowed new enrollments to the plan and vested benefits already accrued under
the plan effective September 30, 1999.

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<PAGE> 72

Retirement benefits are computed on the basis of a straight life annuity,
unless the participant elects another method of payment. If the participant is
married, the benefit is converted into an actuarially equivalent joint and 50%
survivor benefit. The benefits shown in the table above are not subject to
deduction for Social Security or other offset amounts. The Company is
considering various options with respect to the Restated Retirement Plan, which
may include reinstatement, amendments, termination or substitution, among other
things.

EXECUTIVE SECURITY PROGRAM

The Company maintains a non-qualified supplemental retirement plan (the
"ESP") which covers certain management employees hired or promoted to their job
level prior to February 28, 1989. The plan provides salary continuation and/or
death benefits equal to two times the participant's annual salary at retirement
age or at age 65. Participants who complete 20 years of service and terminate
employment prior to attaining retirement age are eligible for a death benefit up
to age 65, at which time they may elect salary continuation and/or death
benefits. Salary continuation benefits are paid from the general assets of the
Company. The benefit accrual under the ESP was frozen effective September 30,
1999. There were approximately 75 active employees covered as of January 1,
2000. Approximately 35 retirees were eligible to receive benefits as of April,
1999 and approximately 46 terminated vested participants are entitled to a
future benefit. The Company maintains Corporate Owned Life Insurance (COLI)
policies purchased on participants covered by the plan prior to the Tax Reform
Act of 1986. The Company continues to maintain COLI policies following
termination or retirement of covered employees, other than with respect to Mr.
Zimmerman. See Item 13. "Certain Relationships and Related Transactions". Of the
Named Officers, only Charles Septer is a participant in the ESP. Upon retirement
and if Mr. Septer chose to waive 100% of the death benefit, Mr. Septer's annual
installment benefit would be approximately $71,900. Continuation of the ESP is
subject to Bankruptcy Court approval. On August 31, 1999, the Bankruptcy Court
approved a motion by the Company to amend the ESP. The amendment ceased the
accrual of benefits and suspended payments effective September 30, 1999. Claims
under the ESP are classified as liabilities subject to compromise by the
Company. See "Notes to Consolidated Financial Statements -- J. Liabilities
Subject to Compromise." During 1999 an ESP committee was formed and the Company
is working with the committee to resolve claims. The Company is considering
various options with respect to the Executive Security Program which may include
reinstatement, amendments, termination or substitution, among other things.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The following table sets forth, as of February 27, 2000, certain
information regarding the beneficial ownership of Common Stock by all directors
of the Company (unless otherwise noted), the Company's Chief Executive Officer
as of January 2, 2000, the four most highly compensated executive officers of
the Company other than such Chief Executive Officer, by all directors and
executive officers as a group, and all other persons beneficially owning greater
than five percent of the Common Stock. The Company believes each director or
officer, except as otherwise indicated, has sole voting and investment power
over the shares of Common Stock listed as beneficially owned by him.

71
<PAGE> 73

SECURITY OWNERSHIP OF CERTAIN
BENEFICIAL OWNERS AND MANAGEMENT

<TABLE>
<CAPTION>
NUMBER OF SHARES PERCENT OF
NAME BENEFICIALLY OWNED CLASS(1)
- ---- ------------------ ----------
<S> <C> <C>
Raymond Zimmerman........................................... 4,396,624
24,341(2)
392,070(3)
566,280(4)
------------
5,379,315(5) 5.3%
Richard P. Crane............................................ 14,113(6)
Charles V. Moore............................................ 163,695(7)(8)
R. Maynard Holt............................................. 11,189(6)(9)
Harold Roitenberg........................................... 43,563(10)
S. Cusano................................................... 225,373(11)
Charles Septer.............................................. 143,593(12)
C. Steven Moore............................................. 30,335(13)
Thomas L. Garrett, Jr. ..................................... 66,667(14)
Gary Sease.................................................. 96,667(15)
All directors and executive officers as a group (15
persons).................................................. 7,557,160(16) 7.5%
</TABLE>

- ---------------
(1) Percentages representing less than 1% of the outstanding shares of Common
Stock are not shown.

(2) Shares held by the Equitable Trust Company in an IRA account.

(3) Represents 239,748 shares owned of record by Mr. Zimmerman as trustee for
two nieces and 152,322 shares as to which Mr. Zimmerman is trustee under
the will of Mary K. Zimmerman.

(4) Represents 405,000 shares owned of record by the Raymond Zimmerman Family
Foundation and 161,280 shares owned of record by the Zimmerman Foundation.

(5) The address for Mr. Zimmerman is 7100 Service Merchandise Drive, Brentwood,
Tennessee 37027.

(6) Includes currently exercisable options to acquire 4,500 shares granted
under the Second Amended and Restated Directors' Equity Plan.

(7) Includes currently exercisable options to acquire 68,297 shares granted
under the Second Amended and Restated Directors' Equity Plan.

(8) Includes 9,280 shares owned by Mr. Moore as custodian for two minor
children.

(9) Includes 1,937 shares owned of record by Mr. Holt as trustee for the R.
Maynard Holt Profit Sharing Plan, a qualified profit sharing plan under the
Internal Revenue Code, 2,100 shares owned by Mr. Holt's wife and 2,000
shares owned by Mr. Holt's mother.

(10) Includes 28,564 shares owned by Roitenberg Investments, Inc., which is 100%
owned by Mr. Roitenberg, and currently exercisable options to acquire
13,495 shares granted under the Second Amended and Restated Directors'
Equity Plan.

(11) Includes 32,206 restricted shares of Common Stock held by the Company until
restrictions lapse.

(12) Includes 1,148 shares held by Mr. Septer's wife (who is an employee of the
Company) and currently exercisable options to acquire 134,051 shares
granted under the Amended and Restated 1989 Stock Incentive Plan.

