SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1997 Commission File No. 2-55860 Ace Hardware Corporation (Exact Name of Registrant as Specified in its Charter) DELAWARE 36-0700810 (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 2200 Kensington Court, Oak Brook, IL 60523 (Address of Principal Executive Offices) (Zip Code) Registrant's telephone number, including Area Code: (630) 990-6600 Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: NONE State the aggregate market value of the voting stock held by non- affiliates of the Registrant. The Registrant's shares are issued only to, and may be held only by, its dealer-stockholders, and the shares held by a dealer-stockholder are subject to repurchase by the Registrant upon termination of the membership agreement of a dealer- stockholder. Thus, there is no market for the Registrant's shares. The repurchase price for each share of Class A stock, the only voting stock issued by the Registrant, is equal to the par value of $1,000 per share. As of February 13, 1998, the aggregate value of the Class A stock held by non-affiliates (dealer-stockholders) calculated on the basis of such repurchase price was $3,872,000. 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 the number of shares outstanding of each of the Registrant's classes of common stock, as of the latest practicable date (applicable only to corporation Registrants). Outstanding shares as of February 13, 1998: Class A (voting) Stock, $1,000 par value 3,872 shares Class B (nonvoting) Stock, $1,000 par value 2,704 shares Class C (nonvoting) Stock, $1,100 par value 2,124,608 shares PART I Item 1. Business Ace Hardware Corporation was formally organized as a Delaware corporation in 1964. In 1973, by means of a corporate merger, it succeeded to the business of Ace Hardware Corporation, an Illinois corporation organized in 1928. Until 1973, the business now being engaged in by the Company had been conducted by the Illinois corporation. The Company's principal executive offices are located at 2200 Kensington Court, Oak Brook, Illinois 60523. Its telephone number is (630) 990-6600. The Company primarily functions as a wholesaler of hardware and related products, and manufactures paint products. Sales of the products distributed by it are presently made primarily to individuals, partnerships or corporations who are engaged in business as retail dealers of hardware or related items and who have entered into Membership Agreements with the Company entitling them to purchase merchandise and services from the Company and to use the Company's marks as provided therein. The Company operates on a cooperative basis and distributes patronage dividends to its eligible member dealers each year in proportion to the amount of their annual purchases of merchandise from it. (See the subheading "Distribution of Patronage Dividends.") At December 31, 1997 there were 5,032 retail business outlets with respect to which such Membership Agreements had been entered into. Those States having the largest concentration of member outlets are California (approximately 10%), Illinois and Texas (approximately 6% each), Florida and Michigan (approximately 5% each) and Georgia (approximately 4%). States into which were shipped the largest percentages of the merchandise sold by the Company in fiscal year 1997 are California (approximately 11%), Illinois and Florida (approximately 7% each), Texas (approximately 5%), Michigan and Georgia (approximately 4% each). Approximately 7% of the Company's sales are made to outlets located outside of the United States or its territories. Information as to the number of the Company's member outlets during each of the past three fiscal years is set forth in the following table: 1997 1996 1995 ----- ----- ----- Member outlets at beginning of period 5,067 5,007 4,940 New member outlets 208 272 285 Member outlets terminated 243 212 218 ----- ----- ----- Member outlets at end of period 5,032 5,067 5,007 ===== ===== ===== Dealers having one or more member 4,022 4,084 4,055 outlets at the end of period The Company services its dealers by purchasing merchandise in quantity lots, primarily from manufacturers, by warehousing substantial quantities of said merchandise and by selling the same in smaller lots to the dealers. Most of the products that the Company distributes to its dealers from its regional warehouses are sold at a dealer price established by the Company ("dealer cost"), to which a 10% adder ("handling charge") is generally added. In fiscal year 1997 warehouse sales accounted for 61% of total sales and bulletin sales accounted for 2% of total sales with the balance of 37% representing direct shipment sales, including lumber and building materials. The proportions in which the Company's total warehouse sales were divided among the various classes of merchandise sold by it during each of the past three fiscal years are as follows: Class of Merchandise 1997 1996 1995 ------------------- ---- ---- ---- Paint, cleaning and related supplies 21% 20% 19% Plumbing and heating supplies 15% 16% 16% Hand and power tools 14% 14% 14% Garden, rural equipment and related supplies 13% 13% 13% General hardware 12% 12% 13% Electrical supplies 12% 12% 13% Sundry 7% 7% 7% Housewares and appliances 6% 6% 5% The Company sponsors two major conventions annually (one in the Spring and one in the Autumn) at various locations. Dealers and vendors are invited to attend, and dealers generally place orders for delivery during the period prior to the next convention. During the convention regular merchandise, new merchandise and seasonal merchandise for the coming season are displayed to attending dealers. Lawn and garden supplies, building materials and exterior paints are seasonal merchandise in many parts of the country, as are certain sundries such as holiday decorations. Warehouse sales involve the purchase of merchandise from the Company that is maintained in inventory by the Company at its warehouses. Direct shipment sales involve the purchase of merchandise from the Company with shipment directly from the vendors. Bulletin sales involve the purchase of merchandise from the Company pursuant to special bulletin offers by the Company. Direct shipment sales are orders placed by dealers directly with vendors, using special purchase orders. Such vendors bill the Company for such orders, which are shipped directly to dealers. The Company, in turn, bills the ordering dealers with an adder ("handling charge") that varies in accordance with the following schedule and is exclusive of sales under the LTL Plus program discussed below. Invoice Amount Adder (Handling Charge) -------------- ----------------------- 0.00 to $ 999.99 2.00% or $1.00 whichever is greater $1,000.00 to $1,999.99 1.75% $2,000.00 to $2,999.99 1.50% $3,000.00 to $3,999.99 1.25% $4,000.00 to $4,999.99 1.00% $5,000.00 to $5,999.99 .75% $6,000.00 to $6,999.99 .50% $7,000.00 to $7,999.99 .25% $8,000.00 and over .00% Bulletin sales are made based upon notification from dealers of their participation in special bulletins offered by the Company. Generally, the Company will give notice to all members of its intention to purchase certain products for bulletin shipment and then purchases only so many of such products as the members order. When the bulletin shipment arrives at the Company, it is not warehoused, but is broken up into appropriate quantities and delivered to members who placed orders. A 6% adder ("handling charge") is generally applied to this category of sales. An additional adder of 3% applies to various categories of sales of merchandise exported to certain dealers located outside of the United States and its territories and possessions. Ace dealers located outside of the United States and its territories and possessions not subject to the additional 3% adder are assessed a flat 2% adder on all direct shipment sales. The Company maintains inventories to meet only normal resupply orders. Resupply orders are orders from members for merchandise to keep inventories at normal levels. Generally, such orders are filled within one day of receipt. Bulletin orders (which are in the nature of resupply orders) may be for future delivery. The Company does not backlog normal resupply orders and, accordingly, no significant backlog exists at any point in time. The Company also has established special sales programs for lumber and building materials products and for products assigned from time to time to an "extreme competitive price sales" classification and for products purchased from specified vendors for delivery to certain of the Company's dealers on a direct shipment basis (LTL Plus Program). Under its lumber and building materials ("LBM") program, the Company imposes no adder ("handling charge"), or national advertising assessment on direct shipment orders for such products. The LBM program enables the Company's dealers to realize important savings resulting from the Company's closely monitored lumber and building materials purchasing procedures. Additionally, the LBM program offers dealers the opportunity to order less-than-truckload quantities of many lumber and building materials products at economical prices under the LTL warehouse redistribution procedure which the Company has established with certain major vendors. The Store Traffic Opportunity Program ("STOP") established by the Company is a program under which certain stockkeeping units of specific products assigned to a "competitive price sales" classification are offered for sale to its dealers for delivery from designated Company retail support centers. Sales under this program are made without the addition of freight charges and with such adder ("handling charge"), if any, of not more than 5% as shall be specified for each item. The Company's officers have authority to add items to, and to withdraw items from, the STOP program from time to time and to establish reasonable minimum or multiple item purchase requirements for the items offered under the program. No allocations or distributions of patronage dividends are made with respect to sales under the STOP program. Purchases under the STOP program are, however, deemed to be warehouse purchases or bulletin purchases, as the case may be, for purposes of calculating the forms of patronage dividend distributions. (See the subheading under this Item 1 entitled "Forms of Patronage Dividend Distributions.") The LTL Plus Program established by the Company is a program under which full or partial truckloads of products are purchased by the Company's dealers from specified vendors for delivery to such dealers on a direct shipment basis. No adder ("handling charge") or national advertising assessment is imposed by the Company on sales under the LTL Plus Program, and the maximum amount of patronage dividends allocated or distributed to the Company's dealers with respect to their purchases of products in the LTL Plus category is .5% of such sales. (See the subheading under this Item 1 entitled "Patronage Dividend Determinations and Allocations.") The Company, in addition to conducting semi-annual and other conventions and product exhibits for its dealers, also provides them with numerous special services (on a voluntary basis and at an established cost), such as inventory control systems, as well as price and bin ticketing. In order for them to have on hand current pricing and other information concerning the merchandise obtainable from the Company, the Company further provides to each of its dealers either a catalogue or CD checklist service or a microfiche film service (whichever the dealer selects), for either of which services the dealer must pay a monthly charge. The Company also provides on a full- participation basis materials for educational and training programs for which dealers must pay an established monthly charge. (See the subheading under this Item 1 entitled "Special Charges and Assessments.") Through its wholly-owned subsidiary, Ace Insurance Agency, Inc., the Company makes available to its dealers a Group Dealer Insurance Program under which they can purchase a package of insurance coverages, including "all risk" property insurance and business interruption, crime, liability and workers' compensation coverages, as well as medical insurance coverage for their employees. AHC Realty Corporation, another wholly-owned subsidiary of the Company, provides the services of a broker to those dealers who desire to sell or seek a new location for a presently owned store or to acquire an additional store. Loss Prevention Services, Inc., another wholly-owned subsidiary provides security training and services for all dealers desiring security assistance. In addition, the Company offers to its dealers retail computer systems consisting of computer equipment, maintenance service and certain software programs and services. These are marketed by the Company under its registered service mark "PACE". During 1996 the Company commenced operations through Ace Hardware Canada, Limited, a wholly-owned subsidiary, as a wholesaler of hardware and related merchandise through two distribution facilities located in Calgary, Alberta and Brantford, Ontario. Ace Hardware Canada, Limited generated less than three percent of the Company's consolidated revenue during fiscal year 1997. As of the date hereof, the Company operates, through A.H.C. Store Development Corp. and Ace Corporate Stores, Inc., its wholly owned subsidiaries, six company-owned retail hardware stores. In addition, three other locations are being developed for company-owned retail hardware stores. Two of the newly acquired locations are expected to be operational by the close of the second quarter of 1998. The third location is under construction and is expected to be operational in the beginning of the fourth quarter of 1998. (See the heading "Properties.") The Company manufactures paint and related products at facilities owned by it in Matteson and Chicago Heights, Illinois. These facilities now constitute the primary source of such products offered for sale by the Company to its dealers. The Company's paint manufacturing business is operated as a separate Division of the Company for accounting purposes. All raw materials used by the Company to manufacture paint are purchased from outside sources. The Company has had adequate sources of raw materials, and no shortages of any materials which would materially impact operations are currently anticipated. The manufacturing of paint is seasonal to the extent that greater paint sales are found in the months of April through September. Historically, compliance with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment or otherwise relating to the protection of the environment have not had any material impact. The Company's business, either in hardware wholesaling or paint manufacturing activities is not dependent on any major suppliers and the Company feels that any seasonal fluctuations do not have a significant impact upon operations. For further discussion of the Company's business, see "Management's Discussion and Analysis of Financial Condition and Results of Operations", in Item 7 hereof. The Company makes available some services to members which are related to the operation of their retail businesses. These services (such as advertising, store supplies and training programs) are provided in order to assist members and/or to utilize the centralized buying power of the Company. Members are rebilled in order to pay the Company the established charge for such services. Strategic Planning This section summarizes the Company's strategic planning initiatives. By reason of the nature of strategic plans, this section contains a number for forward looking statements, all of which are based on current expectations. Actual results may differ materially. The Company believes that it has the facilities, personnel and competitive and financial resources for continued business success in the implementation of these plans, but future developments, including revenues, costs, margins and profits are all influenced by a number of factors, including but not limited to the following, all of which are inherently difficult to forecast. These factors include the uncertain impact of future growth in the hardware and hardlines-related industries, including the lumber/building materials, home center, do-it-yourself, rental and commercial/industrial categories, as well as the condition of the economy domestically, internationally and in specific geographical regions. These factors also include potential changes in merchandise and inventory prices, the impact of increasingly intense competition, potential shifts in market demand, the potential impact of future litigation, and the potential impact of environmental, franchising and licensing laws on the Company's business operations. The Company is presently unable to predict whether, or to what extent such factors may result in future costs or liabilities that are not presently known, or the impact of such factors on the Company's future ability to achieve its plans. The Company has an ongoing strategic planning process and has focused its plans around four cornerstones for future growth and success in this competitive industry. The four cornerstones are: Retail Success (store operations), Wholesale Success (distribution), International growth and new member growth. Dealer retail success is a primary objective since it drives both retail performance and wholesale growth of the Company. The Company has accelerated its efforts in assisting member-dealers in "retail success initiatives" designed to improve their retail performance and competitiveness. The retail success initiatives include retail goals which each dealer should strive for within their store and local competitive environment, but do not dictate material restrictions or requirements on member-dealers. Minimum requirements for acceptance of a member-dealer by the Company are outlined only in the Membership Agreement and in the Member Operational Requirements under the Ace Hardware Membership Agreement. The Operational Requirements do require that, within one year from the Company's acceptance of the Agreement, the member-dealer must make Ace its primary source of supply and terminate participation in the program of any other major hardware wholesaler. There are currently no generally applicable requirements for Ace member-shareholders as to percentage of purchases required through Ace or minimum retail performance which must be achieved (i.e. sales dollars per square foot). The four cornerstones also include present strategic initiatives to focus on the consumer through research, target marketing and the development of an appropriate long- term advertising strategy, as well as the review by the Company of merger and acquisition opportunities and the development of international and domestic non-shareholder franchise programs. "The New Retail Age of Ace" is an extension of previous strategic efforts under "the New Age of Ace" and "Ace 2000" and is not in conflict with these efforts. Special Charges and Assessments The Company sponsors a national advertising program for which its dealers are assessed an amount equal to 1.3% of their purchases (exclusive of purchases of lumber, LTL, LTL Plus, building materials products and PACE hardware and software computer systems), with the minimum annual assessment for each dealer location being established at $1,622.40 effective January 1, 1997 (or such greater amount as would be required to maintain the foregoing minimum applicable assessment at 1.3%) subject to: 1) a maximum annual assessment for each dealer location for which a membership agreement has been entered into with the