Hudson's Bay Company 2004 Annual Financial Report

HBC04_Book2E_sedar 4/20/05 3:50 PM Page FC1

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page FC2

01 Letter to Shareholders 03 Financial Highlights 04 Annual Management’s Discussion and Analysis 34 Consolidated Financial Statements 37 Notes to Consolidated Financial Statements 58 Five-Year Financial Summary 59 Board of Directors 60 Senior Officers IBC Corporate Information HBC04_Book2E_sedar 4/20/05 3:50 PM Page 1

To Our Shareholders

Left George J. Heller 01 President and Chief Executive Officer

Right L. Yves Fortier, C.C., Q.C. Governor

Retailing in Canada continues to evolve and change, and growing the business and profits is frustratingly slow in this climate of rapid change. However, success will go to those who are most responsive to the customer and marketplace while respecting the fundamentals of the business.

Although we are disappointed with the year’s results, we remain confident and committed to the strategy of an integrated Hbc delivering increasingly better and targeted assortments through distinct yet integrated banners, backed by a solid balance sheet, great real estate and a robust “back-of-house” capability.

The consumer continues to be ever more price conscious and selective, for the past decade we have experienced a low level general deflation that is forcing more units at lower prices into the marketplace as retailers look for sales growth. At Hbc, we are accelerating the pace of offering our customers ever better value through consolidating our purchases and finding or engineering great values internationally. Our programs such as Power Buys, Style Outlets and our newest entry, Designer Depot, are meant to ensure we remain in the forefront of delivering value to Canadians.

We are adding to the list of exclusive lines throughout Hbc, giving shoppers differentiated assortments and products uniquely available at Hbc, ones that can’t be discounted by other retailers. We are forming strong relationships internationally with vendors, manufacturers and other retailers, finding more ways to offer our customers fresh, different and new product at prices meant to entice them while maintaining margins.

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Our greatest opportunity comes with the transition of The imperative for sales growth has seen a continua- our buying and marketing functions to one view of the tion of “category expansion” in many retailers. The market opportunity and the ability to assort our stores grocery industry, especially Loblaws, is adding sub- from a larger menu based on customer and market stantial incremental space to general merchandise. demand. We are adding product lines, enhancing Mass merchants are adding more and more grocery, assortments, adding new business and generally pharmacies are expanding to larger assortments of focused on rounding out our offer by banner and store cosmetic/fragrance and the like. based on the customer and not restricted by the channel paradigm. Hbc too has to grow through category expansion, not to support incremental square footage costs, To no one’s surprise, adding grocery, snacks, but to grow space productivity and profit. We are household supplies and much more to a downtown doing just that, leveraging our category skills to Bay store has been successful. Our customers were expand and migrate the in-house knowledge, vendor delighted that we filled their needs; non-traditional relationships and category competency. The Bay’s maybe, but certainly customer driven. Equally, pro- premier knowledge and market share in prestige 02 viding major appliances in pilot Zellers stores was cosmetics and fragrances will build the “masstige” appreciated by the customer. Though not traditional, assortment in Zellers’ 298 stores; as will the Bay’s the customer who bought TVs, digital cameras and competency in major appliances migrate to Zellers. soap detergent saw it as a welcome and natural In turn, the knowledge of running 241 pharmacies addition. In all cases, we have migrated the Hbc plus everyday needs and dominant categories like expertise to complete and enhance customer needs, children’s wear will alter the offer at the Bay. The and we are just beginning. execution risk is minimal as we own the competency, the customer need is clear and the market The competitive environment is just that, competi- opportunity is quantifiable. tive. Of particular note is the rapid growth in retail space in Canada. In the past five years it has grown We want to thank the 70,000 associates and man- four to five times faster than the Canadian popula- agers who work hard to execute the strategy where it tion and disposable income. The explosive power most counts; on the floor and in the supply chain. As centre growth of the past five years mirrors the the marketplace and industry changes to meet new period of the mid-seventies to mid-eighties that saw opportunities and challenges, Hbc, first because of exponential growth in covered malls that ultimately necessity, and now from insight and determination, is came to an abrupt halt as the oversupply inevitably at the forefront of customer driven, market focused created failures. retailing that will ultimately reward the shareholders, associates and customers of this great Company. We have chosen to be prudent, entering power centres with Home Outfitters, Zellers and now Designer Depot, while closing about an equal amount of square footage in less desirable malls. We are strategically reshaping our portfolio and mix to improve our locations while retaining under-market rents and valuable Hbc-owned “George J. Heller” property. We are accelerating our capital expenditures on stores, expanding, renovating, opening and closing considerably more stores than in the recent past. Our de-leveraged balance sheet and past investment in George J. Heller infrastructure gives us the ability to invest in the “front President and of house”, the shopping experience. We will continue Chief Executive Officer our strategy of fewer, larger and newer stores that reflect changing customer shopping patterns, while not growing in total square footage. “L. Yves Fortier” Understandably, the introduction of far more space than spending power leads to competition for customer traffic. We believe the opportunity lies in better stores, better assortments and building new businesses within L. Yves Fortier, C.C., Q.C. our existing footprint; not taking on more exposure to Governor what will undoubtedly be an oversupply with conse- quences not far down the road.