(13) Includes currently exercisable options to acquire 10,335 shares granted
under the Amended and Restated 1989 Stock Incentive Plan.

(14) Includes currently exercisable options to acquire 41,667 shares granted
under the Amended and Restated 1989 Stock Incentive Plan.

(15) Includes currently exercisable options to acquire 96,667 shares granted
under the Amended and Restated 1989 Stock Incentive Plan.

(16) Includes currently exercisable options to acquire 845,845 shares granted
under the Second Amended and Restated Directors' Equity Plan and the
Amended and Restated 1989 Stock Incentive Plan.

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<PAGE> 74

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The Company leased one store property from Raymond Zimmerman. For the
fiscal year ended January 2, 2000, Mr. Zimmerman received $33,750 under this
lease. The rent that has been paid under this lease is comparable to rent paid
by lessees of similar properties in the same general location, and the terms of
such lease are at least as favorable to the Company as the terms that could be
obtained from unaffiliated persons. The Company also entered into certain other
contractual arrangements with certain of its directors and executive officers
during fiscal 1999. See Item 1 "Executive Compensation -- Severance and
Indemnification Agreements; Employment Agreements; Change in Control
Provisions."

On September 28, 1999, the Bankruptcy Court approved the substitution of
Service Realty Company, Inc. ("SRC") for Starwood Ceruzzi Benderson, LLC
("Starwood") as buyer for certain property owned by the Company and located in
Nashville, Tennessee. While SRC is not an affiliate of the Company or a debtor
in the Chapter 11 Cases, SRC's president, Raymond Zimmerman, is also executive
chairman of the Board of Directors of the Company. SRC purchased the property in
connection with the exercise of a right of first refusal with respect to the
property granted to it pursuant to a certain Operating Agreement executed
December 18, 1996, by and between the Company and SRC. The terms of sale,
including a purchase price of $650,000, were otherwise identical to those
offered by Starwood and previously approved by the Bankruptcy Court by order
dated July 18, 1999.

On September 28, 1999, the Bankruptcy Court approved the transfer of a
certain split dollar insurance policy insuring the life of Raymond Zimmerman
from the Company to Mr. Zimmerman. The consideration paid by Mr. Zimmerman,
approximately $730,000, was equal to the cash surrender value of the policy,
which the Company could otherwise have received. The transfer of the policy also
relieved the Company of premium obligations of approximately $114,000 per year.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-K

(a) Documents filed as a part of this report.

1. Financial Statements
See Item 8. Financial Statements and Supplementary Data

2. Financial Statement Schedule
Schedule II Valuation and Qualifying Accounts and Reserves

3. Exhibits Required by Item 601 of Regulation S-K. See Exhibit Index.

EXHIBITS FILED WITH THIS FORM 10-K:

<TABLE>
<CAPTION>
EXHIBIT NO. IN
EXHIBIT NO. UNDER DOCUMENT
ITEM 601 OF WHERE
REGULATION S-K BRIEF DESCRIPTION ORIGINALLY FILED
- ----------------- ----------------- ----------------
<C> <S> <C>
4.19 First Amendment to Post-Petition Credit Agreement dated as
of May 6, 1999, by and among the Registrant, Citicorp USA,
Inc., as administrative agent, Bank Boston, N.A., as
documentation agent and collateral monitoring agent, and
Salomon Smith Barney, Inc., as sole arranger and book
manager.
21 Subsidiaries of the Registrant.
23 Independent Auditors' consent.
27 Financial Data Schedule for the fiscal year ended January 2,
2000.
</TABLE>

73
<PAGE> 75

<TABLE>
<CAPTION>
EXHIBIT NO. IN
EXHIBIT NO. UNDER DOCUMENT
ITEM 601 OF WHERE
REGULATION S-K BRIEF DESCRIPTION ORIGINALLY FILED
- ----------------- ----------------- ----------------
<C> <S> <C>
EXHIBITS INCORPORATED HEREIN BY REFERENCE:
3.1 Registrant's Charter, as amended February 5, 1998 which is 3.1
incorporated herein by reference to the Registrant's Form
10-K for the fiscal year ended December 28, 1997.
3.2 Registrant's By-Laws, as amended (restated in electronic 3.2
format only for the purpose of filing with the Commission)
which is incorporated by reference to the Registrant's Form
10-K for the fiscal year ended January 3, 1999.
4.1 Amended and Restated Rights Agreement dated November 4, 1998 99.2
which is incorporated herein by reference from Registrant's
Form 8-K dated November 4, 1998.
4.2 Note Purchase Agreement dated as of June 28, 1990 concerning 4.2a
the refinancing of $90 million of the Real Estate Bridge
Loan under Credit Agreement dated as of July 24, 1989 among
the Registrant, Various Banks and Chemical Bank as Agent,
which is incorporated herein by reference from the
Registrant's Form 10-Q for the second quarter ended June 30,
1990.
4.3 Trust Indenture dated as of June 28, 1990 concerning the 4.2b
refinancing of $90.0 million of the Real Estate Bridge Loan
under the Credit Agreement dated as of July 24, 1989 among
the Registrant, Various Banks and Chemical Bank as Agent,
which is incorporated herein by reference from the
Registrant's Form 10-Q for the second quarter ended June 30,
1990.
4.4 Indenture, dated as of February 15, 1993, between the 4.1
Registrant and First American National Bank, as Trustee,
regarding the Registrant's $300,000,000 of 9% Senior
Subordinated Debentures due 2004, which is incorporated
herein by reference from the Registrant's
4.5 Form 8-K dated February 17, 1993. First Supplemental 4.2
Indenture, dated as of February 15, 1993, between the
Registrant and First American National Bank, as Trustee,
regarding the Registrant's $300,000,000 of 9% Senior
Subordinated Debentures due 2004, which is incorporated
herein by reference from the Registrant's Form 8-K dated
February 17 1993.
4.6 Form of Debenture, regarding the Registrant's $300,000,000 4.3
of 9% Senior Subordinated Debentures due 2004, which is
incorporated herein by reference from the Registrant's Form
8-K dated February 17, 1993.
4.7 Form of Notes, regarding the Registrant's $100,000,000 of 4.3
8 3/8% Senior Notes due 2001, which is incorporated herein
by reference from the Registrant's Form 8-K dated October
26, 1993.
4.8 Conditional Loan Commitment dated as of September 9, 1996, 4.2
concerning the $75.0 million Real Estate Mortgage Financing
among Service Merchandise Company, Inc., and First Union
National Bank of North Carolina which is incorporated herein
by reference from the Registrant's Form 10-Q for the third
quarter ended September 29, 1996.
</TABLE>