Company of $5,500.00; 2) a maximum total annual assessment for any one dealer determined by multiplying the number of such dealer's retail outlets supplied by the Company which serve the general public by $5,500.00 with certain exemptions from or adjustments to the national advertising assessment for dealer outlets located outside of the contiguous 48 states of the United States and the District of Columbia, based on the evaluation by the Company's management of the amount and nature of the television broadcasts received in the dealer's area. The percentage of bi-weekly purchases to be assessed for the Company's national advertising program and the amount of the maximum annual assessment for such program are both subject to being changed from time to time by action of the Board of Directors of the Company. The Company also has the authority, effective January 1, 1993 to impose a regional advertising assessment (for select geographic regions) not to exceed 2% of annual purchases with the same minimum and maximum assessments imposed by the National Advertising assessment. A special low volume account service charge of $50.00 per bi-weekly billing statement period is imposed on all stores whose annual purchases (exclusive of lumber and LTL purchases) are less than $50,000 and $30.00 per bi-weekly billing for annual purchases between $50,000 and $124,800. Any such charges imposed on a store during a specified year will be auto- matically refunded to the store if its total purchases (exclusive of lumber and LTL purchases) exceed $124,800.00 during the year. All stores are exempt from such special charge during the first 12 months from the date that they are affiliated as Ace dealers. Exceptions to the low volume account service charge are as follows: 1. when a dealer has purchased $124,800.00 of merchandise (exclusive of carload lumber purchases) during the applicable year, the dealer will be given credit on the next bi-weekly billing statement for any low volume charges which have been added to the account during such year and the low volume charge shall no longer be added on any of such dealer's bi- weekly billing statements during the remainder of such period even if the current purchases shown on the billing statement are less than $4,800.00; and 2. the low volume account service charge will not be billed on a bi-weekly basis to those accounts whose previous year's sales volume exceeded the low volume purchases minimum ($124,800.00) for the previous year, but the full annual low volume account service charge will be billed on the last billing statement of the year to those accounts if the minimum purchases to avoid imposition of the charge have not been met for the current year. An Ace store that falls below minimum purchase levels may also be subject to termination. A late payment service charge is added on any past due balance owing by a dealer to the Company for purchases of merchandise and services or for the purchase price of the capital stock of the Company subscribed for by the dealer. The late payment service charge currently in effect is an amount equal to .77% per bi-weekly statement period, except in Texas where the charge is .384% and Georgia where the charge is .692%. A past due balance is created whenever payment of the amounts shown as due on any such statement is not received by the Company within 10 days following the date of the statement. The percentage for determining the amount of the late payment service charge may be changed from time to time by the Company. Subscriptions to a retail training program consisting of video tapes and related course materials (the "S.T.A.R. Program") are mandatory for all stores located in the United States and U.S. Territories. The initial monthly assessment imposed on such stores for such subscriptions is $16 for each single store or parent store and $11 for each branch store. A single store or parent store is an initial retail outlet for which a dealer owns, or has subscribed for, one (1) share of Class A stock and forty (40) shares of Class C stock of the Company. A branch store is an additional retail outlet for which a dealer owns, or has subscribed for, fifty (50) shares of Class C stock of the Company. (See Article XXV, Section 2 of the By-Laws, set forth in Appendix A). Branch stores may, upon request, be granted an exemption from the monthly subscription fee. Subscriptions to a Material Safety Data Sheet information service are also mandatory for all stores located in the United States. The initial annual assessment imposed on such stores for such subscriptions is $20 for each single store or parent store and $10 for each branch store. Trademark and Service Mark Registrations The names "ACE HARDWARE" and "ACE" are used extensively by the Company and by its member-dealers in connection with the promotion, advertising and marketing of products and services sold by the Company. The Company holds the following Trademark and Service Mark Registrations issued by the U.S. Patent and Trademark Office for the marks used by it: Registration Description of Mark Type of Mark Number Expiration Date ------------------- ------------ ------ --------------- "ACE HARDWARE" with winged emblem design Service Mark 840,176 December 5, 2007 "ACE HARDWARE" with winged emblem design Trademark 898,070 September 8, 2000 "THE PAINTIN' PLACE" Service Mark 1,138,654 August 12, 2000 "HARDWARE UNIVERSITY" with Design Service Mark 1,180,539 December 1,2001 "SUPER STRIKER" Trademark 1,182,330 December 15, 2001 "PACE" with design Service Mark 1,208,887 September 14, 2002 "ACE HARDWARE" with winged emblem design Trademark 1,277,581 May 15, 2004 "ACE HARDWARE" in stylized lettering design Trademark 1,426,137 January 27, 2007 "ACE" in stylized lettering design Service Mark 1,464,025 November 3, 2007 "ACE HARDWARE" in stylized lettering design Service Mark 1,486,528 April 26, 2008 "ACE HARDWARE AND GARDEN CENTER" in stylized lettering design Service Mark 1,487,216 May 3, 2008 "ACE NEW EXPERIENCE" in stylized lettering design Trademark 1,554,322 September 5, 2009 "ACE SEVEN STAR" in stylized lettering design Trademark 1,556,389 September 19, 2009 "ACE BEST BUYS" in circle design Service Mark 1,560,250 October 10, 2009 "ACENET" Service Mark 1,574,019 December 26, 1999 "ACE IS THE PLACE" Service Mark 1,602,715 June 19, 2000 "LUB-E" Trademark 1,615,386 October 2, 2000 "ACE PRO" Trademark 1,632,078 January 22, 2001 "ASK ACE" Service Mark 1,653,263 August 6, 2001 Christmas Elves Design Trademark 1,669,306 December 24, 2001 "ACE 2000" Service Mark 1,682,467 April 7, 2002 "ACE" in stylized lettering design Trademark 1,683,538 April 21, 2002 "HARMONY" in stylized lettering design Trademark 1,700,526 July 14, 2002 "SEVEN STAR SATISFACTION GUARANTEED QUALITY ACE PAINTS" with design Service Mark 1,705,321 August 4, 2002 "THE OAKBROOK COLLECTION" in stylized lettering design Trademark 1,707,986 August 18, 2002 "ACE HARDWARE BROWN BAG BONANZA" with design Service Mark 1,761,277 April 13, 2003 "ACE HARDWARE COMMITTED TO A QUALITY ENVIRONMENT" design Service Mark 1,764,803 April 13, 2003 "THE OAKBROOK COLLECTION" in stylized lettering design Trademark 1,783,335 July 20, 2003 "STORE 2000 THE STORE OF THE FUTURE" Service Mark 1,811,032 December 14, 2003 "ENVIRO-CHOICE" Trademark 1,811,392 December 14, 2003 "CELEBRATIONS" Service Mark 1,918,785 September 12, 2005 Repetitive Stylized "A" design Service Mark 1,926,798 October 10, 2005 "The NEW AGE OF ACE" design Service Mark 1,937,008 November 21, 2005 Registration Description of Mark Type of Mark Number Expiration Date ------------------- ------------ ------ --------------- "ACE RENTAL PLACE" in stylized lettering design Service Mark 1,943,140 December 19, 2005 "HELPFUL HARDWARE FOLKS" Service Mark 1,970,828 April 30, 2006 "ACE HOME CENTER" Service Mark 1,982,130 June 25, 2006 "SEALTECH" Trademark 2,007,132 October 8, 2006 "GREAT FINISHES" Trademark 2,019,696 November 26, 2006 "WOODROYAL" Trademark 2,065,927 May 27, 2007 "ROYAL SHIELD" Trademark 2,070,848 June 10, 2007 "ROYAL TOUCH" Trademark 2,070,849 June 10, 2007 "QUALITY SHIELD" Trademark 2,012,305 September 30, 2007 "QUALITY TOUCH" Trademark 2,102,306 September 30, 2007 "STAIN HALT" Trademark 2,122,418 December 16, 2007 Currently, the Company has applications pending before the U.S. Patent and Trademark Office for Registration of "ACE ROYAL" for exterior and interior paint, "ACE DRY GUARD" for waterproofing paint, "ACE CONTRACTOR PRO" for paints, primers and varnishes and "THE OAKBROOK COLLECTION" for bathroom faucets. In addition, the Company also has service mark applications pending for "ACE COMMERCIAL & INDUSTRIAL SUPPLY" for retail store services in the field of hardware and related goods, "NHS NATIONAL HARDLINES SUPPLY" for retail store services in the field of hardware and related goods, "HELPFUL HARDWARE CLUB" for promoting the goods and services of others through various incentive programs offered to preferred customers, "ACE CONTRACTOR CENTER" for retail store services for identifying dealers who sell lumber and building materials, "ACE GARDEN PLACE" for retail store services in the field of hardware, garden products and building materials and "THE FOLKS IN THE RED VEST" for retail store services in the field of hardware and related goods. Competition The competitive conditions in the wholesale hardware industry can be characterized as intensive and increasing due to the fact that independent retailers are required to remain competitive with discount stores and chain stores, such as Wal-Mart, Home Depot, Menard's, Sears, and Lowe's, and with other mass merchandisers. The gradual shift of retail operations to high rent shopping center locations and the trend toward longer store hours have also intensified pressures to obtain low cost wholesale supply sources. The Company directly competes in several U.S. markets with TruServ Corporation, as well as with Hardware Wholesalers, Inc., and United Hardware Distributing Co., all of which companies are also dealer-owned wholesalers. Employees The Company employs 4,685 full-time employees, of which 1,353 are salaried employees. Collective bargaining agreements covering one truck drivers' bargaining unit and three warehouse bargaining units are currently in effect at certain of the Company's distribution warehouses. The Company's employee relations with both union and non- union employees are considered to be good, and the Company has experienced no significant employee-related work stoppage in the past five years. All employees are covered either by negotiated or non- negotiated employee benefit plans which include hospitalization, death benefits and, with few exceptions, retirement benefits. Limitations on Ownership of Stock All of the issued and outstanding shares of capital stock of the Company are owned by its dealers. Only approved retail and other dealers in hardware and related products having Membership Agreements with the Company are eligible to own or purchase shares of any class of the Company's stock. No dealer, regardless of the number of member business outlets owned or controlled by the dealer, shall be entitled to own more than 1 share of Class A Stock, which is the only class of voting stock which can be issued by the Company. This ensures that each stockholder- dealer will have an equal voice in the management of the Company. An unincorporated person or partnership shall be deemed to be controlled by another person, partnership or corporation if 50% or more of the assets or profit shares therein are owned (i) by such other person, partnership or corporation or (ii) by the owner or owners of 50% or more of the assets or profit shares of another unincorporated business firm or (iii) by the owner or owners of 50% or more of the capital stock of an incorporated business firm. A corporation shall be deemed to be controlled by another person, partnership or corporation if 50% or more of the capital stock of said corporation is owned (i) by such person, partnership or corporation or (ii) by the owner or owners of 50% or more of the capital stock of another incorporated business firm or (iii) by the owner or owners of 50% or more of the assets or profit shares of an unincorporated business firm. Distribution of Patronage Dividends The Company operates on a cooperative basis with respect to purchases of merchandise made from it by those of its dealers who have become "members" of the Company as described below and in the Company's By-laws. In addition, the Company operates on a cooperative basis with respect to all dealers who have subscribed for shares but who have not as yet become "members" by reason of the fact that the payments made by them on account of the purchase price of their shares have not yet reached an amount equal to the $1,000 purchase price of 1 share of Class A Voting Stock. All member dealers falling into either of the foregoing classifications are entitled to receive patronage dividend distributions once each year from the Company in proportion to the amount of their annual purchases of merchandise from it. The patronage dividends distributed on wholesale warehouse, bulletin and direct shipment sales made by the Company and on total sales of products manufactured by the Paint Division represented the following percentages of each of said categories of sales during each of the past three fiscal years: 1997 1996 1995 -------- -------- -------- Warehouse Sales 4.32753% 4.53912% 4.42965% Bulletin Sales 2.0% 2.0% 2.0% Direct Shipment Sales 1.0% 1.0% 1.0% Paint Sales 10.3088% 7.9773% 6.8725% In addition to the dividends described above, patronage dividends are calculated separately and distributed on sales of lumber products, building material and millwork products and less-than-truckload (LTL) sales of lumber and building material products. Patronage dividends equal to .4593%, .4328% and .3560% of the total sales of these products (calculated separately by each of these three sales categories) were distributed to the Company's dealers who purchased those products in fiscal years 1997, 1996 and 1995, respectively. Under the LTL Plus Program, patronage dividends are also calculated separately on sales of full or partial truckloads of products purchased by eligible dealers from specified vendors (see discussion of LTL Plus Program set forth above in this Item 1). The maximum amount of patronage dividends allocable to LTL Plus sales is .5% of such sales. The LTL Plus Program dividend was .5% of such sales for fiscal years 1997, 1996 and 1995. Patronage Dividend Determinations and Allocations The amounts distributed by the Company as patronage dividends consist of its gross profits on business done with dealers who qualify for patronage dividend distributions after deducting from said gross profits a proportionate share of the Company's expenses for administration and operations. Such gross profits consist of the difference between the price at which merchandise is sold to such dealers and the cost of such merchandise to the Company. All income and expenses associated with activities not directly related to patronage transactions are excluded from the computation of patronage dividends. Generally these include profits on business done with dealers who do not qualify for patronage dividend distributions and any income (loss) realized by the Company from the disposition of property and equipment (except that, to the extent that depreciation on such assets has been deducted as an expense during the time that the Company has been operating on a cooperative basis and is recaptured in connection with such a disposition, the income derived from such recapture would be included in computing patronage dividends). The By-laws of the Company provide that, by virtue of a dealer being a "member" of the Company (that is, by virtue of his ownership of 1 share of Class A Voting Stock), he will be deemed to have consented to include in his gross income for federal income tax purposes for the dealer's taxable year in which they are received by him all patronage dividends distributed to him by the Company in connection with his purchases of merchandise from the Company. A dealer who has not yet paid an amount which at least equals the $1,000 purchase price of the 1 share of Class A Voting Stock subscribed for by him will also be required to include all patronage dividends distributed to him by the Company in his gross income for federal income tax purposes in the year in which they are received by him. This is required by virtue of a provision in the Subscription Agreement executed by him under which he expressly consents to take all such patronage dividends into his gross income for such purposes. The amount of the patronage dividends which must be included in a dealer's gross income includes both the portion of such patronage dividends received by him in cash or applied against indebtedness owing by him to the Company in accordance with Section 7 of Article XXIV of the Company's By-laws and the portion or portions thereof which he receives in shares of Class C Nonvoting Stock of the Company or in patronage refund certificates. Patronage dividends on each of the Company's three basic categories of sales (warehouse sales, bulletin sales and direct shipment sales) are allocated separately, as are patronage dividends under the LTL Plus Program. However, the maximum amount of patronage dividends allocable to LTL Plus Program sales is an amount no greater than .5% of such sales, the maximum amount of patronage dividends allocable to direct shipment sales exclusive of LTL Plus Program sales is an amount equal to 1% of such sales and the maximum amount of patronage dividends allocable to bulletin sales is an amount equal to 2% of that category of sales. All remaining patronage dividends resulting from sales made under these programs are allocated by the Company to warehouse sales. The Company feels that this allocation procedure provides a practical and understand- able method for the distribution of these patronage dividends in a fair and equitable manner. Sales of lumber and building materials products are not included as part of warehouse sales, bulletin sales or direct shipment sales for patronage dividend purposes. Patronage dividends are calculated separately and distributed to the Company's dealers with respect to their purchases within each of four sales categories involving these types of products. These four categories are (a) lumber products (other than less-than- truckload sales); (b) building materials products (other than less-than- truckload sales); (c) millwork products and (d) less-than-truckload ("LTL") sales of lumber and building material products. Patronage dividends are also calculated separately and distributed to the Company's dealers for full and partial truckloads of products purchased under the LTL Plus Program. (See the discussion of the LTL Plus Program set forth above in this Item 1 and under the subheading "Forms of Patronage Dividend Distributions," subparagraphs 2(a)-(b) below). Any manufacturing profit realized on intracompany sales of the products manufactured by the Company's Paint Division is allocated among and distributed as patronage dividends to those member dealers who are eligible to receive patronage dividends from the Company in proportion to their respective annual dollar purchases of paint and related products manufactured by said Division. The earnings realized by the Company on wholesale sales of such products made by it to its member dealers are distributed as patronage dividends to all of its dealers who are eligible to receive patronage dividends from it as part of the patronage dividends which they receive each year with respect to the basic patronage