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Financial Highlights

January 31 (millions of dollars) 2005 2004 2003 (restated) (restated) 03 Sales and revenue 7,069.7 7,295.1 7,303.9 Net earnings 59.7 60.0 85.4

Cash flow from operating activities 267.5 377.1 160.7 Capital expenditures 190.0 114.8 133.1

Debt:equity ratio 0.20:1 0.23:1 0.37:1

(dollars) Per share Net earnings 0.86 0.87 1.23 Net earnings – diluted 0.86 0.86 1.19 Dividends 0.36 0.36 0.36

Sales and Revenue Net Earnings Earnings per Share ($ millions) ($ millions) ($)

7,303.9 7,295.1 85.4 1.23 7,069.7

60.0 59.7 0.87 0.86

2003 2004 2005 2003 2004 2005 2003 2004 2005

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Annual Management’s Discussion and Analysis

The following Management’s Discussion and Analysis (MD&A) for Hudson’s Bay Company (Hbc or the Company) should be read in conjunction with the Company’s audited annual consolidated financial statements and the accompanying notes for the year ended January 31, 2005. Additional information about the Company, including the Annual Information Form, can be found on SEDAR at www.sedar.com.

Business Profile Hudson’s Bay Company, established in 1670, is Canada’s largest Department store retailer, its oldest corporation and one of Canada’s largest employers. The Company provides Canadians with a wide selection of goods and services through its various retail channels. The Company operates more than 500 stores, consisting mainly of the Bay and Zellers stores, and Home Outfitters, a kitchen, bed and bath superstore chain of 47 stores. It has also recently opened its first Designer Depot, a stand-alone store in the new Vaughan Mills regional mall in Ontario, 04 offering customers major savings on designer brands. The Company also operates Fields, a chain of 103 small value-priced general merchandise stores located in western Canada. In addition, Hbc operates a Financial Services division offering credit card, loyalty and other customer services, and is engaged in several other smaller operating and retailing activities: Hbc Direct, the Company’s direct-to-consumer business, which includes catalogue operations, third party loyalty programs and the Company’s online customer fulfillment offering.

Built on a 335-year tradition of serving the people of Canada, the Hudson’s Bay Company of today has been guided by the following mission statement since 1998:

Hudson’s Bay Company is a seamless retail organization built to best serve the needs of the majority of Canadian consumers through several highly focused formats, linked by customer bridges and enabled by common and integrated support services.

Strategy Since 1998, Hbc has been pursuing its mission to satisfy a greater proportion of the shopping needs of Canadians through Hbc’s various retail formats. It has engaged in a process of aligning and leveraging all of the assets of the Company in furtherance of this mission. Hbc’s unparalleled breadth of assortments, network of retail locations and historical relationship with Canadians assist Hbc in achieving its goal of selling more to Canadians. Fundamental to the strategy is the operation of the Company as a single retail organization that is constantly changing and adapting to meet the future needs of Canadian consumers; this implies that the retail formats operated by the Company, and the assortments carried in these formats will change as the customer changes.