74
<PAGE> 76

<TABLE>
<CAPTION>
EXHIBIT NO. IN
EXHIBIT NO. UNDER DOCUMENT
ITEM 601 OF WHERE
REGULATION S-K BRIEF DESCRIPTION ORIGINALLY FILED
- ----------------- ----------------- ----------------
<C> <S> <C>
4.9 Loan Agreement dated as of October 4, 1996 concerning the 4.2a
$75.0 million Real Estate Mortgage Financing among
SMC-SPE-1, Inc., and First Union National Bank of North
Carolina which is incorporated herein by reference from the
Registrant's Form 10-Q for the third quarter ended September
29, 1996.
4.10 Loan Agreement dated as of October 4, 1996 concerning the 4.2b
$75.0 million Real Estate Mortgage Financing among
SMC-SPE-2, Inc., and First Union National Bank of North
Carolina which is incorporated herein by reference from the
Registrant's Form 10-Q for the third quarter ended September
29, 1996.
4.11 First Amendment to Loan Agreement dated as of November 7, 4.19
1996 concerning the $75.0 million Real Estate Mortgage
Financing among SMC-SPE-2, Inc., and First Union National
Bank of North Carolina which is incorporated herein by
reference to the Registrant's Form 10-K for the fiscal year
ended December 29, 1996.
4.12 Second Amendment to Loan Agreement dated as of December 20, 4.20
1996 concerning the $75.0 million Real Estate Mortgage
Financing among SMC-SPE-2, Inc., and First Union National
Bank of North Carolina which is incorporated herein by
reference to the Registrant's Form 10-K for the fiscal year
ended December 29, 1996.
4.13 Third Amendment to Loan Agreement dated as of January 16, 4.22
1997 concerning the $75.0 million Real Estate Mortgage
Financing among SMC-SPE-2, Inc., and First Union National
Bank of North Carolina which is incorporated herein by
reference to the Registrant's Form 10-K for the fiscal year
ended December 29, 1996.
4.14 Note Issuance Agreement dated September 30, 1997 among 4.15
Service Merchandise Company, Inc., H.J. Wilson Co., Inc. and
The Long-Term Credit Bank of Japan, Ltd. which is
incorporated herein by reference to the Registrant's Form
10-K for the fiscal year ended December 28, 1997
4.15 Post-Petition Credit Agreement dated as of March 29, 1999, 4.17
by and among the Registrant, Citicorp USA, Inc., as
administrative agent, Bank Boston, N.A., as documentation
agent and collateral monitoring agent, and Salomon Smith
Barney, Inc., as sole arranger and book manager which is
incorporated by reference to the Registrant's Form 10-K for
the fiscal year ended January 3, 1999.
4.16 Master Security Agreement dated as of March 29, 1999 by and 4.18
among Registrant and the Guarantors as Grantors and
Citicorp, USA, Inc. as Administrative Agent which is
incorporated by reference to the Registrant's Form 10-K for
the fiscal year ended January 3, 1999.
4.17 Second Amendment to Post-Petition Credit Agreement dated as 99.2
of September 29, 1999 by and among the Registrant, Citicorp
USA, Inc., as administrative agent, Bank Boston, N.A., as
documentation agent and collateral monitoring agent, and
Salomon Smith Barney, Inc., as sole arranger and book
manager which is incorporated by reference to the
Registrant's Form 8-K dated October 7, 1999.
</TABLE>

75
<PAGE> 77

<TABLE>
<CAPTION>
EXHIBIT NO. IN
EXHIBIT NO. UNDER DOCUMENT
ITEM 601 OF WHERE
REGULATION S-K BRIEF DESCRIPTION ORIGINALLY FILED
- ----------------- ----------------- ----------------
<C> <S> <C>
10.1 Stock Option Pledge Agreement between Service Merchandise 10.2
Company, Inc., and the Service Merchandise Foundation dated
October 15, 1990, which is incorporated herein by reference
from the Registrant's Form 10-K for the fiscal year ended
December 29, 1990.
10.2 Aircraft Lease Agreement dated as of June 26, 1998 between 10.1
the Registrant and General Electric Capital Corporation
which is incorporated herein by reference from the
Registrant's Form 10-Q for the second quarter ended June 28,
1998.
EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS:
10.3 Form of Indemnification Agreement between the Registrant and Exhibit A
each of Messrs. Zimmerman, Crane, Holt, Moore, Roitenberg,
Cusano, Mulet and Septer which is incorporated herein by
reference from the Registrant's Proxy Statement dated April
19, 1989.
10.4 Directors' Deferred Compensation Plan, which is incorporated 10.1
herein by reference from the Registrant's Form 10-K for the
fiscal year ended December 29, 1990.
10.5 Key Executive Severance Plan Agreement for execution by 10.2
certain key executives in replacement of employment
contracts which is incorporated herein by reference from the
Registrant's Form 10-Q for the third quarter ended October
2, 1994.
10.6 Amended and Restated 1989 Employee Stock Incentive Plan 10.2
which is incorporated herein by reference from the
Registrant's Form 10-K for the fiscal year ended January 1,
1995.
10.7 Retirement Benefits Agreement dated as June 25, 1998 which 10.1
is incorporated herein by reference from the Registrant's
Form 10-Q for the third quarter ended September 27, 1998.
10.8 Letter Agreement II between the Registrant and Jay Alix & 10.9
Associates dated March 23, 1999 which is incorporated by
reference to the Registrant's Form 10-K for the fiscal year
ended January 3, 1999.
10.9 Form of Severance Agreement Amendment between the Registrant 10.10
and each of Messrs. [Cusano, Mulet, Sease and Septer] which
is incorporated by reference to the Registrant's Form 10-K
for the fiscal year ended January 3, 1999.
10.10 Letter Agreement among the Registrant and S. Cusano dated 10.14
February 1, 1999 which is incorporated by reference to the
Registrant's Form 10-K for the fiscal year ended January 3,
1999.
10.11 Second Amended and Restated Directors' Equity Plan which is 10.15
incorporated by reference to the Registrant's Form 10-K for
the fiscal year ended January 3, 1999.
10.12 Employment Agreement between the Registrant and S. Cusano 10.16
dated March 23, 1999 which is incorporated by reference to
the Registrant's Form 10-K for the fiscal year ended January
3, 1999.
10.13 Employment Agreement between the Registrant and Charles 10.17
Septer dated March 23, 1999 which is incorporated by
reference to the Registrant's Form 10-K for the fiscal year
ended January 3, 1999.
</TABLE>