dividend categories established for warehouse sales, bulletin sales, and direct shipment sales. Under Section 8 of Article XXIV of the Company's By-laws, if the Paint Division's manufacturing operations for any year result in a net loss, rather than a profit, to the Paint Division, such loss would be netted against the earnings realized by the Company from its other activities during the year, with the result that the earnings available from such other activities for distribution as patronage dividends for such year would be correspondingly reduced. Forms of Patronage Dividend Distributions Patronage dividend distributions will be made to the eligible and qualified member dealers of the Company in cash, shares of the Company's Class C stock and patronage refund certificates in accordance with the following plans which have been adopted by the Company's Board of Directors with respect to purchases of merchandise made by such dealers from the Company on or after the dates indicated, and which will continue to be in effect until such time as the Board of Directors, in the exercise of their authority and discretion based upon business conditions from time to time and the requirements of the Company, shall determine that such plan should be altered or amended: A. For purchases made on or after January 1, 1998, 1. with respect to each store owned or controlled by each eligible and qualifying dealer, such dealer shall receive a minimum cash distribution determined as follows: (a) an amount equal to 20% of the first $5,000 of the total patronage dividends allocated for distribution each year to such dealer in connection with the purchases made for such store; (b) an amount equal to 25% of the portion of the total patronage dividends allocated for distribution each year to such dealer for such store which exceeds $5,000 but does not exceed $7,500; (c) an amount equal to 30% of the portion of the total patronage dividends allocated for distribution each year to such dealer for such store which exceeds $7,500 but does not exceed $10,000; (d) an amount equal to 35% of the portion of the total patronage dividends allocated for distribution each year to such dealer for such store which exceeds $10,000 but does not exceed $12,500; (e) an amount equal to 40% of the portion of the total patronage dividends allocated for distribution each year to such dealer for such store which exceeds $12,500; 2. The portion of the total annual distribution allocated to any such dealer for each store owned or controlled by such dealer in excess of the amount to be distributed to such dealer for such store in cash shall be distributed each year in the form of shares of Class C Non-voting Stock of Ace Hardware Corporation (par value $100 per share), valued at the par value thereof, until the total par value of all shares of all classes of capital stock of the corporation held by such dealer with respect to such store equals the greater of: (a) $20,000; or (b) a sum equal to the total of the following categories of purchases made by such dealer for such store during the most recent calendar year; (i) 15% of the volume of Ace manufactured paint and related products purchases, plus (ii) 3% of the volume of drop-shipment or direct purchases (excluding Ace manufactured paint and related products), plus (iii) 15% of the volume of warehouse (including STOP and excluding Ace manufactured paint and related products) and bulletin purchases, plus (iv) 3% of the volume of lumber and building material (excluding LTL) purchases, subject to a maximum lumber and building material capital stock requirement of $25,000, plus (v ) 4% of the volume of LTL Plus purchases; provided, however, that no fractional shares of Class C nonvoting Stock shall be issued to any dealer and that any amount which would have otherwise been distributable as a fractional share of such stock shall instead be distributed to such dealer in cash. 3. The portion of the total patronage dividends allocated each year to any such dealer for each store owned or controlled by such dealer which exceeds the sum of (a) the amount to be distributed to such dealer for such store in cash pursuant to Paragraph 1. above and (b) any amount to be distributed to him in the form of shares of Class C Nonvoting Stock of Ace Hardware Corporation (par value $100 per share) pursuant to Paragraph 2. above shall be distributed to such dealer in cash; provided, however, that in no event shall the total amount distributed under this plan to any such dealer for any such store in cash exceed 45% of the total patronage dividends allocated for such store for such year, and to the extent that any distribution to be made to any such dealer for any store pursuant to this Paragraph 3. would otherwise cause the total cash distribution to such dealer for such store to exceed 45% of the total patronage dividends allocated for such store for such year, the distribution to be made under this Paragraph 3. shall instead be made in the form of a non-negotiable patronage refund certificate having such a maturity date and bearing interest at such an annual rate as shall be determined by the Board of Directors prior to the issuance thereof. B. For purchases made between January 1, 1995-December 31, 1997, 1. with respect to each store owned or controlled by each eligible and qualifying dealer, such dealer shall receive a minimum cash distribution determined as follows: (a) an amount equal to 20% of the first $5,000 of the total patronage dividends allocated for distribution each year to such dealer in connection with the purchases made for such store; (b) an amount equal to 25% of the portion of the total patronage dividends allocated for distribution each year to such dealer for such store which exceeds $5,000 but does not exceed $7,500; (c) an amount equal to 30% of the portion of the total patronage dividends allocated for distribution each year to such dealer for such store which exceeds $7,500 but does not exceed $10,000; (d) an amount equal to 35% of the portion of the total patronage dividends allocated for distribution each year to such dealer for such store which exceeds $10,000 but does not exceed $12,500; (e) an amount equal to 40% of the portion of the total patronage dividends allocated for distribution each year to such dealer for such store which exceeds $12,500; 2. The portion of the total annual distribution allocated to any such dealer for each store owned or controlled by such dealer in excess of the amount to be distributed to such dealer for such store in cash shall be distributed each year in the form of shares of Class C nonvoting Stock of Ace Hardware Corporation (par value $100 per share), valued at the par value thereof, until the total par value of all shares of all classes of capital stock of the corporation held by such dealer with respect to such store equals the greater of: (a) $20,000; or (b) a sum equal to the total of the following categories of purchases made by such dealer for such store during the most recent calendar year; (i) 15% of the volume of warehouse (including STOP and excluding Ace manufactured paint and related products) and bulletin purchases, plus (ii) 15% of the volume of Ace manufactured paint and related products purchases, plus (iii) 3% of the volume of drop-shipment or direct purchases (excluding Ace manufactured paint and related products), plus (iv) 4% of the volume of lumber, building material and millwork (excluding LTL) purchases, plus (v) 4% of the volume of LTL Plus purchases; provided, however, that no fractional shares of Class C nonvoting Stock shall be issued to any dealer and that any amount which would have otherwise been distributable as a fractional share of such stock shall instead be distributed to such dealer in cash. 3. The portion of the total patronage dividends allocated each year to any such dealer for each store owned or controlled by such dealer which exceeds the sum of (a) the amount to be distributed to such dealer for such store in cash pursuant to Paragraph 1., above and (b) any amount to be distributed to him in the form of shares of Class C non-voting Stock of Ace Hardware Corporation (par value $100 per share) pursuant to Paragraph 2., above shall be distributed to such dealer in cash; provided, however, that in no event shall the total amount distributed under this plan to any such dealer for any such store in cash exceed 45% of the total patronage dividends allocated for such store for such year, and to the extent that any distribution to be made to any such dealer for any store pursuant to this Paragraph 3., would otherwise cause the total cash distribution to such dealer for such store to exceed 45% of the total patronage dividends allocated for such store for such year, the distribution to be made under this Paragraph 3., shall instead be made in the form of a non-negotiable patronage refund certificate having such a maturity date and bearing interest at such an annual rate as shall be determined by the Board of Directors prior to the issuance thereof. With certain modifications, the above plans are applied separately in determining the form in which patronage dividends accrued with respect to sales of lumber and building materials products are distributed. In this connection the combined patronage dividends allocated annually to a store from (a) sales of lumber products (other than LTL sales), (b) sales of building materials (other than LTL sales) (c) sales of millwork products, and (d) LTL sales to the store are used in determining the minimum cash distribution percentages to be applied under Paragraph 1 of the above plans. A store's patronage dividends from any other sales category with respect to which patronage dividends are distributed by the Company are not taken into account in determining either the minimum portion or any additional portion of the store's patronage dividends derived from its purchases of lumber and building materials products which is to be distributed in cash. Also, Paragraphs 2 and 3 of the above plans are applied separately to patronage dividends on lumber and building materials sales and the requirements of Paragraph 2 of the plans shall not be deemed to have been complied with in the cases of (a) purchases of lumber products (other than LTL purchases), (b) purchases of building materials products (other than LTL purchases) or (c) purchases of millwork products until the store's holdings of Class C non- voting Stock of the Company resulting from patronage dividends on the Company's sales to it within the particular one of those two sales categories for which a patronage dividend distribution is to be made equal 3% of the volume of the store's purchases within such category during the most recent calendar year, subject to a maximum lumber and building materials capital stock requirement of $25,000 under the 1998 plan and 4% of the volume of the store's purchases within such category during the most recent applicable calendar year (not subject to a maximum lumber and building materials capital stock requirement) under the 1995-1997 plan. However, no such special Class C Stock requirement applies to patronage dividends accrued on LTL purchases. Notwithstanding the provisions of the above-described plans, however, under Section 7 of Article XXIV of the Company's By-laws the portion of any patronage dividends which would otherwise be distributable in cash with respect to a retail dealer outlet which is a member of the Company will instead be applied against any indebtedness owing by the dealer to the Company to the extent of such indebtedness in any case where the membership for such outlet is cancelled or terminated prior to the distribution of such patronage dividends except that an amount equal to 20% of the dealer's total annual patronage dividends for such outlet will be paid in cash if a timely request for the payment of such amount in cash is submitted to the Company by the dealer. Because of the requirement of the U. S. Internal Revenue Code that the Company withhold 30% of the annual patronage dividends distributed to member dealers of the Company whose places of business are located in foreign countries or Puerto Rico (except in the case of unincorporated Puerto Rico dealers owned by individuals who are U.S. citizens and certain dealers incorporated in Guam, American Samoa, the Northern Mariana Islands, or the U.S. Virgin Islands, if less than 25% of its stock is owned by foreign persons, and at least 65% of the Corporation's gross income for the last three years has been effectively connected with the conduct of a trade or business in such possession or in the United States), the cash portion of the annual patronage dividends of such dealers shall in no event be less than 30%. It is anticipated that the terms of any patronage refund certificates issued pursuant to Paragraph 3. of the foregoing plans would include provisions giving the Company a first lien thereon for the amount of any indebtedness owing to it at any time by the owner of any such certificate and provisions subordinating the certificates to all the rights and claims of secured, general and bank creditors against the Company. It is further anti- cipated that all such patronage refund certificates will have maturity dates which will be no later than five years from the dates of issuance thereof. In order to aid the Company's dealers in acquiring and installing standardized exterior signs identifying the retail stores operated by them as member outlets supplied by the Company, the Board of Directors of the Company has authorized a program under which a dealer may borrow from the Company within a range of $100 to $20,000 per location the funds required for such purpose. A dealer who obtains a loan under this program may either repay the loan in twelve substantially equal payments billed on such dealer's regular by-weekly billing statement, or may execute a direction to have the portion of the dealer's annual patronage dividends which would otherwise be distributed under the above plan in a form other than cash from no more than the next three annual distributions of such dividends applied toward payment of the principal and interest on the loan. In order to aid the Company's dealers in acquiring and installing PACE and PAINTMAKER computer systems purchased from the Company and to finance capital improvements, the Board of Directors of the Company has also authorized programs under which the Company will finance, for qualified dealers, (but not to exceed 80% of the cost of any system) in the case of a PAINTMAKER computer, within the range of $1,000 to $15,000 per location repayable over a period of three (3) years, in the case of a PACE computer, within the range of $5,000 to $50,000 per location repayable over a period of five (5) years for such purpose and in the case of capital improvements, up to $2.00 per square foot of retail space repayable over a period of three (3) years for such purpose. Dealers who obtain financing from the Company for these purposes direct the Company, during the financing term, to first apply toward the principal and interest due on such loans, the patronage dividends which would otherwise be payable in the form of patronage refund certificates for each year, and then to apply the patronage dividends which would otherwise be payable for the same year in the form of the Company's Class C stock. The aforementioned signage, computer financing and store retrofit programs may be revised or discontinued by the Board at any time. Federal Income Tax Treatment of Patronage Dividends (See Previous Heading "Opinions of Experts") Both the shares of Class C non-voting Stock and the patronage refund certificates used by the Company to pay patronage dividends that accrue to its eligible and qualifying dealers constitute "qualified written notices of allocation" within the meaning of that term as used in Sections 1381 through 1388 of the U.S. Internal Revenue Code, which specifically provide for the income tax treatment of cooperatives and their patrons and which have been in effect since 1963. The stated dollar amounts of such qualified written notices of allocation must be taken into the gross income of each of the recipients thereof for the taxable years in which such written notices of allocation are received, not withstanding the fact that stated dollar amounts may not be received in such taxable years. In order for the Company to receive a deduction from its gross income for federal income tax purposes for the amount of any patronage dividends paid by it to a patron (that is, to one of its eligible and qualifying dealers) in the form of qualified written notices of allocation, it is necessary that the Company pay (or apply against indebtedness owing to the Company by such patron in accordance with Section 7 of Article XXIV of the Company's By-laws) not less than 20% of the total patronage dividends distributable to such patron in cash and that the patron consent to having the written notices of allocation, at their stated dollar amounts, included in his gross income for the taxable year in which they are received by him. It is also required under the Code that any patronage dividend distributions deducted by the Company on its federal income tax return with respect to business done by it with patrons during the year for which such deduction is taken must be made to the Company's patrons within 8 months after the end of such year. Dealers who have become "members" of the Company by owning 1 share of Class A Voting Stock are deemed under the U.S. Internal Revenue Code to have consented to take any written notices of allocation distributed to them into their gross income by their act of obtaining or retaining membership in the Company and by having received from the Company a written notification of the By-law provision providing that membership in the Company constitutes such consent. In accordance with another provision in the Internal Revenue Code, nonmember dealers who have subscribed for shares of the Company's stock will also be deemed to have consented, by virtue of the consent provisions included in their Subscription Agreements, to take any written notices of allocation distributed to them into their gross income. A dealer receiving a patronage refund certificate as part of the dealer's patronage dividends in accordance with the last clause of Para- graph 3 of the patronage dividend distribution plan previously described under the heading "The Company's Business," subheading, "Forms of Patronage Dividend Distributions," may be deemed to have received interest income in the form of an original issue discount to the extent of any excess of the face amount of the certificate over the present value of the stated principal and interest payments to be made by the Company under the terms of the certificate. Such income would be taxable to the dealer ratably over the term of the certificate under Section 7872(b) (2) of the U.S. Internal Revenue Code. The present value for this purpose is to be determined by using a discount rate equal to the applicable Federal rate in effect as of the day of issuance of the certificate, compounded semi-annually. The Company will be required to withhold for federal income tax on the total patronage dividend distribution which is made to a payee who has not furnished his taxpayer identification number to the Company or as to whom the Company has notice of the fact that the number furnished to it is incorrect. A cooperative organization may also be required to withhold on the cash portion of each patronage dividend distribution made to a payee who becomes a member of the cooperative if the payee fails to certify to the cooperative that he is not