76
<PAGE> 78

<TABLE>
<CAPTION>
EXHIBIT NO. IN
EXHIBIT NO. UNDER DOCUMENT
ITEM 601 OF WHERE
REGULATION S-K BRIEF DESCRIPTION ORIGINALLY FILED
- ----------------- ----------------- ----------------
<C> <S> <C>
10.14 Employment Agreement between Registrant and C. Steven Moore 10.18
dated March 23, 1999 which is incorporated by reference to
the Registrant's Form 10-K for the fiscal year ended January
3, 1999.
10.15 Commitment Letter and Term Sheet of Fleet Retail Finance 99.2
Inc. for Debtor-in-Possession Credit Facility and
post-confirmation Revolving Credit Facility dated February
21, 2000 which is incorporated by reference to the
Registrant's Form 8-K dated February 25, 2000.
</TABLE>

(b) Reports on Form 8-K.

During the quarter ended January 2, 2000, the Company filed the following
four reports on Form 8-K: (i) dated October 7, 1999 announcing that its lenders
had approved an amendment to the $750.0 million debtor-in-possession financing
agreement that provided for the release of the $50.0 million borrowing base
reserve which had been in effect pending negotiation of financial covenants;
(ii) dated October 27, 1999 attaching the Monthly Operating Report filed with
the Bankruptcy Court for the period ending October 3, 1999; (iii) dated November
24, 1999 attaching the Monthly Operating Report filed with the Bankruptcy Court
for the period ending October 31, 1999; and (iv) dated December 22, 1999
attaching the Monthly Operating Report filed with the Bankruptcy Court for the
period ending November 28, 1999.

77
<PAGE> 79

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned thereunto duly authorized.

SERVICE MERCHANDISE COMPANY, INC.

By: /s/ S. CUSANO
------------------------------------
S. Cusano
Chief Executive Officer

March 15, 2000

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.

<TABLE>
<S> <C>
/s/ RAYMOND ZIMMERMAN
- --------------------------------------------------------
Raymond Zimmerman
Chairman of the Board
March 15, 2000

/s/ S. CUSANO
- --------------------------------------------------------
S. Cusano
Director and Chief Executive Officer
(Principal Executive Officer)
March 15, 2000

/s/ RICHARD P. CRANE, JR.
- --------------------------------------------------------
Richard P. Crane, Jr.
Director
March 15, 2000

/s/ CHARLES V. MOORE
- --------------------------------------------------------
Charles V. Moore
Director
March 15, 2000

/s/ R. MAYNARD HOLT
- --------------------------------------------------------
R. Maynard Holt
Director
March 15, 2000
</TABLE>

78
<PAGE> 80
<TABLE>
<S> <C>

/s/ HAROLD ROITENBERG
- --------------------------------------------------------
Harold Roitenberg
Director
March 15, 2000

/s/ CHARLES SEPTER
- --------------------------------------------------------
Charles Septer
Director, President and Chief Operating Officer
March 15, 2000

/s/ THOMAS L. GARRETT, JR.
- --------------------------------------------------------
Thomas L. Garrett, Jr.
Senior Vice President and Chief Financial Officer
(Principal Financial Officer)
March 15, 2000

/s/ KENNETH A. CONWAY
- --------------------------------------------------------
Kenneth A. Conway
Vice President -- Controller and Chief
Accounting Officer
(Principal Accounting Officer)
March 15, 2000
</TABLE>

<PAGE> 1

EXHIBIT 4.19

EXECUTION COPY

FIRST AMENDMENT TO

POST-PETITION CREDIT AGREEMENT AND

MASTER SECURITY AGREEMENT

FIRST AMENDMENT (this "Amendment"), dated as of May 6, 1999, to
POST-PETITION CREDIT AGREEMENT dated as of March 29, 1999, among SERVICE
MERCHANDISE COMPANY, INC., a Tennessee corporation and a debtor and
debtor-in-possession under chapter 11 of the Bankruptcy Code (as defined in the
Credit Agreement referenced below) (the "Borrower"), the financial institutions
and other entities identified from time to time parties thereto as a Lender (as
defined in the Credit Agreement referenced below), CITICORP USA, INC., a
Delaware corporation ("Citicorp"), as collateral agent and administrative agent
for the Lenders (in such capacity, the "Administrative Agent"), and BANKBOSTON,
N.A., a national banking association ("BankBoston"), as documentation agent and
collateral monitoring agent for the Lenders (in such capacities, the "Collateral
Monitoring Agent") and to MASTER SECURITY AGREEMENT dated as of March 29, 1999,
by and among the Borrower, the Subsidiaries of the Borrower party thereto (the
"Grantors"), and the Administrative Agent.