subject to back-up withholding. It is the opinion of the council for the Company that this provision is not applicable to any patronage dividend distribution to a payee unless 50% or more of the total distribution is made in cash. Since all of the Company's patronage dividends for a given year are distributed at the same time and the Company's currently effective patronage dividend plan does not permit any store which is a member of the Company to receive more than 45% of its patronage dividends for the year in the form of cash, it is said counsel's further opinion that such a certification failure would ordinarily have no effect on the Company or any of its dealers. Patronage dividends distributed by a cooperative organization to its patrons who are located in foreign countries or certain U.S. possessions have been held to constitute fixed or determinable annual or periodic income on which such patrons are required to pay a tax of 30% of the amount received in accordance with the provisions of Sections 871(a)(1)(A) and 881(a)(1) of the Internal Revenue Code, as do patronage dividends distributed to patrons which are incorporated in Puerto Rico or who reside in Puerto Rico but have not become citizens of the United States. With respect to its dealers who are subject to such 30% tax, the Company is also obligated to withhold from their patronage dividends and pay over to the U.S. Internal Revenue Service an amount equal to the tax. The foregoing provisions do not apply to a corporation organized in Guam, American Samoa, the Northern Mariana Islands, or the U.S. Virgin Islands if less than 25% of its stock is owned by foreign persons and at least 65% of its gross income for the last three years has been effectively connected with the conduct of a trade or business in such possession or in the United States. The 20% minimum portion of the patronage dividends to be paid in cash to a patron with respect to whom the Company is neither required to withhold 30% of his total patronage dividend distribution nor permitted to apply such minimum portion against indebtedness owing to it by him may be insufficient, depending upon the income tax bracket of each individual patron, to provide funds for the full payment of the federal income tax for which such patron will be liable as a result of the receipt of the total patronage dividends distributed to him during the year, including cash, patronage refund certif- icates and/or Class C non-voting Stock. In the opinion of the Company's management, payment in cash of not less than 20% of the total patronage dividends distributable each year to the Company's eligible and qualifying dealers will not have a material adverse effect on the operations of the Company or its ability to obtain adequate working capital for the normal requirements of its business. Membership Agreement In addition to signing a Subscription Agreement for the purchase of shares of the Company's stock, each retail dealer who applies to become an Ace dealer (excluding firms which are discussed below under the sub- heading "International Retail Merchants") must sign the Company's customary Membership Agreement. A payment of $400 must accompany the signed Membership Agreement to defray the Company's estimated costs of processing the member- ship application. If the application is accepted, copies of both the Member- ship Agreement and the Stock Subscription Agreement, signed on behalf of the Company to evidence its acceptance, are forwarded to the dealer. No royalties are payable at any time by a dealer for an outlet which the Company accepts as a member-shareholder. Membership may be terminated upon various notice periods and for various reasons (including voluntary termination by either party) as prescribed in the Membership Agreement, except to the extent that special laws or regulations applicable to specific locations may limit the Company's right to terminate memberships, or may prescribe greater periods of notice under particular circumstances. International Retail Merchants and Non-Member Accounts In 1989, the Company's Board of Directors authorized the Company to affiliate International Retail Merchants, who operate retail businesses outside the United States, its territories and possessions. International Retail Merchants do not sign the Company's Regular Membership Agreement, but may, depending on the circumstances, be granted a license to use certain of the Company's trademarks and service marks. They do not sign stock subscription agreements or become shareholders of the Company, nor do they receive distribution of patronage dividends. As of the end of fiscal years 1997, 1996 and 1995, International Retail Merchant volume accounted for approximately 4% of the Company's total sales in each such year. In 1995, the Company's Board of Directors authorized the Company to affiliate non- member retail accounts, which are not entitled to membership in the cooperative, and which therefore will neither own stock in the Company, nor receive patronage dividends. (See Article XXV, Sections 3 and 4 of the By-laws regarding International Retail Merchants and non-member accounts.) In 1996, the Company commenced operations through Ace Canada Limited. Ace Canada merchants are not shareholders of the Company, nor do they receive distribution of patronage dividends. Year 2000 A detailed plan has been established to identify and track progress on the identification of systems, changing of non-compliant systems and testing of those systems for Year 2000 compliant status. The assessment to identify the systems affected by the Year 2000 issue will be completed by the end of the first quarter 1998. Project completion is planned for the middle of 1999. In addition, a plan is being developed for all devices (time clocks, power systems, etc.) within the Company. The Company expects its Year 2000 date conversion project to be completed on a timely basis. The Company expects to incur internal staff costs as well as incremental consulting and other expenses related to infrastructure and facilities enhancements necessary to prepare the systems for the Year 2000. A significant portion of these costs will represent the re-deployment of existing information technology resources. However, management has not yet fully assessed the Year 2000 compliance expense. To date, correspondence has been received from the Company's primary vendors that plans are being developed to address processing of transactions in the Year 2000. However, there can be no assurance that the systems of other companies on which the Company's systems rely will be converted timely or that any such failure to convert by another company would not have an adverse effect on the Company's systems. Item 2. Properties The Company's general offices are located at 2200 Kensington Court, Oak Brook, Illinois 60523. Information with respect to the Company's principal properties follows: Square Feet Owned Lease of Facility or Expiration Location (Land in Acres) Leased Date ------------------------- ----------- ------ ---------- General Offices: Oak Brook, Illinois 206,030 Leased September 30, 2009 Oak Brook, Illinois 70,508 Owned Markham, Ontario, Canada (1) 15,372 Leased February 28, 2006 Distribution Warehouses: Lincoln, Nebraska 346,000 Leased December 31, 2006 Arlington, Texas 313,000 Leased July 31, 2002 Perrysburg, Ohio 396,000 Leased November 1, 2004 Tampa, Florida 391,760 Owned Harmans, Maryland 277,000 Owned Yakima, Washington 502,400 Owned Maumelle, Arkansas 585,500 Owned LaCrosse, Wisconsin 363,000 Owned Bloomfield, Connecticut (2) 449,820 Owned Huntersville, North Carolina 354,000 Owned Rocklin, California 470,000 Owned Gainesville, Georgia 478,000 Owned Prescott Valley, Arizona 633,000 Owned Princeton, Illinois 1,080,000 Owned Carol Stream, Illinois (3) 250,000 Leased September 30, 1999 Chicago, Illinois (4) 18,168 Leased May 31, 1999 Brantford, Ontario, Canada (5) 434,000 Leased March 31, 2006 Baltimore, Maryland (6) 158,485 Leased March 31, 1998 Colorado Springs, Colorado 493,000 Owned Wilton, New York 795,000 Leased September 1, 2007 Calgary, Alberta, Canada (5) 240,000 Leased December 31, 2001 Square Feet Owned Lease of Facility or Expiration Location (Land in Acres) Leased Date ------------------------- ----------- ------ ---------- Print Shop Facility: Downers Grove, Illinois 41,000 Leased April 30, 2002 Paint Manufacturing Facilities: Matteson, Illinois 356,000 Owned Chicago Heights, Illinois 194,000 Owned Other Property: Aurora, Illinois 72 acres Owned LaCrosse, Wisconsin (7) 3 acres Owned (1) This facility is leased by the Company's wholly owned subsidiary, Ace Hardware Canada, Limited for use as its corporate office. (2) This facility no longer operates as a distribution warehouse and is for sale. (3) This facility was leased by the Company in October, 1994, for use as a bulk merchandise redistribution center. (4) This facility was leased by the Company in June, 1994 for use as a freight consolidation center. (5) This facility is leased by the Company's wholly owned subsidiary, Ace Hardware Canada, Limited for use as a distribution warehouse. The Brantford facility includes 80,000 square feet leased for a two year period commencing January 1, 1998 and expiring December 31, 2000. (6) This facility was leased by the Company in February, 1995 for use as a redistribution center. The Company does not intend to renew this lease. (7) This land is adjacent to the Company's LaCrosse, Wisconsin warehouse. In addition to the above principal properties, the Company also leases other property for the purpose of operating retail hardware stores through its wholly owned subsidiaries, A.H.C. Store Development Corp. and Ace Corporate Stores, Inc. A.H.C. Store Development Corp. leases two properties in Illinois, one in Wisconsin, one in Michigan and two in Georgia. Ace Corporate Stores, Inc. leases one property in Illinois. The Company is also leasing real estate in Georgia for the purpose of operating a company- owned retail hardware store. This property is under construction. The Company also leases a fleet of transportation equipment for the primary purpose of delivering merchandise from the Company's warehouses to its dealers. Item 3. Legal Proceedings There are no material pending legal proceedings which either individually or in the aggregate involve claims for damages that exceed 10% of the current assets of the Company and its subsidiaries on a consolidated basis. Item 4. Submission of Matters to a Vote of Security Holders None. PART II Item 5. Market for The Registrant's Common Equity and Related Stockholder Matters There is no existing market for the stock of the Company and there is no expectation that any market will develop. The Company is organized and operates as a cooperative corporation, and its stock is owned exclu- sively by retailers of hardware and related merchandise who are members of the Company. The number of holders of record as of February 13, 1998 of each class of stock of the Company is as follows: Title of Class Number of Record Holders -------------- ------------------------ Class A stock, $1,000 par value 3,872 Class B stock, $1,000 par value 2,704 Class C stock, $100 par value 4,824 Dividends, other than patronage dividends are prohibited by the Company's Articles of Incorporation and By-laws. See the discussion of patronage dividends under Item 1. Business. Item 6. Selected Financial Data SELECTED FINANCIAL DATA Income Statement Data: For the Years Ended December 31, ------------------------------------------------------------ 1997 1996 1995 1994 1993 ---------- ---------- ---------- ---------- ---------- (000's omitted) Net sales $2,907,259 $2,742,451 $2,436,012 $2,326,115 $2,017,763 Cost of sales 2,682,863 2,535,014 2,253,430 2,152,322 1,866,768 ---------- ---------- ---------- ---------- ---------- Gross profit 224,396 207,437 182,582 173,793 150,995 Total expenses 148,009 135,130 118,840 109,271 93,903 ---------- ---------- ---------- ---------- ---------- Net earnings $ 76,387 $ 72,307 $ 63,742 $ 64,522 $ 57,092 ========== ========== ========== ========== ========== Patronage dividends (Notes A, B, 5 and 8) $ 76,153 $ 73,837 $ 64,716 $ 64,520 $ 59,023 ========== ========== ========== ========== ========== Balance Sheet Data: Year Ended December 31, ------------------------------------------------------------- 1997 1996 1995 1994 1993 ---------- ---------- ---------- ---------- ---------- (000's omitted) Total assets $ 976,571 $ 916,375 $ 759,133 $ 723,610 $ 666,022 Working capital 159,011 146,911 139,805 150,514 138,652 Long-term debt 96,815 71,837 57,795 64,287 71,286 Patronage refund certificates payable, long- term 49,044 49,639 54,741 63,666 56,270 Member dealers' equity 245,814 233,363 217,245 199,827 186,028 (A) The Company operates as a cooperative organization, and pays patronage dividends to member dealers on earnings derived from business done with such dealers. It is the practice of the Company to distribute substan- tially all patronage sourced earnings in the form of patronage dividends. (B) The form in which patronage dividends are to be distributed can only be determined at the end of each year when the amount distributable to each of the member dealers is known. For the five years ended December 31, 1997, patronage dividends were payable as follows: 1997 1996 1995 1994 1993 ------- ------- ------- ------- ------- (000's omitted) In cash $29,943 $28,178 $23,522 $27,302 $25,766 In patronage refund certificates payable 13,726 9,500 5,032 9,920 12,728 In Class C Stock 22,366 26,474 27,506 21,766 19,064 In patronage financing deductions 10,118 9,685 8,656 5,532 1,465 Total patronage ------- ------- ------- ------- ------- dividends $76,153 $73,837 $64,716 $64,520 $59,023 ======= ======= ======= ======= ======= (C) Numbered notes refer to Notes to Consolidated Financial Statements, beginning on page F-8. (5) & (8) refers to Notes (5) and (8) of the Consolidated Financial Statements beginning on page F-8 of this Form 10-K. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources The Company's ability to generate cash adequate to meet its needs ("liquidity") results from internally generated funds, short-term lines of credit and long-term financing (see Notes 3 and 4 to the financial statements). The Company's long and short-term liquidity is dependent on retail growth as described under the "Company's Business." Nothing in the Company's plans as discussed under the "Company's Business" has led or is expected to lead to any material change in pricing, margins or product focus or is expected to materially impact the results or operations or liquidity of the Company. The Company's long-term strategic plan is only for a renewed focus on supporting retail growth. Retail growth provides equity growth for the Company. Recognizing the need for equity growth in order to properly capitalize the Company, the patronage stock formula for years beginning in 1995 was changed. See "Forms of Patronage Dividend Distributions." The Company believes that these changes and the retail growth of the membership will provide adequate liquidity for the long-term. The Company has an established, unsecured revolving credit facility with a group of banks. The Company has unsecured lines of credit of $175.0 million of which $133.0 million was available at December 31, 1997. Any borrowings under these lines of credit would bear interest at the prime rate or less. Long-term financings are arranged as determined necessary to meet the Company's capital or other requirements, with principal amount, timing and form dependent on prevailing debt markets and general economic conditions. The Company's credit facilities provide that certain ratios be maintained with the only material covenant related to fixed charge coverage. The Company is in compliance with all debt covenants. Capital expenditures for new and improved facilities were $49.4, $40.4 and $31.3 million in 1997, 1996 and 1995, respectively. During 1997, the Company financed the $49.4 million of capital expenditures out of current and accumulated internally generated funds and short-term and long-term borrowings. 1998 capital expenditures are anticipated to be approximately $32.0 million primarily for improvements to existing facilities. As a cooperative, the Company distributes substantially all of its patronage sourced earnings to its members in the form of patronage dividends, which are deductible for income tax purposes (see headings "Patronage Dividend Determinations And Allocations" and "Federal Tax Treatment of Patronage Dividends"). Prior to 1994, patronage dividends were distributed on the basis of taxable income. Accordingly, patronage dividends can exceed net income or be less than net income due to the timing of certain items for income tax purposes. The Board of Directors does have the authority to determine reasonable reserves for the purpose of ensuring the welfare of the Company, but it has been the practice of the Company to distribute substantially all patronage sourced earnings in the form of patronage dividends. No adverse trends in revenue or net income have occurred since the end of the Company's last reported financial period. The Company expects that existing and new internally generated funds, along with established lines of credit and long-term financing, will continue to be sufficient to finance the Company's working capital requirements and patronage dividend and capital expenditure programs. Operations-1997 Compared to 1996 Net sales increased 6% due to increases in existing retailer volume, targeted efforts on new store development and conversions, and a full year of Canadian operations. Sales of basic hardware and paint merchandise (including warehouse, bulletin and direct shipments) increased 5.1% while lumber and building material sales increased 10.3% due to accelerated sales efforts. Excluding Canadian operations, international sales increased 27.5% primarily due to new international store development. Gross profit increased $17.0 million or 8.2% and increased as a percent of sales to 7.72% vs. 7.56% in 1996. Domestic gross profit as a percent of sales increased over 1996 due to increased manufacturing gross profit and additional company-owned stores. Canadian operations also contributed to the increased gross profit due to a full year of operation. Warehouse and distribution expenses increased $2.6 million or 7.2% due to the operation of one additional domestic facility and two Canadian facilities in 1997. The replacement of an existing facility also contributed to the increase, partially offset by increased traffic revenues. Selling, general and administrative expenses increased $4.6 million or 6.7% due to increased data processing costs and additional costs for a full year of Canadian operations. Excluding Canadian operations, selling, general and administrative expenses increased 4.8% and decreased slightly as a percent of sales resulting from continued cost containment and re- engineering efforts. Retail success and development expenses increased $3.9 million or 18.2% due to increased new business development costs, reduced retail systems income and costs associated with additional company-owned stores. Increases in this category are directly related to retail support of the Ace retailer as the Company continues to make investments in our dealer base. Paint Division sales increased 5.0% to $108.3 million. As a separate division of the Company, the Paint Division produced net manufacturing profits of $11.3 million in 1997 vs. $8.3 million in 1996. The increased net manufacturing profit results from the 5.0% sales increase and resulting gross margin and improved utilization of the Company's second facility. Paint is the only product manufactured by the Company. As discussed on page 9, patronage dividends are calculated separately for paint sales and increased to 10.31% in 1997 vs. 7.98% in 1996. Interest expense increased $2.9 million due to increased borrowings for the addition of a new facility in 1996 and 1997 and additional dealer dating programs. Other income increased due to increased past due service charges and reduced losses from the sale of property and equipment. Income taxes increased $792,000 due to improved profitability of the company's non- patronage operations. Operations-1996 Compared to 1995 Net sales increased 12.6% due to increases in existing retailer volume, targeted efforts on new store development and conversions, and the start-up of Canadian operations. 