W I T N E S S E T H:

WHEREAS, pursuant to the above-referenced Post-Petition Credit
Agreement (as, supplemented or otherwise modified from time to time, the "Credit
Agreement") the Lenders have agreed to make, and have made, Loans to the
Borrower and have issued Letters of Credit for the account of the Borrower; and

WHEREAS, pursuant to the above-referenced Master Security Agreement
(as, supplemented or otherwise modified from time to time, the "Security
Agreement") (i) the Grantors guaranteed the prompt and complete payment and
performance by the Borrower of the Credit Agreement Obligations, (ii) as
security for the Grantors' obligations, the Grantors granted the Administrative
Agent, for the benefit of the Secured Parties, a security interest in
substantially all of their tangible and intangible property and (iii) as
security for the Borrower's Credit Agreement Obligations, the Borrower granted
the Administrative Agent, for the benefit of the Secured Parties, a security
interest in substantially all of its tangible and intangible property; and

WHEREAS, the Borrower and the Lenders have agreed to amend certain of
the provisions of the Credit Agreement and the Security Agreement, upon the
terms and subject to the conditions set forth below;

<PAGE> 2
NOW, THEREFORE, in consideration of the premises and the mutual
covenants and provisions hereinafter contained, the parties hereto hereby agree
as follows:

1. DEFINED TERMS. Capitalized terms used herein and not defined
herein but defined in the Credit Agreement are used herein as defined in the
Credit Agreement.

2. AMENDMENT TO SUBSECTION 1.1.

(a) The definition of "Notes" in subsection 1.1 of the Credit
Agreement is hereby amended by inserting the words, "Term Notes" immediately
after the words "Revolving Credit Notes."

(b) Clause (i) of the definition of "Permitted Expenses" in
subsection 1.1 of the Credit Agreement is hereby amended by deleting such
clause in its entirety and inserting in its place the following clause (i):

"(i)(A) allowed professional fees and disbursements incurred by the
professionals (the "Professionals") retained, pursuant to sections 327(a)
or (e) of the Bankruptcy Code under a general retainer (excepting ordinary
course professionals) or 1103(a), by the Loan Parties and up to two
statutory committees (each, a "Committee") appointed in the Reorganization
Cases and (B) the expenses of any member of any such committee allowed
under section 503(b)(3)(F) of the Bankruptcy Code, which collectively may
not exceed the sum of $3,000,000 in the aggregate, inclusive of any
holdbacks required by the Bankruptcy Court, for post-default services, plus
professional fees and disbursements previously incurred, accrued or
invoiced prior to such Event of Default and the delivery of notice as
provided below, to the extent previously or subsequently allowed, and"

(e) The definition of "Real Property Amortization Amount" in
subsection 1.1 of the Credit Agreement is hereby amended by deleting the
definition thereof in its entirety and inserting in its place following
definition:

"Real Property Amortization Amount;" with respect to all Eligible
Mortgaged Real Property at any time, an amount equal to (a) $500,000 times
(b) the number of full three-month periods that have been elapsed since the
Effective Date.

3. AMENDMENT TO SUBSECTION 3.1(A). The first sentence of subsection
3.1(a) of the Credit Agreement is hereby amended by adding the words "(the
"Interim Maximum Amount")" before the period but after the words "the Borrowing
Base at such time and $500,000,000."

<PAGE> 3

4. AMENDMENT TO SUBSECTION 4.1(c). Subsection 4.1(c) of the Credit
Agreement is hereby amended and restated in its entirety as follows:

"(c) The Borrower shall repay the Term Loans and the Revolving Loans
within three Business Days after the receipt by the Borrower or any
Restricted Subsidiary of any Asset Sale Proceeds in respect of the
Collateral other than (i) Collateral related to the Initial GOB Stores in
an amount equal to such Asset Sale Proceeds and (ii) other Collateral from
additional GOB stores in an aggregate amount in any Fiscal Year not to
exceed $15,000,000, such payment to be applied to Term Loans and Revolving
Loans pro rata in accordance with the aggregate principal amount of Term
Loans then outstanding and Revolving Credit Commitments then in effect. The
Borrower shall repay the Revolving Loans within three business days after
the receipt by the Borrower or any Restricted Subsidiary of any other Asset
Sale Proceeds in an amount equal to such Asset Sale Proceeds. The
application of any repayment pursuant to this subsection 4.1(c) shall be
made first to ABR Loans and second to Eurodollar Loans. Amounts prepaid on
account of the Term Loans shall be applied to installments of the Term
Loans in the inverse order of their maturity and may not be reborrowed."

5. AMENDMENT TO SUBSECTION 8.11. The cross-reference in subsection 8.11
to "subsection 8.5(e)" is hereby revised to be a cross-reference to "subsection
8.5(f)".

6. AMENDMENT TO SUBSECTION 9(m). Subsection 9(m) of the Credit
Agreement is hereby amended and restated in its entirety as follows:

"Any of the Reorganization Cases shall be dismissed, suspended or
converted to a case under chapter 7 of the Bankruptcy Code (which, in the
case of a conversion, such Reorganization Case(s) individually or together
with any Reorganization Case that was previously or is simultaneously
converted own or possess assets whose value exceeds $2,000,000, which value
shall be determined by reference to the schedule of assets and liabilities
filed with the Bankruptcy Court (unless such conversion occurs prior to the
filing of such schedules, in which case any conversion shall constitute an
Event of Default) or a trustee shall be appointed in any of the
Reorganization Cases, or an application shall be filed by a Loan Party for
the approval of, or there shall arise, any other claim having priority
senior to or pari passu with the claims of the Administrative Agent and the
Lenders under the Loan Documents or any other claim having priority over
any or all administrative expenses of the kind specified in sections 503(b)
or 507(b) of the Bankruptcy Code (other than Permitted Expenses); provided
that (i) upon the occurrence of an Event of Default caused by the
appointment of a chapter 11 trustee and (ii) provided no other Event of
Default shall have occurred, the Lenders will in good faith negotiate a
stipulation with such trustee, the terms and conditions of which are
reasonably acceptable to the Lenders and the Agents, for the use of such
collateral for a period of not less than five Business Days; or

3
<PAGE> 4

7. AMENDMENT TO SUBSECTION 9(r)(v). Clause (v) of subsection
9(r) of the Credit Agreement is hereby amended by adding the words "if such
motion is not dismissed within 60 days of the filing thereof" before the
semicolon but immediately following the words "under section 506(e) of the
Bankruptcy Code."

8. AMENDMENT TO SUBSECTION 11.1.

(a) Clause (i) of Subsection 11.1 of the Credit Agreement is
hereby amended and restated in its entirety as follows:

"reduce the amount or extend the scheduled date of maturity of any Loan or
of any installment thereof, or reduce the stated rate of any interest or
fee payable hereunder, or extend the scheduled date of any payment thereof,
increase the amount or extend the expiration date of any Lender's
Commitment, or amend subsection 4.1(c) or the definitions of "Initial GOB
Stores" or "Asset Sale Proceeds" as used in subsection 4.1(c), in each case
without the consent of each Lender adversely affected thereby."

(b) A new clause (vii) in inserted therein (and the present
clauses (vii) through (x) are renumbered accordingly) as follows:

"(vii) amend or modify the definitions of Majority Lenders or
Required Lenders without the consent of all the Lenders,"

9. AMENDMENT TO SUBSECTION 11.6(c). Subsection 11.6(c) of the
Credit Agreement is hereby amended by:

(i) capitalizing the word "affiliate" in the first sentence
thereof and adding the words "or for the purposes of the Term Loans, engaged in
the business of investing in loans" after the words "or other entity that is
then engaged in the business of lending money"; and

(ii) amending and restating clause (d) of the first proviso
thereto in its entirety as follows:

"(d) any Lender may make an assignment consisting solely of Term Loans
(without regard to the requirements of clause (a) above) so long as the
aggregate principal amount of Term Loans so assigned (if less than the
Assignor's entire interest) is at least $5,000,000, and"

10. AMENDMENT TO SUBSECTION 11.6(e). Subsection 11.6(e) of the
Credit Agreement is hereby amended capitalizing the word "affiliate" in the
first sentence thereof.

11. AMENDMENT TO SUBSECTION 3.6(a). Subsection 3.6(a) of the
Security Agreement is hereby amended by deleting the words "five days' notice"
in the sixth sentence thereof and replacing therefor the words "five Business
Days notice".

4
<PAGE> 5
12. AMENDMENT TO SUBSECTION 3.7. Subsection 3.7 of the Security
Agreement is hereby amended by deleting the words "five days' notice" in the
first sentence thereof and replacing therefor the words "five Business Days
notice".

13. AMENDMENT TO SUBSECTION 11.1(a). Subsection 11.1(a) of the
Security Agreement is hereby amended by adding the words "or subsection
5.5(b)" immediately after the words "subsection 3.5" in the proviso thereto.

14. CONDITIONS PRECEDENT TO THE EFFECTIVENESS OF THIS AMENDMENT. This
Amendment shall become effective as of the date hereof on the date (the
"Amendment Effective Date") when the following conditions precedent have been
satisfied:

(a) Certain Documents. The Administrative Agent shall have received,
on or before the Amendment Effective Date, all of the following, all of which
shall be in form and substance satisfactory to the Administrative Agent, in
sufficient originally executed copies for each of the Lenders:

(i) this Amendment, executed by the Borrower and the
Lenders constituting the Required Lenders;

(ii) the Acknowledgement attached hereto executed by each
Subsidiary Guarantor, and

(iii) such additional documentation as the Agents or the
Required Lenders may reasonably require.

(b) Representations and Warranties. Each of the representations and
warranties made by the Borrowers or the Subsidiary Guarantors in or pursuant to
the Credit Agreement, as amended hereby, and the other Loan Documents to which
the Borrower or any of the Subsidiary Guarantors is a party or by which the
Borrower or any of the Subsidiary Guarantors is bound, shall be true and
correct in all material respects on and as of the Amendment Effective Date
(other than representations and warranties in any such Loan Document which
expressly speak as of a different date).

(c) Corporate and Other Proceedings. All corporate and other
proceedings, and all documents, instruments and other legal matters in
connection with the transactions contemplated by this Amendment shall be
satisfactory in all respects in form and substance to the Administrative Agent
and the Required Lenders.

(d) No Event of Default. No Event of Default or Default shall have
occurred and be continuing on the Amendment Effective Date.

15. REPRESENTATIONS AND WARRANTIES. On and as of the date hereof
after giving effect to this Amendment, the Borrower hereby represents and
warrants to the Lenders as follows:

5
<PAGE> 6
(a) Each of the representations and warranties contained in Section 5
of the Credit Agreement or in any certificate, document or financial or other
statement furnished at any time under or in connection therewith are true and
correct in all material respects on and as of the such date as if made on and as
of such date, except to the extent that such representations and warranties
specifically relate to an earlier date, in which case such representations and
warranties shall be true and correct in all material respects as of such earlier
date; provided that references therein to the "Credit Agreement" shall be deemed
to include this Amendment;

(b) No Default or Event of Default has occurred and is continuing.