1996 domestic same store sales increased 9.8% due to retailer store upgrades and continued emphasis on retail success. Sales of basic hardware and paint merchandise (including warehouse, bulletin and direct shipments) increased 11.6%. Lumber and building material sales experienced slightly higher percentage increases in 1996 due to accelerated sales efforts and industry-wide lumber price increases. Net dealer outlets increased in 1996 due to targeted sales efforts on new store development and conversions to the Ace program and continued emphasis on retail success. Gross profit increased $24.9 million or 13.6% and increased as a percent of sales to 7.56% vs. 7.50% in 1995 due primarily to gross profit from Canadian operations. Domestic gross profit as a percent of sales is comparable to 1995 as higher merchandise discounts and allowances were completely offset by lower levels of dealer price increases in 1996. Emphasis on low upfront pricing continued with total upfront rebates increasing 16.9% in 1996. Warehouse and distribution expenses increased $6.8 million or 22.8% due to start-up costs for the opening of one domestic and two Canadian facilities in 1996. Excluding Canadian operations, warehouse and distribution expenses increased 13.6% and increased slightly as a percent of sales due to wage increases to support the sales growth and start-up costs for the new facility. Selling, general and administrative expenses increased $7.9 million or 13.2% due to personnel costs for the start-up operations and increased data processing expenses. Excluding Canadian operations, selling, general and administrative expenses increased 7.5% and declined as a percent of sales due to reduced corporate administrative expenses resulting from 1996 re-engineering efforts. Retail success and development expenses increased $3.0 million or 16.4% due to increased new business development costs, increased retail training expenses and reduced retail systems income. Increases in this category are directly related to retail support of the Ace retailer as the Company continues to make investments in our dealer base. Paint Division sales increased 16.5% to $103.1 million. As a separate division of the Company, the Paint Division produced net manufacturing profits of $8.3 million in 1996 vs. $5.8 million in 1995. The increased net manufacturing profit results from the 16.5% sales increase and resulting gross margin and improved utilization of the Company's second facility partially offset by increased 1996 advertising expenses. Paint is the only product manufactured by the Company. As discussed on page 9, patronage dividends are calculated separately for paint sales and increased to 7.98% in 1996 vs. 6.87% in 1995. Interest expense decreased $1.3 million or 9.8% due to lower inventory levels resulting from improved inventory turnover in 1996. Additional dealer dating programs and long-term debt to fund 1996 capital investments partially offset the interest expense decline. Impact of New Accounting Standards In June, 1997, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income," which requires the prominent display of comprehensive income and its components in the financial statements. The Company is required to comply with SFAS No. 130 in fiscal year 1998 and estimates its adoption will not have a material effect on the consolidated financial statements. In June, 1997, the FASB issued SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information." SFAS No. 131 establishes standards for reporting information about operating segments in annual financial statements. The Company is required to comply with SFAS No. 131 in fiscal year 1998 and estimates its adoption will not have a material effect on the consolidated financial statements. Inflation and Changes in Prices The Company's business is not generally governed by contracts that establish prices substantially in advance of the receipt of goods or services. As vendors increase their prices for merchandise supplied to the Company, the Company increases the price to its dealers in an equal amount plus the normal handling charge on such amounts. In the past, these increases have provided adequate gross profit to offset the impact of inflation on operating expenses. Item 7a. Quantitative and Qualitative Disclosures about Market Risk Not Applicable. Item 8. Financial Statements and Supplementary Data Financial statements covered by the report of the Company's independent certified public accountants are listed on Page F-1. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosures None. PART III Item 10. Directors and Executive Officers of the Company The directors and the executive officers of the Company are: Position(s) Held Name Age and Business Experience ---- --- ----------------------- Jennifer C. Anderson 47 Director since June 6, 1994; term expires 2000; President of Davis Lumber and Ace Hardware, Inc., Davis, California. Eric R. Bibens II 41 Director since June 2, 1997; term expires 2000; President of Bibens Home Center, Inc., Springfield, Vermont. Lori L. Bossmann 37 Vice President-Controller effective September, 1997; Controller effective January, 1994; Assistant Controller effective November, 1990. Michael C. Bodzewski 48 Vice President-Merchandising effective June, 1990; General Merchandise Manager effective April, 1988. Lawrence R. Bowman 51 Director since February 4, 1991; term expires 1998; President of Owenhouse Hardware Co., Inc., Bozeman, Montana. James T. Glenn 38 Director since June 3, 1996; term expires 1999; President of Ace Hardware of Chattanooga, Chattanooga, Tennessee. Ray A. Griffith 44 Vice President-Retail Development and Marketing effective September, 1997; Director-Retail Operations, Western Division effective September, 1994; from July, 1993- April, 1994, President and Chief Executive Officer of Servistar/ Coast to Coast Corporation; from July, 1992-June, 1993, Executive Vice President and Chief Operating Officer of Servistar/Coast to Coast Corporation; from January, 1990-June, 1992, Vice President-General Manager of the Northern Division of Servistar/Coast to Coast Corporation. Position(s) Held Name Age and Business Experience ---- --- ----------------------- D. William Hagan 40 Director since June 2, 1997; term expires 2000; President of Hagan Ace Hardware, Orange Park, Florida. David F. Hodnik 50 President and Chief Executive Officer effective January 1, 1996; President and Chief Operating Officer effective January 1, 1995; Executive Vice President and Chief Operating Officer effective January, 1994; Executive Vice President and Treasurer effective January, 1991; Senior Vice President and Treasurer effective January, 1988; Vice Pres- ident-Finance and Management Infor- mation Systems and Treasurer effective September, 1986; Vice President-Finance and Treasurer effective December, 1982. Paul M. Ingevaldson 52 Senior Vice President-International and Technology effective September, 1997; Vice President-Corporate Strategy and International Business effective September, 1992; Vice President-Retail Support Services effective August, 1989; Vice President-Western Region effective September 1, 1988; Vice President-Distribution effective September, 1986; Vice President- Management Information Systems effective October, 1985; Director of Data Processing effective October, 1982. Mark Jeronimus 49 Director since June 3, 1991; term expires 2000; President of Duluth Hardware, Inc., Duluth, Minnesota. Rita D. Kahle 41 Senior Vice President-Wholesale effective September, 1997; Vice President-Finance effective January, 1994; Vice President-Controller effective January, 1992; Controller effective July, 1988. John E. Kingrey 54 Director since May 17, 1992; term expires 1999; President of WK&K Corp., Wimberley, Texas. Richard E. Laskowski 56 Chairman of the Board since February 18, 1992 and Director since June 1, 1987; term expires 1998; President of Ace Hardware Home Center of Round Lake, Inc., Round Lake, Illinois. David W. League 58 Vice President-General Counsel and Secretary effective June, 1990; General Counsel and Secretary effective January, 1990; General Counsel effective January, 1989. William A. Loftus 59 Executive Vice President-Retail effective September, 1997; Senior Vice President-Retail Operations and Marketing effective October, 1994; Senior Vice President-Marketing and Advertising effective September, 1992; Senior Vice President since January 1, 1991; Vice President- Retail Support Operations effective August, 1989; Vice President- Eastern Region effective September 1, 1988; Vice President-Sales effective October, 1983; National Sales Manager effective October, 1976. Position(s) Held Name Age and Business Experience ---- --- ----------------------- David F. Myer 52 Vice President-Retail Support effective September, 1997; Vice President-Retail Support and New Business effective October, 1994; Vice President-Retail Support effective August, 1992; Vice Pres- ident-Distribution effective July, 1989. Fred J. Neer 58 Vice President-Human Resources effective April, 1989; Director of Human Resources effective April, 1986. Roger E. Peterson 60 Director since June 5, 1995; term expires 1998; Chief Executive Officer effective January 1, 1995; President and Chief Executive Officer effective December, 1989; President effective August, 1986; Executive Vice President effective March, 1985; Vice President-Operations effective December, 1982. Donald L. Schuman 59 Vice President-Information Technology effective June, 1990; Director-Information Systems effective January, 1987. Jon R. Weiss 62 Director since June 4, 1990; term expires 1999; President of John W. Weiss Hardware Company, Glenview, Illinois. James R. Williams, Jr. 50 Director since June 5, 1989; term expires 1998; Vice President of Williams Ace Hardware, Inc., Wichita, Kansas. The By-laws of the Company provide that its Board of Directors shall be comprised of such number of persons, not less than 9 and not greater than 12, as shall be fixed from time to time by the Board of Directors. A minimum of 9 of the directors shall be dealer directors. A maximum of two of the directors may be non-dealer directors, but non-dealer directors may not exceed 25% of the total number of directors in office at any one time. A person shall be eligible for election or appointment as a non-dealer director without regard to whether or not such person is the owner of a retail business organization which is a stockholder of Ace Hardware Corporation, or an executive officer, general partner or general manager of such a retail business organization. The By-laws also provide for three classes of directors who are to be elected for staggered 3-year terms. The By-laws provide that no person is eligible to serve as a dealer director unless such person is either the owner of a retail business organ- ization holding stock in the Company or an executive officer, general partner or general manager of such a retail business organization. Regional dealer directors are elected from geographic regions of the United States established by the Board. If the Board determines that all regions have representation by regional dealer directors and the maximum number of directors would not there- by be exceeded, then dealer directors at large may also be elected. In accordance with the applicable procedure established by the By-laws, the following directors have been selected as nominees for reelection at the annual stockholders meeting to be held on June 1, 1998, as a dealer director and a non-dealer director, respectively, of the classes, from the regions and for terms as indicated below: Nominee Class Region Term ------- ----- ------ ---- Lawrence R. Bowman 3 7 3 years Roger E. Peterson 3 N/A* 3 years Mr. James R. Williams is not eligible for reelection as a director commencing in 1998. The person named below has been selected as the nominee for election to the Board for the first time at the 1998 annual meeting as a dealer director of the class, from the region and for the term indicated: Nominee Age Class Region Term ------- --- ----- ------ ---- Daniel L. Gust 48 3 5 3 years In addition, Chairman of the Board Richard E. Laskowski is not eligible for reelection as a director commencing in 1998. The person named below has been selected as the nominee for election to the Board at the 1998 annual meeting as a director from the class, from the region and for the term indicated: Nominee Age Class Region Term ------- --- ----- ------ ---- Mario R. Nathusius 54 3 N/A* 3 years The person named below has been selected as the nominee for the election to the Board at the 1998 annual meeting as a dealer director at large from the class, from the region and for the term indicated: Nominee Age Class Region Term ------- --- ----- ------ ---- Howard J. Jung 50 3 N/A* 3 years Mr. Jung previously served on the Board of Directors from 1987 through May, 1996. If elected, Mr. Jung has been selected to serve as Chairman of the Board effective June 1, 1998 when Mr. Laskowski's term expires. *Non-dealer directors and dealer directors at large are not elected with respect to particular geographic regions. Reference should be made to Article IV of the By-laws for information concerning the qualifications required for membership on the Board of Directors, the terms of directors, the limitations on the total period of time for which a director may hold office, the procedure established for the designation of Nominating Committees to select certain persons as nominees for election to the Board of Directors, and the procedure for filling vacancies on the Board for the remaining portion of unexpired terms. None of the events described under Item 401(f) of Regulation S-K occurred during the past 5 years with respect to any director of the Registrant, any nominee for membership on the Board of Directors of the Registrant or any executive or staff officer of the Registrant. Item 11. Executive Compensation The following information is set forth with respect to the cash compensa- tion paid by the Company to each of the five highest paid executive officers of the Company whose cash compensation exceeded $100,000, for services ren- dered by them in all capacities to the Company and its subsidiaries during the fiscal year ended December 31, 1997 and the two previous fiscal years: SUMMARY COMPENSATION TABLE Long-Term Annual Compensation Compensation --------------------------------- -------------------- (2) (4) Other (3) All Name Annual Long- Other and (1) Compen- Term Compen- Principal Salary Bonus sation Payouts sation Position Year ($) ($) ($) ($) ($) -------- ---- ------ ----- ------ ------- ------- David F. Hodnik 1997 $600,000 - $14,147 $195,666 $133,167 President and Chief 1996 500,000 - 20,110 173,223 104,989 Executive Officer 1995 450,000 - 17,021 105,870 97,624 (CEO effective 1/1/96) William A. Loftus 1997 308,300 53,628 12,853 83,241 71,778 Executive Vice 1996 290,000 49,880 8,442 81,132 60,644 President-Retail 1995 275,000 42,350 6,298 80,204 59,153 Paul M. Ingevaldson 1997 272,300 49,453 11,738 74,259 46,922 Senior Vice 1996 257,000 40,092 11,188 72,450 49,579 President- 1995 247,000 33,100 7,215 71,221 49,466 International and Technology Rita D. Kahle 1997 250,000 46,237 8,647 57,813 46,733 Senior Vice 1996 218,000 36,406 6,826 50,436 33,122 President- 1995 195,000 32,175 9,012 44,807 35,573 Wholesale Michael C. Bodzewski 1997 235,750 45,420 9,988 57,990 34,785 Vice President- 1996 217,250 37,018 7,312 52,107 36,384 Merchandising 1995 192,500 36,800 9,555 48,158 36,523 (1) The Incentive Compensation Plan covers each of the executive officers (except Mr. Hodnik). The bonus amounts awarded to participants in the Plan are determined in accordance with achievement of individual per- formance based objectives and achievement of corporate goals. The max- imum short-term incentive award for each executive officer is 20% of their respective salary. The short-term bonus award becomes payable to each participant as early as practicable at or after the end of the fiscal year. (2) The Company provided automobiles to certain of its executive officers. The Company requires them to maintain records with respect to any bus- iness automobile use. Such officers pay, both directly and by reim- bursement to the Company, personal automobile expenses. During 1997, Company provided automobiles were replaced with automobile allowances. Country club memberships granted prior to 1994 to some officers have been eliminated, except for the President. The compensation table set forth above includes the value of these items and such value for any officer did not exceed the lesser of $25,000 or 10% of the compensation reported for each in said table. (3) Includes the long-term incentive award under the Long-Term Incentive Compensation Deferral Option Plan effective in 1995. The long-term Officer incentive plan is based upon corporate performance over a three year period with emphasis on total shareholder return through maximizing both year-end patronage dividends and upfront dividends (throughout the year) through pricing programs and discounts. This plan maintains the commitment to long-term performance and shareholder return in a co- operative environment. One third of the total long-term incentive award is subject to a one year vesting provision. Total awards paid in 1997 were $195,666, $83,241, $74,259, $57,990 and $57,813 for Messrs. Hodnik, Loftus, Ingevaldson, Bodzewski and Ms. Kahle, respectively. Effective January 1, 1995, executive officers may elect to defer a portion (20% to 100%, in 20% increments) of the annual award granted. Par- ticipants' compensation deferrals are credited with a specified rate of interest to provide a means to accumulate supplemental retirement benefits. Deferred benefits are payable over a period of 5 to 20 years. Annual elec- tions are required for the upcoming deferral year by December of the pre- ceding year. Of the total 1997 awards, amounts deferred were $104,355, $61,043, $74,259, $38,660 and $57,813 for Messrs. Hodnik, Loftus, Ingevaldson, Bodzewski and Ms. Kahle, respectively. (4) Includes contributions to the Company's Profit Sharing Plan which has been in existence for the period of January 1, 1953 through December 31, 1996, the Company's Profit Sharing Plus Plan which has been in existence since January 1, 1997, and contributions to the Company's Retirement Benefits Replacement Plan. All active employees are eligible to partic- ipate in the Company's profit sharing plan after one year of service. Those active employees covered by a collective bargaining agreement regarding retirement benefits, which were the subject of good faith bar- gaining, are not eligible if such agreement does not include them in the plan. For the year 1997, the Company contributed a maximum of 10.5% of each participant's eligible compensation to the Profit Sharing Plus Plan (9.5% profit sharing and 1% Company 401-K match). During the year 1997, $16,800 was expensed by the Company pursuant to the Plan for Messrs. Hodnik, Loftus, Ingevaldson, Bodzewski and Ms. Kahle. The Company has also established a Retirement Benefits Replacement Plan covering all executive officers of the Company. This is an unfunded Plan under which the participants therein are eligible to receive retirement benefits equal to the amounts by which the benefits they would otherwise have been entitled to receive under the Company's Profit Sharing Plan may be reduced by reason of the limitations on contributions and benefits imposed by any current or future provisions of the U.S. Internal Revenue Code or other federal legislation. During the year 1997, amounts expensed by the Company pursuant to the Plan were $116,367 for Mr. Hodnik, $54,978 for Mr. Loftus, $30,122 for Mr. Ingevaldson, $17,985 for Mr. Bodzewski and $29,933 for Ms. Kahle. The Company also funds the base premium for a supplemental universal life insurance policy for each officer but does not contribute to supplemental retirement benefits through this vehicle. Participants may elect to deposit a portion (up to one-third) of the long term incentive award into the var- iable annuity insurance policy in their name or may elect to defer this portion under the Deferral Option Plan. (5) As a cooperative whereby all stockholders are member dealers, the Company does not grant or issue stock awards of any kind. Messrs. Hodnik, Loftus, and Ingevaldson are employed under contracts, each dated January 1, 1997 for respective terms of two years, terminating December 31, 1998. Mr. Bodzewski and Ms. Kahle are employed under contracts dated April 1, 1997 and January 1, 1998 for a two year term terminating March 31, 1999 and December 31, 1999, respectively. The contracts provide for annual compensation effective January 1, 1998 of $600,000, $315,000, $279,000, $240,000 and $270,000, respectively or such increased amount, if any, as shall be approved by the Board of Directors. The Company also maintains a Pension Plan which has been in existence since December 31, 1970. All active employees are eligible to participate in this Plan on the first January 1 that they are working for the Company. Those active employees covered by a collective bargaining agreement regarding retirement benefits, which were the subject of good faith bargaining are not eligible if such agreement does not include them in the plan. The Plan provides benefits at retirement at or after age 65 determined under a formula which takes into account 60% of a participant's average base pay (including overtime) during the 5 highest consecutive calendar years of employment and years of service prior to age 65, and under which an offset is applied for the straight life annuity equivalent of the vested portion of the participant in the amount of benefits provided for them by the Company under the Profit Sharing Plan. In December 1995, the Company settled a portion of its pension liability to retirees and vested terminated participants through lump sum payments and the purchase of single premium annuity contracts. The Plan was closed to new entrants on December 31, 1995. Examples of yearly benefits provided by the Pension Plan (prior to reduction by the Profit Sharing Plan offset) are as follows: Years of Service Remuneration 10 15 20 25 30 or more ------------ ------- ------- ------- ------- ---------- $150,000 $30,000 $45,000 $60,000 $75,000 $90,000 $100,000 20,000 30,000 40,000 50,000 60,000 $ 50,000 10,000 15,000 20,000 25,000 30,000 The amounts shown above represent straight life annuity amounts. Maximum benefits from the Pension Plan are attained after 30 years of service and attainment of age 65. The compensation covered by the Pension Plan consists of base compensation (exclusive of bonuses and non-recurring salary or wage payments) and shall not exceed $150,000 of such total remuneration paid to a participant during any plan year. Remuneration and yearly benefits under the Plan are limited, and subject to adjustment, under Sections 415(d) and 401(a)17 of the U.S. Internal Revenue Code. The amount of covered compensation under the Pension Plan, therefore is $150,000 for each Executive Officer named in the Compensation table. The present credited years of service under the Pension Plan for the currently employed executive officers named in the compen- sation table are as follows: David F. Hodnik-25 years; William A. Loftus-21 years; Paul M. Ingevaldson-18 years; Michael C. Bodzewski-20 years and Rita D. Kahle-11 years. Compensation Committee Report The Compensation Committee reviews and approves compensation and benefits provided to all senior executives. The corporation's Executive Compensation philosophy is one that supports the Company's fundamental business strategies. The Committee stresses long term measured results, focus on teamwork, accepting prudent risks, and are strongly committed to fulfilling dealer/ consumer needs. Our compensation program reflects a policy of market place comparisons and corporate and individual performance based pay. Our competitors for talented people include publicly owned for profit retail corporations, privately owned for profit retail enterprises, and other national hardware/LBM cooperatives. Each of these comparative groupings has quite a different compensation practice/ philosophy. An annual review is performed of executive cash compensation pro- vided by competitors and by participating in various executive compensation sur- veys. Our orientation is to be cognizant of their respective practices and pay levels, but to give greater emphasis to that which supports our strategic busi- ness objectives and the needs of our dealer network. The Compensation Committee changed the compensation mix in 1994 and again in 1998 to one which stresses the provision of more significant performance based incentives, particularly long-term. Annual and long-term incentive opportunities have increased, with substantive changes in long-term performance criteria. Long-term performance is evaluated heavily on a measurement of total shareholder return including both year-end patronage dividends and upfront dividends through low-upfront pricing programs and discounts. This criteria maximizes total return to our membership. As it relates to the President/CEO compensation, the President's compen- sation includes a competitive base salary and a long-term incentive award to maintain the commitment to long-term Company performance and shareholder return. Compensation of Directors Effective January 1, 1998, and January 1, 1997, each member of the Board of Directors receives a monthly fee of $2,500 and $2,850, respectively, for their services. Effective January 1, 1998 each member of the Board of Directors receives $1,500 per Board of Directors meeting attended. In addition effective March 1, 1998 each Board of Director Committee Chairperson receives $500 per meeting chaired. Effective as of the foregoing dates, Mr. Laskowski is paid a total annual fee of $150,000 and $135,000 per year, respectively, in his capacity as Chairman of the Board. In 1994, the previous Deferred Director Fee Plan was amended, restated and retitled the Directors' Deferral Option Plan. Like the Officers' Long Term Incentive Compensation Deferral Option Plan, under this Directors' Plan, direc- tors may elect to defer a portion (5% to 100%, in 5% increments) of their annual director's fee. Deferred benefits are payable over a period of 5 to 20 years, as elected. Annual elections are required for the upcoming deferral year by December of the preceding year. Each member of the Board is also reimbursed for the amount of travel and lodging expenses incurred in attending meetings of the Board and of the Commit- tees of the Board. The expenses incurred by them in attending the semi-annual conventions and exhibits which the Company sponsors are also paid by the Com- pany. Each member of the Board is also paid $200 per diem compensation for special committee meetings and nominating committee regional trips attended. Item 12. Security Ownership of Certain Beneficial Owners and Management With the exception of Mr. Laskowski, no shares of the Company's stock were held by any of its officers. No person owns of record or is known by the Com- pany to own beneficially more than five percent of the outstanding voting securities of the Company. The following table sets forth the shares of Class B Stock and Class C Stock of the Company held beneficially, directly or indirectly, by each direc- tor (and nominee) owning such shares, individually itemized, and by all officers and directors as a group, as of February 13, 1998: Class B Stock Owned Class C Stock Owned --------------------- -------------------- Number Percent Number Percent of Shares of Class of Shares of Class --------- -------- --------- -------- Jennifer C. Anderson 4 0.148 3,224 .152 Eric R. Bibens II - - 531 .025 Lawrence R. Bowman 4 0.148 2,049 .096 James T. Glenn 4 0.148 7,873 .371 Daniel Gust - - 246 .012 D. William Hagan 4 0.148 2,235 .105 Mark Jeronimus - - 730 .034 Howard J. Jung - - 555 .026 John E. Kingrey 4 0.148 1,263 .059 Richard E. Laskowski 4 0.148 13,163 .620 Mario Nathusius - - 2,943 .139 Jon R. Weiss 4 0.148 2,754 .130 James R. Williams, Jr. 4 0.148 772 .036 All above directors and ---- ------- ------- ------- officers as a group 32 1.184 38,338 1.805 ==== ======= ======= ======= There are no known contractual arrangements nor any pledge of securities of the Company which may at a subsequent date result in a change in control of the Company. Item 13. Certain Relationships and Related Transactions No director, executive officer or security holder who is known to the Registrant to own of record or beneficially more than five percent of any class of the Registrant's voting securities, or any member of the immediate family of any of the foregoing persons, had during the last fiscal year or is currently proposed to have any material interest, direct or indirect, in any transaction in which the amount involved exceeds $60,000 and to which the Registrant was or is to be a party, except that each of the directors purchased merchandise and services from the Registrant in the ordinary course of business on behalf of the retail hardware businesses in which they have ownership interests. None of such persons received benefits not shared by other hardware retailers supplied by the Registrant. No director has had any business relationship which is required to be dis- closed pursuant to Item 404(b) of Regulation S-K of the Securities and Exchange Commission, during the Registrant's last fiscal year. Mr. Peterson, who was elected as an outside Director effective June 5, 1995 and retired as CEO of the Company effective May 31, 1995 is subject to an agreement through May 31, 2000 providing for non-competition within the industry, participation in designated Company functions and total renumeration of $150,000 per year over the 5 year term. No director, director nominee, executive officer, any member of the immed- iate family of any of the foregoing, or any corporation or organization of which any of the foregoing is an executive officer, partner, or, directly or in- directly, the beneficial owner of ten percent or more of any class of equity securities, or any trust or other estate in which any of the foregoing has a substantial beneficial interest or as to which such person serves as a trustee or in a similar capacity, has been indebted to the Registrant or its subsid- iaries at any time since the beginning of the Registrant's last fiscal year in an amount in excess of $60,000, except for indebtedness incurred in connection with purchases of merchandise and services made from the Registrant in the ord- inary course of business by the retail hardware businesses in which the direc- tors have ownership interest. PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) 1. Financial Statements The financial statements listed in the accompanying index (page F-1) to the consolidated financial statements are filed as part of this annual report. 2. Financial Statement Schedules None. 3. Exhibits The exhibits listed on the accompanying index to exhibits (pages E-1 through E-6) are filed as part of this annual report. (b) Reports on Form 8-K None. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. ACE HARDWARE CORPORATION By RICHARD E. LASKOWSKI ------------------------ (Richard E. Laskowski Chairman of the Board and Director) DATED: March 18, 1998 Pursuant to the requirement of the Securities Exchange Act of 1934, this Annual Report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date RICHARD E. LASKOWSKI Chairman of the Board March 18, 1998 ---------------------- and Director (Richard E. Laskowski) DAVID F. HODNIK President and Chief March 18, 1998 ---------------------- Executive Officer (David F. Hodnik) LORI L. BOSSMANN Vice President- March 18, 1998 ---------------------- Controller (Lori L. Bossmann) (Principal Financial and Accounting Officer) Jennifer C. Anderson, Eric R. Bibens II, Directors Lawrence R. Bowman, James T. Glenn, D. William Hagan, Mark Jeronimus, John E. Kingrey, Roger E. Peterson, Jon R. Weiss, and James R. Williams, Jr. *By DAVID F. HODNIK ------------------------ (David F. Hodnik) *By LORI L. BOSSMANN March 18, 1998 ------------------------ (Lori L. Bossmann) *Attorneys-in-fact THIS PAGE INTENTIOANLLY LEFT BLANK INDEX TO EXHIBITS Exhibits Enclosed Description ------------ ----------- 21 Subsidiaries of the Registrant 24 Powers of Attorney Exhibits Incorporated by Reference Description ------------ ----------- 2 No Exhibit 3-A Restated Certificate of Incorporation of the Registrant dated September 18, 1974 filed as Exhibit 3-A to the Registrant's Form S-1 Registration Statement (Regis- tration No. 2-55860) on March 30, 1976 and incorporated herein by reference. 3-B By-laws of the Registrant as amended through August 19, 1997 included as Appendix A to the Prospectus constituting a part of the Post Effective Amendment No. 3 to the Registrant's Form S-2 Registration Statement filed on or about March 18, 1998 (Registration No. 33-58191) and incorporated herein by reference. 3-C Certificate of Amendment to the restated Certificate of Incor- poration of the Registrant dated May 19, 1976 filed as Exhibit 3-D to Amendment No. 1 to the Registrant's Form S-1 Registra- tion Statement (Registration No. 2-55860) on June 10, 1976 and incorporated herein by reference. 3-D Certificate of Amendment to the restated Certificate of Incor- poration of the Registrant dated May 21, 1979 filed as Exhibit 3-F to Amendment No. 1 to the Registrant's Form S-1 Registra- tion Statement (Registration No. 2-63880) on May 23, 1979 and incorporated herein by reference. 3-E Certificate of Amendment to the restated Certificate of Incor- poration of the Registrant dated June 7, 1982 filed as Exhibit 3-G to the Registrant's Form S-1 Registration Statement (Regis- tration No. 2-82460) on March 16, 1983 and incorporated herein by reference. 3-F Certificate of Amendment to the restated Certificate of Incor- poration of the Registrant dated June 5, 1987 filed as Exhibit 3-F to the Registrant's Form S-1 Registration Statement (Regis- tration No. 33-4299) on March 29, 1988 and incorporated herein by reference. 3-G Certificate of Amendment to the restated Certificate of Incor- poration of the Registrant dated June 16, 1989 filed as Exhibit 4-G to Post Effective Amendment No. 1 to the Registrant's S-2 Registration Statement filed on or about March 20, 1990 and incorporated by reference. 3-H Certificate of Amendment to the restated Certificate of Incor- poration of the Registrant dated June 3, 1996 filed as Exhibit 4-H to Post-Effective Amendment No. 2 to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) filed on or about March 12, 1997 and incorporated herein by reference. 4-A Specimen copy of Class B stock certificate as revised as of November, 1984, filed as Exhibit 4-A to Post-Effective Amend- ment No. 2 to the Registrant's Form S-1 Registration Statement (Registration No. 2-82460) on March 15, 1985 and incorporated herein by reference. Exhibits Incorporated by Reference ------------ 4-B Specimen copy of Patronage Refund Certificate as revised in 1988 filed as Exhibit 4-B to Post-Effective Amendment No. 2 to the Registrant's Form S-1 Registration Statement (Registra- tion No. 33-4299) on March 29, 1988 and incorporated herein by reference. 4-C Specimen copy of Class A stock certificate as revised in 1987 filed as Exhibit 4-C to Post-Effective Amendment No. 2 to the Registrant's Form S-1 Registration Statement (Registration No. 33-4299) on March 29, 1988 and incorporated herein by reference. 4-D Specimen copy of Class C stock certificate filed as Exhibit 4-I to the Registrant's Form S-1 Registration Statement (Registra- tion No. 2-82460) on March 16, 1983 and incorporated herein by reference. 4-E Copy of current standard form of Subscription for Capital Stock Agreement to be used for dealers to subscribe for shares of the Registrant's stock in conjunction with new membership agree- ments submitted to the Registrant filed as Exhibit 4-L to Post- Effective Amendment No. 2 to the Registrant's Form S-2 Regis- tration Statement (Registration No. 33-46449) on or about March 23, 1994 and incorporated herein by reference. 4-F Copy of plan for the distribution of patronage dividends with respect to purchases of merchandise made from the Registrant from January 1, 1995-December 31, 1997 adopted by the Board of Directors of the Registrant on July 26, 1994 filed as Exhibit 4-F to Post-Effective Amendment No. 3 to the Registrant's Form S-2 Registration Statement on or about March 18, 1998 (Regis- tration No. 33-58191) and incorporated herein by reference. 4-G Copy of plan for the distribution of patronage dividends with respect to purchases of merchandise made from the Registrant on and after January 1, 1998 adopted by the Board of Directors of the Registrant filed as Exhibit 4-G to Post-Effective Amend- ment No. 3 to the Registrant's Form S-2 Registration Statement on or about March 18, 1998 (Registration No. 33-58191) and incorporated herein by reference. 9 No Exhibit 10-A Copy of Ace Hardware Corporation Retirement Benefits Replace- ment Plan Restated and Adopted December 7, 1993 filed as Ex- hibit 10-A to Post-Effective Amendment No. 3 to the Regis- trant's Form S-2 Registration Statement (Registration No. 33- 58191) on or about March 18, 1998 and incorporated herein by reference. 10-B Copy of First Amendment to Restated Ace Hardware Corporation Retirement Benefits Replacement Plan adopted on August 19, 1997 filed as Exhibit 10-B to Post-Effective Amendment No. 3 to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) on or about March 18, 1998 and incorporated herein by reference. 10-C Copy of First Amendment to Ace Hardware Corporation Deferred Compensation Plan adopted on August 19, 1997 filed as Exhibit 10-C to Post-Effective Amendment No. 3 to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) on or about March 18, 1998 and incorporated herein by reference. Exhibits Incorporated by Reference ------------ 10-D Copy of Restated PREP Plan (formerly known as Executive Supple- mental Benefit Plans) adopted August 19, 1997 filed as Exhibit 10-D to Post-Effective Amendment No. 3 to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) on or about March 18, 1998 and incorporated herein by reference. 10-E Copy of the "Ace Hardware Corporation Officer's (sic) Incentive Compensation Plan" as amended and restated effective January 1, 1994, filed as Exhibit 10-G to Post-Effective Amendment No. 2 to the Registrant's Form S-2 Registration Statement (Regis- tration No. 33-46449) on or about March 23, 1994 and incorpor- ated herein by reference. 