16. CONTINUING EFFECT; NO OTHER AMENDMENTS. Except as expressly amended
hereby, all of the terms and provisions of the Credit Agreement and the other
Loan Documents are and shall remain in full force and effect. The amendments
contained herein shall not constitute an amendment of any other provision of the
Credit Agreement or the other Loan Documents or for any other purpose except as
expressly set forth herein.

17. GOVERNING LAW; COUNTERPARTS; MISCELLANEOUS.

(a) THIS AMENDMENT SHALL BE GOVERNED BY, AND CONSTRUED AND INTERPRETED
IN ACCORDANCE WITH, THE LAW OF THE STATE OF NEW YORK.

(b) This Amendment may be executed in any number of counterparts and by
the different parties on separate counterparts, each of which counterparts when
executed and delivered shall be an original, but all of which shall together
constitute one and the same instrument.

(c) Section captions used in this Amendment are for convenience only
and shall not affect the construction of this Amendment.

(d) From and after the effective date hereof, all references in the
Credit Agreement to the "Agreement" shall be deemed to be references to such
Agreement as modified hereby.

[THE REMAINDER OF THIS PAGE IS INTENTIONALLY LEFT BLANK]

6
<PAGE> 7

IN WITNESS WHEREOF, the undersigned parties have executed this FIRST
AMENDMENT TO POST-PETITION CREDIT AGREEMENT and MASTER SECURITY AGREEMENT to be
effective for all purposes as of the Amendment Effective Date.

SERVICE MERCHANDISE COMPANY, INC.
as the Borrower

By: /s/ Thomas L. Garrett, Jr.
-----------------------------------
Name: Thomas L. Garrett, Jr.
Title: CFO

SIGNATURE PAGE TO
FIRST AMENDMENT TO POST-PETITION CREDIT AGREEMENT
AND MASTER SECURITY AGREEMENT
<PAGE> 8

CITICORP USA, INC.,
as Administrative Agent, as a Lender

By: /s/ Claudia Slacik
---------------------------------
Claudia Slacik
Vice President

CITIBANK, N.A.
as an Issuing Bank

By: /s/ Claudia Slacik
---------------------------------
Claudia Slacik
Vice President

SIGNATURE PAGE TO
FIRST AMENDMENT TO POST-PETITION CREDIT AGREEMENT
AND MASTER SECURITY AGREEMENT
<PAGE> 9

BANKBOSTON, N.A.,
as Documentation Agent and Collateral
Monitoring Agent, as a Lender, and as
an Issuing Bank

By: /s/ Betsy Ratto
--------------------------------
Betsy Ratto
Vice President

SIGNATURE PAGE TO
FIRST AMENDMENT TO POST-PETITION CREDIT AGREEMENT
AND MASTER SECURITY AGREEMENT
<PAGE> 10

NATIONAL CITY COMMERCIAL FINANCE, INC.,
as a Lender

By: /s/ Thomas R. Poe
--------------------------------------
Name: Thomas R. Poe
Title: President & CEO,
National City Commercial Finance

SIGNATURE PAGE TO
FIRST AMENDMENT TO POST-PETITION CREDIT AGREEMENT
AND MASTER SECURITY AGREEMENT

<PAGE> 11

HELLER FINANCIAL, INC.
as a Lender

By: /s/ T. Bukoroski
-------------------------------
Name: T. Bukoroski
Title: Sr. Vice President

SIGNATURE PAGE TO
FIRST AMENDMENT TO POST-PETITION CREDIT AGREEMENT
AND MASTER SECURITY AGREEMENT
<PAGE> 12

FOOTHILL CAPITAL CORPORATION
as a Lender

By: /s/ Michael P. Baranocoski
------------------------------
Name: Michael P. Baranocoski
Title: Vice President

SIGNATURE PAGE TO
FIRST AMENDMENT TO POST-PETITION CREDIT AGREEMENT
AND MASTER SECURITY AGREEMENT
<PAGE> 13

JACKSON NATIONAL LIFE INSURANCE
COMPANY, as a Lender

By: PFM FINANCE, INC.,
its Attorney-in-Fact

By: /s/ Jeffrey J. Podwika
----------------------------
Name: Jeffrey J. Podwika
Title: Vice President
Attorney-in-Fact

SIGNATURE PAGE TO
FIRST AMENDMENT TO POST-PETITION CREDIT AGREEMENT
AND MASTER SECURITY AGREEMENT
<PAGE> 14

ACKNOWLEDGMENT

Reference is hereby made to the Master Security Agreement (as defined
in the Credit Agreement) to which each of the undersigned is a party. Each of
the undersigned hereby consents to the terms of the foregoing First Amendment
to Post-Petition Credit Agreement and agrees that the terms thereof shall not
affect in any way its obligations and liabilities under the Master Security
Agreement or any other Loan Document, all of which obligations and liabilities
shall remain in full force and effect and each of which is hereby affirmed.

B.A. PARGH, INC.
H.J. WILSON CO., INC.
H.J. WILSON CO. REALTY, INC.
HOMEOWNERS WAREHOUSE, INC.
SERVICE MERCHANDISE CO. BROAD, INC.
SERVICE MERCHANDISE COMPANY OF IOWA, INC.
SERVICE MERCHANDISE COMPANY OF KANSAS, INC.
SERVICE MERCHANDISE CO. NO 30, INC.
SERVICE MERCHANDISE CO. NO 34, INC.
SERVICE MERCHANDISE CO. NO 35, INC.
SERVICE MERCHANDISE CO. NO 51, INC.
SERVICE MERCHANDISE CO. NO 93, INC.
SERVICE MERCHANDISE CO. NO 99, INC.
SERVICE MERCHANDISE FINANCIAL CO., INC.
SERVICE MERCHANDISE INDIANA PARTNERS (by its
Partners Service Merchandise Co. No. 34, Inc.,
and Service Merchandise Co. No. 35, Inc.)
SERVICE MERCHANDISE OF TENNESSEE LIMITED
PARTNERSHIP (by its General Partner, Service
Merchandise Company, Inc.)
SERVICE MERCHANDISE OF TEXAS LIMITED
PARTNERSHIP (by its General Partner, Service
Merchandise Company, Inc.)
SMC-HC, INC.
THE TOY STORE, INC.
WHOLESALE SUPPLY COMPANY, INC.
A.F.S. MARKETING SERVICES, INC.
SERVICE MERCHANDISE OF NEW YORK, INC.
SERVICE MERCHANDISE OFFICE SUPPLY, INC.
SERVICE MERCHANDISE SHOWROOMS, INC.
SERVICE MERCHANDISE RM, INC.
THE McNALLY SUPPLY COMPANY
TRAVEL MANAGEMENT CONSULTANTS, INC.
PROMOTABLES, INC.
as Guarantors