10-F Second Modification of Amended and Restated Note Purchase and Private Shelf Agreement dated as of August 23, 1996, as amended by the First Modification of Amended and Restated Purchase and Private Shelf Agreement dated as of April 2, 1997, with the Prudential Insurance Company of America filed as Exhibit 10-F to Post-Effective Amendment No. 3 to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) on or about March 18, 1998, and incorporated herein by reference. 10-G Copy of Participation Agreement with PNC Commercial Corp. dated December 17, 1997 establishing a $10,000,000 discretionary leasing facility for the purchase of land and construction of retail hardware stores filed as Exhibit 10-G to Post-Effective Amendment No. 3 to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) on or about March 18, 1998 and incorporated herein by reference. 10-H Copy of Form of Executive Officer Employment Agreement effec- tive January 1, 1996 filed as Exhibit 10-a-17 to Post-Effective Amendment No. 1 to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) on or about March 15, 1996 and incorporated herein by reference. 10-I Copy of Note Purchase and Private Shelf Agreement with the Prudential Insurance Company of America dated September 27, 1991 securing 8.74% Senior Series A Notes in the principal sum of $20,000,000 with a maturity date of July 1, 2003 filed as Exhibit 10-A-q to the Registrant's Form S-2 Registration State- ment (Registration No. 33-46449) on March 23, 1992 and incor- porated herein by reference. 10-J Copy of Standard Form of Ace Hardware International Retail Mer- chant Agreement adopted in 1990, filed as Exhibit 10-A-q to Post Effective Amendment No. 2 to the Registrant's Form S-2 Registration Statement (Registration No. 33-27790) on March 20, 1991 and incorporated herein by reference. 10-K Copy of current standard form of Ace Hardware Membership Agree- ment filed as Exhibit 10-P to Pre-Effective Amendment No. 2 to the Registrant's form S-2 Registration Statement (Registration No. 33-58191) on or about April 26, 1995 and incorporated herein by reference. 10-L Copy of 6.89% Senior Series B notes in the aggregate principal sum of $20,000,000 issued July 29, 1992 with a maturity date of January 1, 2000 pursuant to Note Purchase and Private Shelf Agreement with the Prudential Insurance Company of America dated September 27, 1991 and filed as Exhibit 10-A-r to Post Effective Amendment No. 1 to the Registrant's Form S-2 Regis- tration Statement (Registration No. 33-46449) on March 22, 1993 and incorporated herein by reference. Exhibits Incorporated by Reference ------------ 10-M Copy of 6.47% Senior Series A notes in the aggregate principal amount of $30,000,000 issued September 22, 1993 with a maturity date of June 22, 2008, and $20,000,000 Private Shelf Facility, pursuant to Note Purchase and Private Shelf Agreement with the Prudential Insurance Company of America dated as of September 22, 1993, filed as Exhibit 10-R to Post-Effective Amendment No. 2 to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) on or about March 23, 1994 and incorporated herein by reference. 10-N Copy of Lease dated March 24, 1997 for print shop facility of the Registrant in Downers Grove, Illinois filed as Exhibit 10-N to Post-Effective Amendment No. 3 to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) on or about March 18, 1998 and incorporated herein by reference. 10-O Copy of Lease dated September 30, 1992 for general offices of the Registrant in Oak Brook, Illinois filed as Exhibit 10-A-u to the Registrant's Form S-2 Registration Statement (Registra- tion No. 33-46449) on March 22, 1993 and incorporated herein by reference. 10-P Copy of Ace Hardware Corporation Deferred Director Fee Plan as amended on June 8, 1993, filed as Exhibit 10-W to Post-Effec- tive Amendment No. 2 to the Registrant's Form S-2 Registration Statement (Registration No. 33-46449) on or about March 23, 1994 and incorporated herein by reference. 10-Q Copy of Ace Hardware Corporation Deferred Compensation Plan effective January 1, 1994, filed as Exhibit 10-X to Post- Effective Amendment No. 2 to the Registrants Form S-2 Registra- tion Statement (Registration No. 33-46449) on or about March 23, 1994 and incorporated herein by reference. 10-R Copy of Lease dated September 22, 1994 for bulk merchandise redistribution center of the Registrant in Carol Stream, Illinois filed as Exhibit 10-Y to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) on or about March 23, 1995 and incorporated herein by reference. 10-S Copy of Lease dated May 4, 1994 for freight consolidation center of the Registrant in Chicago, Illinois filed as Exhibit 10-Z to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) on or about March 23, 1995 and incorporated herein by reference. 10-T Copy of Long-Term Incentive Compensation Deferral Option Plan of the Registrant effective January 1, 1995 adopted by its Board of Directors on December 6, 1994 filed as Exhibit 10-a-1 to the Registrant's Form S-2 Registration Statement (Registra- tion No. 33-58191) on or about March 23, 1995 and incorporated herein by reference. 10-U Copy of Directors' Deferral Option Plan of the Registrant effective January 1, 1995 adopted by its Board of Directors on December 6, 1994 filed as Exhibit 10-a-2 to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) on or about March 23, 1995 and incorporated herein by reference. Exhibits Incorporated by Reference ------------ 10-V Copy of Agreement dated January 6, 1995 between Ace Hardware Corporation and Roger E. Peterson filed as Exhibit 10-a-9 to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) on or about March 23, 1995 and incorporated herein by reference. 10-W Copy of Lease dated July 28, 1995 between A.H.C. Store Develop- ment Corp. and Tri-R Corporation for retail hardware store premises located in Yorkville, Illinois filed as Exhibit 10-a- 11 to Post-Effective Amendment No. 1 to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) on or about March 15, 1996 and incorporated herein by reference. 10-X Copy of Lease dated October 31, 1995 between Brant Trade & Industrial Park, Inc. and Ace Hardware Canada Limited for ware- house space in Brantford, Ontario, Canada filed as Exhibit 10-a -12 to Post-Effective Amendment No. 1 to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) on or about March 15, 1996 and incorporated herein by reference. 10-Y Copy of Lease dated November 27, 1995 between 674573 Ontario Limited and Ace Hardware Canada Limited for general office space in Markham, Ontario, Canada filed as Exhibit 10-a-13 to Post-Effective Amendment No. 1 to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) on or about March 15, 1996 and incorporated herein by reference. 10-Z Copy of Lease dated February 9, 1995 between Leroy M. Merritt and the Registrant for its Baltimore, Maryland redistribution center filed as Exhibit 10-a-14 to Post-Effective Amendment No. 1 to the Registrant's Form S-2 Registration Statement (Regis- tration No. 33-58191) on or about March 15, 1996 and incorporated herein by reference. 10-a-1 Copy of First Amendment to the Ace Hardware Corporation Long- Term Incentive Compensation Deferral Option Plan effective December 5, 1995 filed as Exhibit 10-a-15 to Post-Effective Amendment No. 1 to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) on or about March 15, 1996 and incorporated herein by reference. 10-a-2 Copy of First Amendment to the Ace Hardware Corporation Direc- tors' Deferral Option Plan effective December 5, 1995 filed as Exhibit 10-a-16 to Post-Effective Amendment No. 1 to the Regis- trant's Form S-2 Registration Statement (Registration No. 33- 58191) on or about March 15, 1996 and incorporated herein by reference. 10-a-3 Copy of Ace Hardware Corporation Executive Benefit Security Trust Agreement effective July 19, 1995 filed as Exhibit 10-a- 18 to Post-Effective Amendment No. 1 to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) on or about March 15, 1996 and incorporated herein by reference. 10-a-4 Copy of current standard form License Agreement for Interna- tional Retail Merchants adopted in 1996 filed as Exhibit 10-a- 12 to Post-Effective Amendment No. 2 to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) on or about March 12, 1997 and incorporated herein by reference. Exhibits Incorporated by Reference ------------ 10-a-5 Copy of Lease Agreement dated as of September 1, 1996 for the Registrant's project facility in Wilton, New York filed as Exhibit 10-a-13 to Post-Effective Amendment No. 2 to the Regi- strant's Form S-2 Registration Statement (Registration No. 33- 58191) on or about March 12, 1997 and incorporated herein by reference. 10-a-6 Copy of 6.47% Series A Senior Notes in the aggregate principal amount of $30,000,000 issued August 23, 1996 with a maturity date of June 22, 2008, and $70,000,000 Private Shelf Facility, pursuant to Amended and Restated Note Purchase and Private Shelf Agreement with the Prudential Insurance Company dated August 23, 1996 and filed as Exhibit 10-a-14 to Post-Effective Amendment No. 2 to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) on or about March 12, 1997 and incorporated herein by reference. 10-a-7 Copy of First Amendment to Ace Hardware Corporation Officer Incentive Plan adopted on August 19, 1997 filed as Exhibit 10- a-7 to Post-Effective Amendment No. 3 to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) on or about March 18, 1998, and incorporated herein by reference. 11 No Exhibit. 12 No Exhibit. 13 No Exhibit. 16 No Exhibit. 18 No Exhibit. 22 No Exhibit. 23 Consent of KPMG Peat Marwick LLP, dated March 16, 1998, filed as Exhibit 23(a) to Post-Effective Amendment No. 3 to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) filed on or about March 18, 1998 and incorporated herein by reference. 27 Financial Data Schedule filed as Exhibit 27 to Post-Effective Amendment No. 3 to the Registrant's Form S-2 Registration Statement (Registration No. 33-58191) filed on or about March 18, 1998 and incorporated herein by reference. 99 No Exhibit. Supplemental Information to be Furnished with Reports Filed Pursuant to Section 15(d) of the Act by Registrants which have not Registered Securities Pursuant to Section 12 of the Act. As of the date of the foregoing Report, no annual report for the Regis- trant's year ended December 31, 1997, nor any proxy soliciting materials for the Registrant's 1998 annual meeting have been sent to security holders. Copies of such Annual Report and proxy soliciting materials will subsequently be sent to security holders and furnished to the Securities and Exchange Commission. Item 14(a). Index to Consolidated Financial Statements and Financial Statement Schedules Page ---- Independent Auditors' Report F-2 Consolidated Balance Sheets at December 31, 1997 and 1996 F-3 Consolidated Statements of Earnings for each of the years in the three-year period ended December 31, 1997 F-5 Consolidated Statements of Member Dealers' Equity for each of the years in the three-year period ended December 31, 1997 F-6 Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 31, 1997 F-7 Notes to Consolidated Financial Statements F-8 All schedules have been omitted because the required information is not present or is not present in amounts sufficient to require submission of the schedule or the required information is included in the consolidated financial statements or the notes thereto. INDEPENDENT AUDITORS' REPORT The Board of Directors Ace Hardware Corporation: We have audited the accompanying consolidated balance sheets of Ace Hardware Corporation and subsidiaries as of December 31, 1997 and 1996 and the related consolidated statements of earnings, member dealers' equity and cash flows for each of the years in the three-year period ended December 31, 1997. These con- solidated financial statements are the responsibility of the Company's manage- ment. Our responsibility is to express an opinion on these consolidated finan- cial statements based on our audits. We conducted our audits in accordance with generally accepted auditing stan- dards. 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, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Ace Hardware Corpor- ation and subsidiaries as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1997 in conformity with generally accepted accounting principles. KPMG PEAT MARWICK LLP Chicago, Illinois January 28, 1998 ACE HARDWARE CORPORATION CONSOLIDATED BALANCE SHEETS December 31, 1997 and 1996 ASSETS 1997 1996 -------- -------- (000's omitted) Current assets: Cash and cash equivalents $ 14,171 $ 12,657 Receivables: Trade 320,166 305,742 Other 45,554 43,206 -------- -------- 365,720 348,948 Less allowance for doubtful receivables (2,086) (1,700) --------- -------- Net receivables 363,634 347,248 Inventories (Note 2) 338,509 327,145 Prepaid expenses and other current assets 12,873 11,880 -------- -------- Total current assets 729,187 698,930 -------- -------- Property and equipment (Note 9): Land 17,480 17,464 Buildings and improvements 188,967 162,100 Warehouse equipment 66,330 57,246 Office equipment 71,578 71,689 Manufacturing equipment 15,312 13,132 Transportation equipment 13,686 14,609 Leasehold improvements 16,110 15,654 Construction in progress 6,686 12,501 -------- -------- 396,149 364,395 Less accumulated depreciation and amortization (153,170) (150,861) -------- -------- Net property and equipment 242,979 213,534 Other assets 4,405 3,911 -------- -------- $976,571 $916,375 ======== ======== See accompanying notes to consolidated financial statements. ACE HARDWARE CORPORATION CONSOLIDATED BALANCE SHEETS December 31, 1997 and 1996 LIABILITIES AND MEMBER DEALERS' EQUITY 1997 1996 --------- -------- (000's omitted) Current liabilities: Current installments of long-term debt (Note 4) $ 7,515 $ 6,727 Short-term borrowings (Note 3) 42,000 71,000 Accounts payable 423,499 394,070 Patronage dividends payable in cash (Note 5) 29,943 28,178 Patronage refund certificates payable (Note 5) 13,636 14,138 Accrued expenses 53,583 37,906 -------- -------- Total current liabilities 570,176 552,019 Long-term debt (Note 4) 96,815 71,837 Patronage refund certificates payable (Note 5) 49,044 49,639 Other long-term liabilities 14,722 9,517 -------- -------- Total liabilities 730,757 683,012 -------- -------- Member dealers' equity (Notes 5 and 8): Class A Stock of $1,000 par value 3,874 3,937 Class B Stock of $1,000 par value 6,499 6,499 Class C Stock of $100 par value 213,609 196,742 Class C Stock of $100 par value, issuable to dealers for patronage dividends 22,366 26,474 Additional stock subscribed, net 383 502 Retained earnings 3,354 3,120 Contributed capital 3,295 3,295 -------- -------- 253,380 240,569 Less: Treasury stock, at cost (7,566) (7,206) -------- -------- Total member dealers' equity 245,814 233,363 Commitments (Notes 6 and 9) -------- -------- $976,571 $916,375 ======== ======== See accompanying notes to consolidated financial statements. ACE HARDWARE CORPORATION CONSOLIDATED STATEMENTS OF EARNINGS Year Ended December 31, ------------------------------------- 1997 1996 1995 ---------- ---------- --------- (000's omitted) Net sales $2,907,259 $2,742,451 $2,436,012 Cost of sales 2,682,863 2,535,014 2,253,430 ---------- ---------- ---------- Gross profit 224,396 207,437 182,582 ---------- ---------- ---------- Operating expenses: Warehouse and distribution 39,292 36,658 29,849 Selling, general and administrative 72,218 67,661 59,772 Retail success and development 25,573 21,644 18,596 ---------- ---------- ---------- Total operating expenses 137,083 125,963 108,217 ---------- ---------- ---------- Operating income 87,313 81,474 74,365 Interest expense (Note 11) (14,751) (11,855) (13,137) Other income, net 5,735 3,806 3,715 Income taxes (Note 7) (1,910) (1,118) (1,201) ---------- ---------- ---------- Net earnings 76,387 72,307 63,742 ========== ========== ========== Retained earnings at beginning of year 3,120 4,650 5,624 Net earnings 76,387 72,307 63,742 Patronage dividends (Notes 5 and 8) (76,153) (73,837) (64,716) ---------- ---------- ---------- Retained earnings at end of year 3,354 3,120 4,650 ========== ========== ========== See accompanying notes to consolidated financial statements. ACE HARDWARE CORPORATION CONSOLIDATED STATEMENTS OF MEMBER DEALERS' EQUITY Three Years Ended December 31, 1997 (000's omitted) Class C Stock Issuable to Dealers for Class A Class B Class C Patronage Stock Stock Stock Dividends ------- ------- -------- ------------- Balance at December 31, 1994 $3,924 $6,499 $164,666 $21,766 Net earnings - - - - Net payments on subscriptions - - - - Patronage financing deductions - - - (15) Stock issued 237 - 23,149 (21,751) Stock repurchased - - - - Stock retired (256) - (9,998) - Stock issuable as patronage dividends - - - 27,506 Patronage dividends payable - - - - ------- ------- -------- -------- Balance at December 31, 1995 $3,905 $6,499 $177,817 $27,506 Net earnings - - - - Net payments on subscriptions - - - - Patronage financing deductions - - - (43) Stock issued 268 - 28,854 (27,463) Stock repurchased - - - - Stock retired (236) - (9,929) - Stock issuable as patronage dividends - - - 26,474 Patronage dividends payable - - - - ------- ------- -------- -------- Balance at December 31, 1996 $3,937 $6,499 $196,742 $26,474 Net earnings - - - - Net payments on subscriptions - - - - Patronage financing deductions - - - (119) Stock issued 236 - 29,263 (26,355) Stock repurchased - - - - Stock retired (299) - (12,396) - Stock issuable as patronage dividends - - - 22,366 Patronage dividends payable - - - - ------- ------- -------- -------- Balance at December 31, 1997 $3,874 $6,499 $213,609 $22,366 ======= ======= ======== ======== ACE HARDWARE CORPORATION CONSOLIDATED STATEMENTS OF MEMBER DEALER'S EQUITY Three Years Ended December 31, 1997 (000s omitted) Additional Retained Contributed Treasury Stock Earnings Capital Stock Total ---------- -------- ----------- -------- -------- Balance at December 31, 1994 $ 555 $ 5,624 $3,295 $(6,502) $199,827 Net Earnings - 63,742 - - 63,742 Net Payments on Subscriptions 1,580 - - - 1,580 Patronage financing deductions - - - - (15) Stock issued (1,620) - - - 15 Stock repurchased - - - (10,694) (10,694) Stock retired - - - 10,254 - Stock issuable as patronage dividends - - - - 27,506 Patronage dividends payable (64,716) - - (64,716) ---------- -------- ----------- -------- -------- Balance at December $ 515 $ 4,650 $3,295 $ (6,942) $217,245 31, 1995 Net Earnings - 72,307 - - 72,307 Net Payments on Subscriptions 1,603 - - - 1,603 Patronage financing deductions - - - - (43) Stock issued (1,616) - - - 43 Stock repurchased - - - (10,429) (10,429) Stock retired - - - 10,165 - Stock issuable as patronage dividends - - - - 26,474 Patronage dividends payable - (73,837) - - (73,837) ---------- -------- ----------- -------- -------- Balance at December $ 502 $ 3,120 $3,295 $ (7,206) $233,363 31,1996 Net Earnings - 76,387 - - 76,387 Net Payments on Subscriptions 2,906 - - - 2,906 Patronage financing deductions - - - - (119) Stock issued (3,025) - - - 119 Stock repurchased - - - (13,055) (13,055) Stock retired - - - 12,695 - Stock issuable as patronage dividends - - - - 22,366 Patronage dividends payable - (76,153) - - (76,153) ---------- -------- ----------- -------- -------- Balance at December $ 383 $ 3,354 $3,295 $ (7,566) $245,814 31, 1997 ========== ======== =========== ======== ======== * Additional stock subscribed is comprised of the following amounts at December 31, 1995, 1996 and 1997: 1995 1996 1997 ------ ------ ------ Class A Stock $ 332 $ 337 $ 387 Class B Stock - - - Class C Stock 2,332 2,450 2,329 ------ ------ ------ 2,664 2,787 2,716 Less unpaid portion 2,149 2,285 2,333 ------ ------ ------ $ 515 $ 502 $ 383 ====== ====== ====== See accompanying notes to consolidated financial statements. ACE HARDWARE CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended December 31, --------------------------------------- (000's omitted) 1997 1996 1995 ---------- --------- ---------- Operating Activities: Net Earnings $76,387 $72,307 $63,742 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation 19,494 17,517 16,837 Loss on sale of property and equipment 285 712 3 Increase in accounts receivable, net (16,386) (60,170) (27,526) Decrease (increase) in inventories (11,364) (72,694) 15,940 Increase in prepaid expenses and other current assets (993) (2,556) (2,135) Increase in accounts payable and accrued expenses 45,106 64,616 41,860 Increase in other long-term liabilities 5,205 4,066 1,107 ---------- --------- -------- Net Cash Provided by Operating Activities 117,734 23,798 109,828 Investing Activities: Purchase of property and equipment (49,373) (40,379) (31,263) Proceeds from sale of property and equipment 149 120 27 Decrease (increase) in other assets (494) 12 579 ---------- --------- -------- Net Cash Used in Investing Activities (49,718) (40,247) (30,657) Financing Activities: Proceeds (payments) of short-term borrowings (29,000) 58,000 (17,000) Proceeds from notes payable 32,994 20,853 - Payments on long-term debt (7,228) (7,462) (6,483) Payment of cash portion of patronage dividend (28,178) (23,522) (27,302) Payments of patronage refund certificates and patronage financing deductions (24,941) (22,790) (11,287) Proceeds from sale of common stock 2,906 1,603 1,580 Repurchase of common stock (13,055) (10,429) (10,694) ---------- --------- -------- Net Cash Provided by (Used in) Financing Activities (66,502) 16,253 (71,186) ---------- --------- -------- Increase (Decrease) in Cash and Cash Equivalents 1,514 (196) 7,985 Cash and Cash Equivalents at beginning of year 12,657 12,853 4,868 ---------- --------- -------- Cash and Cash Equivalents at end of year $14,171 $12,657 $12,853 ========== ========= ======== See accompanying notes to consolidated financial statements. ACE HARDWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) Summary of Significant Accounting Policies (a) The Company and Its Business Ace Hardware Corporation (the Company) operates as a wholesaler of hardware and related products and manufactures paint products. As a dealer-owned cooperative, the Company distributes substantially all of its patronage sourced earnings in the form of patronage dividends to member dealers based on their volume of merchandise purchases. The accompanying consolidated financial state- ments include the accounts of the Company and subsidiaries, all of which are wholly-owned. All significant intercompany transactions have been eliminated. (b) Cash Equivalents The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. (c) Receivables Receivables from dealers include amounts due from the sale of merchan- dise and special equipment used in the operation of dealers' businesses. Other receivables are principally amounts due from suppliers for promotional and ad- vertising allowances. (d) Inventories Inventories are valued at the lower of cost or net realizable value. Cost is determined primarily using the last-in, first-out method. (e) Property and Equipment Property and equipment are stated at cost less accumulated depreciation and amortization. Expenditures for maintenance, repairs and renewals of rel- atively minor items are generally charged to earnings. Significant improvements or renewals are capitalized. Depreciation expense is computed on both straight line and accelerated methods based on estimated useful lives as follows: Useful Life Principal Years Depreciation Method ----------- ------------------- Buildings and improvements 10-40 Straight line Warehouse equipment 5-10 Accelerated Office equipment 3-10 Various Manufacturing equipment 3-20 Straight line Transportation equipment 3-7 Straight line Leasehold improvements are generally amortized on a straight-line basis over the term of the respective lease. (f) Foreign Currency Translation Substantially all assets and liabilities of foreign operations are translated at the rate of exchange in effect at the balance sheet date while revenues and expenses are translated at the average monthly exchange rates prevailing during the year. The Company has utilized foreign exchange forward contracts to hedge non-U.S. equity investments. Foreign currency translation adjustments were insignificant in 1997 and 1996. ACE HARDWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued) (g) Financial Instruments The carrying value of assets and liabilities that meet the definition of a financial instrument included in the accompanying Consolidated Balance Sheets approximate fair value. The fair market value of foreign exchange forward contracts approximates carrying cost at December 31, 1997 and 1996. (h) Retirement Plans The Company has retirement plans covering substantially all non-union employees. Costs with respect to the noncontributory pension plans are deter- mined actuarially and consist of current costs and amounts to amortize prior service costs and unrecognized gains and losses. The Company contribution under the profit sharing plan is determined annually by the Board of Directors. (i) Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assump- tions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses dur- ing the reporting period. Actual results could differ from those estimates. (j) Reclassifications Certain financial statement reclassifications have been made to prior year amounts to conform to comparable classifications followed in 1997. (2) Inventories Inventories consist primarily of merchandise inventories. Substantially all of the Company's domestic inventories are valued on the last-in, first-out (LIFO) method; the excess of replacement cost over the LIFO value of inventory was approximately $67,151,000 and $69,867,000 at December 31, 1997 and 1996, respectively. Indirect costs, consisting primarily of warehousing costs, are absorbed as inventory costs rather than period costs. (3) Short-Term Borrowings Short-term borrowings were utilized during 1997 and 1996. The maximum amount outstanding at any month-end during the period was $113.0 million in 1997 and $97.5 million in 1996. The weighted average interest rate effective as of December 31, 1997 and 1996 was 6.60% and 7.13%, respectively. Short-term borrow- ings outstanding as of December 31, 1997 and 1996 were $42.0 million and $71.0 million, respectively. At December 31, 1997 the Company has available a revol- ving credit facility with a group of banks providing for $100 million in commit- ted lines and also has available $75 million in uncommitted lines. The aggre- gate unused line of credit available at December 31, 1997 and 1996 was $133 million and $109 million, respectively. At December 31, 1997 the Company had no compensating balance requirements. ACE HARDWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued) (4) Long-Term Debt Long-term debt is comprised of the following: December 31, ------------------------- 1997 1996 -------- -------- (000's omitted) Notes Payable: $20,000,000 due in quarterly installments of $540,500 with interest payable quarterly at a fixed rate of 8.74% $ 12,432 $14,595 $20,000,000 due in quarterly installments of $952,400 with interest payable quarterly at a fixed rate of 6.89% 8,571 12,381 $30,000,000 due in semi-annual installments of $2,000,000 commencing June 22, 2001 with interest payable quarterly at a fixed rate of 6.47% 30,000 30,000 $20,000,000 due in quarterly installments of $714,300 commencing September 15, 2004 with interest payable quarterly at a fixed rate of 7.49% 20,000 20,000 $30,000,000 due in annual installments of $6,000,000 commencing March 25, 2005 with interest payable quarterly at a fixed rate of 7.55% 30,000 - Liability under capitalized leases (see Note 9) 2,171 664 Installment notes with maturities through 2001 with various interest rates 1,156 924 -------- -------- 104,330 78,564 Less current installments 7,515 6,727 -------- -------- $ 96,815 $71,837 ======== ======== Aggregate maturities of long-term debt are $7,515,000, $7,092,000, $3,657,000, $6,282,000, $6,162,000 in 1998 through 2002, respectively and $73,622,000 thereafter. (5) Patronage Dividends and Refund Certificates Payable The Company operates as a cooperative organization and has paid or will pay patronage dividends to member dealers on the portion of earnings derived from business done with such dealers. Patronage dividends are allocated in proportion to the volume of purchases by member dealers during the period. The amount of patronage dividends to be remitted in cash depends upon the level of dividends earned by each member outlet, varying from 20% on the total dividends under $5,000 and increasing by 5% on total dividends for each subsequent $2,500 earned to a maximum of 40% on total dividends exceeding $12,500. All amounts exceeding the cash portions will be distributed in the form of Class C $100 par value stock, to a maximum based upon the current year purchase volume or $20,000 whichever is greater, and thereafter in a combination of additional cash and patronage refund certificates having maturity dates and bearing interest as determined by the Board of Directors. A portion of the dealer's annual patronage dividends distributed under the above plan in a form other than cash can be applied toward payment of principal and interest on any balances outstanding for approved exterior signage, computer equipment and store retrofit financing. ACE HARDWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued) The patronage dividend composition for 1997, 1996 and 1995 follows: Subordinated Class Patronage Total Cash Refund C Financing Patronage Portion Certificates Stock Deductions Dividend --------- -------------- ------- ------------ --------- (000's omitted) 1997 $29,943 $13,726 $22,366 $10,118 $76,153 1996 28,178 9,500 26,474 9,685 73,837 1995 23,522 5,032 27,506 8,656 64,716 Patronage dividends are allocated on a calendar year basis with issuance in the following year. The patronage refund certificates outstanding or issuable at December 31, 1997 are payable as follows: Interest January 1, Amount Rate ---------- --------------- -------- (000's omitted) 1998 $13,636 6.00% 1999 11,377 6.00 2000 9,415 7.00 2001 5,079 6.00 2002 9,447 6.25 2003 13,726 6.00 (6) Retirement Plans The Company has defined benefit pension plans covering substantially all non-union employees. Benefits are based on years of service, highest average compensation (as defined) and the related profit sharing and primary social security benefit. Contributions to the plan are based on the Entry Age Normal, Frozen Initial Liability actuarial funding method and are limited to amounts that are currently deductible for tax reporting purposes. As of December 31, 1997 plan assets were held primarily in equities, mutual funds and group annuity contracts. Pension expense for the years 1997, 1996 and 1995 included the following components: 1997 1996 1995 ------ ------ ------- (000's omitted) Service cost - benefits earned during the period 358 72 355 Interest cost on projected benefit obligation 351 486 845 Actual return on plan assets (1,820) (786) (2,288) Net amortization and deferral 1,243 292 1,257 ------ ----- ------- Net periodic pension expense $132 $ 64 $169 ====== ===== ======= In 1995 and 1996, the plan settled a portion of the liability to retirees and vested terminated participants through lump sum payments and the purchase of single premium annuity contracts. In addition to the net periodic pension expense, the Company recognized a net loss of $475,000 and $1,380,000 in 1996 and 1995, respectively, related to this settlement. ACE HARDWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued) The following table sets forth the funded status of the plans and amounts recognized in the Company's Consolidated Balance Sheet at December 31, 1997 and 1996 (December 31st measurement date): 1997 1996 -------- -------- (000's omitted) Accumulated benefit obligation, including vested benefits of $4,072,000 and $3,953,000 $ 4,305 $ 4,189 ======== ========= Plan assets at fair value $ 9,122 $ 7,965 Projected benefit obligation for service renderedto date 5,041 4,814 Plan assets in excess of -------- --------- projected benefit obligation $ 4,081 $ 3,151 Unrecognized net gain from past experience different from that assumed and effects of changes in assumptions (2,661) (1,538) Remaining unrecognized net asset being amortized over participants average remaining service period (784) (845) -------- --------- Prepaid pension cost included in other assets $ 636 $ 768 ======== ========= The weighted average discount rate used in determining the actuarial pre- sent value of the projected benefit obligation was 7.25% in 1997 and 7.5% in 1996. The related expected long-term rate of return was 8.0% in 1997 and 1996. The rate of increase in future compensation was projected using actuarial salary tables plus 1.0% in 1997 and 1996. The Company also participates in several multi-employer plans covering union employees. Amounts charged to expense and contributed to the plans totaled approximately $225,000, $265,000 and $275,000, in 1997, 1996 and 1995, respec- tively. The Company's profit sharing plan contribution for the years ended 1997, 1996 and 1995 was approximately $12,240,000, $11,357,000 and $9,902,000, re- spectively. (7) Income Taxes As a cooperative, the Company distributes substantially all of its patronage sourced earnings to its members in the form of patronage dividends. The 1997, 1996 and 1995 provisions for federal income taxes were $1,501,000, $860,000 and $939,000, respectively, and for state income taxes were $409,000, $258,000 and $262,000, respectively. The Company made tax payments of $2,807,000, $1,524,000 and $1,625,000 during 1997, 1996 and 1995, respectively. ACE HARDWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued) (8) Member Dealers' Equity The Company's classes of stock are described below: Number of Shares at December 31, ------------------- 1997 1996 ------ ------ Class A Stock, voting, redeemable at par value - Authorized 10,000 10,000 Issued and outstanding 3,874 3,937 Class B Stock, nonvoting, redeemable at not less than twice par value- Authorized 6,500 6,500 Issued 6,499 6,499 Outstanding 2,716 2,896 Treasury stock 3,783 3,603 Class C Stock, nonvoting, redeemable at not less than par value - Authorized 4,000,000 4,000,000 Issued and outstanding 2,136,085 1,967,420 Issuable as patronage dividends 223,600 264,740 Additional Stock Subscribed: Class A Stock 387 337 Class B Stock - - Class C Stock 23,920 24,500 At December 31, 1997 and 1996 there were no common shares reserved for options, warrants, conversions or other rights; nor were any options granted or exercised during the two years then ended. Member dealers may subscribe for the Company's stock in various prescribed combinations. Only one share of Class A Stock may be owned by a dealer with respect to the first member retail outlet controlled by such dealer. Only four shares of Class B Stock may be owned by a dealer with respect to each retail outlet controlled by such dealer, but only if such outlet was a member of the Company on or before February 20, 1974. An appropriate number of shares of Class C Stock must be included in any subscription by a dealer in an amount to provide that such dealer has a par value of all shares subscribed for equal to $5,000 for each retail outlet. Unregistered shares of Class C Stock are also issued to dealers in connection with patronage dividends. No dividends can be declared on any shares of any class of the Company's Stock. Upon termination of the Company's membership agreement with any retail outlet, all shares of stock of the Company, held by the dealer owning or con- trolling such outlet, must be sold back to the Company, unless a transfer of such shares is made to another party accepted by the Company as a member dealer with respect to the same outlet. ACE HARDWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued) A Class A share is issued to a member dealer only when the share subscribed has been fully paid. Class B and Class C shares are only issued when all such shares subscribed with respect to a retail outlet have been fully paid. Addi- tional Stock Subscribed in the accompanying statements represents the par value of shares subscribed, reduced by the unpaid portion. All shares of stock are currently issued and repurchased at par value, ex- cept for Class B Stock which is repurchased at twice its par value, or $2,000 per share. Upon retirement of Class B shares held in treasury, the excess of re- demption price over par is allocated equally between contributed capital and retained earnings. Transactions during 1995, 1996 and 1997 affecting treasury shares follow: Shares Held in Treasury --------------------------- Class A Class B Class C ------- ------- ------- Balance at December 31, 1994 - 3,251 - Stock issued - - - Stock repurchased 256 220 99,975 Stock retired (256) - (99,975) ------- ------- ------- Balance at December 31, 1995 - 3,471 - Stock issued - - - Stock repurchased 236 132 99,290 Stock retired (236) - (99,290) ------- ------- ------- Balance at December 31, 1996 - 3,603 - Stock issued - - - Stock repurchased 299 180 123,964 Stock retired (299) - (123,964) ------- ------- ------- Balance at December 31, 1997 - 3,783 - ======= ======= ======= (9) Commitments Leased property under capital leases is included as "Property and Equip- ment" in the consolidated balance sheets as follows: December 31, ---------------------- 1997 1996 -------- -------- (000's omitted) Buildings and improvements - $3,422 Data processing equipment 3,633 1,783 Less: accumulated depreciation and amortization (1,506) (4,678) -------- -------- $2,127 $ 527 ======== ======== ACE HARDWARE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued) The Company rents buildings and warehouse, office and certain other equip- ment under capital and operating leases. At December 31, 1997 annual minimum rental commitments under leases that have initial or remaining noncancelable terms in excess of one year are as follows: Year Ending December 31, Capital Operating - ------------ ----------- ------------- (000's omitted) 1998 $ 1,170 $17,372 1999 832 15,648 2000 257 12,831 2001 - 10,613 2002 - 7,697 Thereafter - 25,674 ---------- ------------ Total minimum lease payments 2,259 $89,835 ============ Less amount representing interest 88 ---------- Present value of total minimum lease payments $2,171 ========== All leases expire prior to 2010. Under certain leases, the Company pays real estate taxes, insurance and maintenance expenses in addition to rental expense. Management expects that in the normal course of business, leases that expire will be renewed or replaced by other leases. Rent expense was approx- imately $33,343,000, $29,747,000 and $25,024,000 in 1997, 1996 and 1995, respec- tively. Rent expense includes $5,956,000, $5,503,000 and $4,724,000 in contin- gent rentals paid in 1997, 1996 and 1995, respectively, primarily for transpor- tation equipment mileage. (10) Media Expense The Company expenses media costs the first time the advertising takes place. Gross media expense, prior to income offsets from dealers and suppliers, amounting to $65,013,000, $64,551,000 and $58,963,000 was charged to operations in 1997, 1996 and 1995, respectively. (11) Interest Expense Interest paid was $15,281,000, $12,481,000 and $13,631,000 in 1997, 1996 and 1995, respectively, net of capitalized interest of $1,022,000, $523,000 and $497,000.