By: /s/ Thomas L. Garrett, Jr.
-------------------------------------
Name: Thomas L. Garrett, Jr.
Title: CFO

ACKNOWLEDGMENT TO
FIRST AMENDMENT TO POST-PETITION CREDIT AGREEMENT
AND MASTER SECURITY AGREEMENT

<PAGE> 1

Exhibit 21

SUBSIDIARIES OF THE REGISTRANT

The following is a list of subsidiaries of the Registrant as of January 2, 2000
all of which are wholly-owned:

PARENT STATE OF
INCORPORATION
Service Merchandise Company, Inc. Tennessee
<S> <C>

SUBSIDIARIES

Service Merchandise Co. Broad, Inc. Tennessee
Service Credit Corp. Tennessee
Service Merchandise Co. No. 34, Inc. Tennessee
Service Merchandise Co. No. 35, Inc. Tennessee
Service Merchandise Co. No. 51, Inc. Illinois
Service Merchandise Co. No. 93, Inc. Tennessee
Service Merchandise Co. No. 30, Inc. Tennessee
Service Merchandise Co. No. 99, Inc. Nevada
Service Merchandise Company of Iowa, Inc. Tennessee
Service Merchandise Company of Kansas, Inc. Tennessee
The Toy Store, Inc. Tennessee
B. A. Pargh Co., Inc. Tennessee
Service Merchandise Showrooms, Inc. Tennessee
Wholesale Supply Company, Inc. Tennessee
Homeowners Warehouse, Inc. Florida
Service Merchandise RM, Inc. Tennessee
The McNally Supply Company Tennessee
SMC Aviation, Inc. New Hampshire
H. J. Wilson Co., Inc. Louisiana
Service Merchandise Co. of New York, Inc. Tennessee
Travel Management Consultants, Inc. Tennessee
A. F. S. Marketing Services, Inc. Tennessee
Service Merchandise Financial Co., Inc. Tennessee
Service Merchandise Indiana Partners Indiana
Service Merchandise of Tennessee, Limited Partnership Delaware
Service Merchandise of Texas, Limited Partnership Delaware
Service Merchandise Co., SPE-1, Inc. Delaware
Service Merchandise Co., SPE-2, Inc. Delaware
Service Merchandise Co., HC, Inc. Delaware
Promotables, Inc. Tennessee
Service Merchandise Office Supply, Inc. Tennessee
Surplus Assurance Company, Ltd. Bermuda
H. J. Wilson Co. Realty, Inc. Texas
</TABLE>

<PAGE> 1
EXHIBIT 23

INDEPENDENT AUDITORS' CONSENT

We consent to the incorporation by reference in Registration Statement Nos.
33-60201, 33-7079, 33-11340, 33-30983 and 33-50185 on Form S-8 of our report
dated February 4, 2000 (February 21, 2000 as to Note V) (which expresses an
unqualified opinion and includes explanatory paragraphs concerning the change in
accounting for recording layaway sales, the Company's filing for reorganization
under Chapter 11 of the Federal Bankruptcy Code, and substantial doubt about the
Company's ability to continue as a going concern), appearing in the Annual
Report on Form 10-K of Service Merchandise Company, Inc. for the fiscal year
ended January 2, 2000.

/s/ DELOITTE & TOUCHE LLP

Nashville, Tennessee
March 14, 2000

<ARTICLE> 5
<MULTIPLIER> 1,000

<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> JAN-02-2000
<PERIOD-START> JAN-04-1999
<PERIOD-END> JAN-02-2000
<CASH> 61,591
<SECURITIES> 0
<RECEIVABLES> 13,171
<ALLOWANCES> 19,474
<INVENTORY> 642,997
<CURRENT-ASSETS> 746,894
<PP&E> 805,088
<DEPRECIATION> 437,374
<TOTAL-ASSETS> 1,161,944
<CURRENT-LIABILITIES> 322,016
<BONDS> 429,507
0
0
<COMMON> 100,012<F1>
<OTHER-SE> (67,067)
<TOTAL-LIABILITY-AND-EQUITY> 1,161,944
<SALES> 2,230,500
<TOTAL-REVENUES> 2,230,500
<CGS> 1,735,948
<TOTAL-COSTS> 1,735,948
<OTHER-EXPENSES> 623,328<F2>
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 64,835
<INCOME-PRETAX> (230,129)
<INCOME-TAX> (874)
<INCOME-CONTINUING> (229,255)
<DISCONTINUED> 0
<EXTRAORDINARY> (7,851)
<CHANGES> (6,566)<F3>
<NET-INCOME> (243,672)
<EPS-BASIC> (2.45)
<EPS-DILUTED> (2.45)
<FN>
<F1>Amount represents the number of $0.50 par value common shares outstanding.
<F2>Amount includes (i) depreciation and amortization; (ii) selling, general and
administrative expenses.
<F3>The Company changed its method of accounting for layaway sales. Layaway
sales for 1999 have been recognized upon delivery of merchandise to the
customer. Layaway sales in prior years were recognized when the initial layaway
deposit was received.
</FN>

</TABLE>