From 1999 to 2004, Hbc was fundamentally transformed into an efficient and effective retailer capable of realiz- ing the strategic vision of being an integrated shopping solution for Canadians, by paralleling consumer spend patterns. This re-engineering of the Company’s operations included the renovation of Hbc’s technology platform, logistics and supply chain networks. These networks now support an Hbc back-of-house that is an industry leader ensuring that Hbc stores have the right products, at the right time and at the right prices. The transformation extended to the Company’s financial position. Hbc has successfully reduced debt, cut costs and improved cash flow. During this time, the Company also invested in and developed several touch points based on the Company’s one customer orientation: the Hbc Rewards program, Hbc credit card offering and Hbc gift card. These build an affinity to Hbc as a retail brand, while providing Hbc with an unprecedented opportunity to establish profitable and rewarding one-to-one relationships with customers.

With a fundamentally new business model and a transformed retail infrastructure, in fiscal 2004 Hbc entered the next stage of the Company’s strategic plan – the ‘growth’ phase. In September 2003, the Company announced that it would be pursuing a number of initiatives and programs that are enabled by the capabilities of the “transformed Hbc infrastructure”, in order to deliver comparable store sales growth from existing retail assets. These include:

• the expansion of Hbc’s sales of big ticket items such as furniture and electronics; • the expansion and transferring of merchandise programs across Hbc’s retail formats based on the assessment of local customer demand; • the development of new businesses, both in existing stores and new formats, to capture the emerging ‘off- price’ market in Canada;

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•improvement in productivity and store service; and • the leveraging of Hbc’s customer information resource, realized from the Hbc Rewards and Credit Card Programs, to drive profitable incremental behaviour from Hbc’s most profitable and highest potential customer segments.

These growth opportunities have been developed based on an analysis of the Canadian marketplace and Hbc’s core capabilities and dominant assortments.

In the Fall of 2004, the Company announced the re-organization of Hbc’s leadership team to reflect one Hbc operating structure. This is consistent with the Company’s transformation to an aligned and integrated customer centric retailer. As of February 1, 2005, merchandise, marketing and store operations that operated within the Company’s banner divisions were reorganized to support Hbc as a single retail organization, built on the principles of serving the Canadian customer in multiple ways, with a single view of market opportunities. The Bay and Zellers continue to operate with unique brands and customer value propositions; however, they are supported and merchandised by a single, common and integrated structure. 05 The Company is now entering the first full year with the entire organization transformed to the strategic vision. The focus of its associates is to execute the strategy and deliver incremental sales growth that will result in accelerated value creation for customers, associates and shareholders.

Overview The Company’s fiscal year-end is January 31. The financial tables and commentaries referring to 2004 and 2002 fiscal years cover the 52-week periods ended January 31, 2005, and 2003, respectively, and the 2003 fiscal year covers the 53-week period ended January 31, 2004. The additional week in fiscal 2003 accounted for $85 million of retail sales and approximately $3 million ($0.03 per share) of earnings before interest and taxes (EBIT) in fiscal 2003, which are included in the results described in the following commentaries.

In 2004, sales and revenue of $7,070 million were down approximately 3.1% from 2003 levels of $7,295 million. Excluding the additional week in the fourth quarter of 2003, sales and revenue in 2004 declined by 1.9% from 2003 reflecting sales declines in the Bay (excludes Home Outfitters) and Zellers, offset partly by an increase in sales at Home Outfitters. Comparable store sales in 2004 were down 2.3% at Zellers and 0.2% at the Bay (excludes Home Outfitters) and increased 5.3% at Home Outfitters compared to 2003. For Hbc, sales declined in most product groups except for grocery, stationary, hardware, cosmetics and jewellery.

For the Bay and Zellers, sales for 2004 were unfavourably impacted by unseasonable weather conditions in the second and third quarters compared to last year and a continuing weaker apparel market. In addition, the impact of the net reduction in Zellers’ store portfolio over the last twelve months lowered sales in 2004.

Revenue from the Financial Services division is included in the results of the major retail divisions, the Bay and Zellers. Financial Services’ revenue in 2004 was $317 million, compared with $333 million in 2003. The decrease in revenue reflected the reduction in store sales, the lower credit card blend at the Bay and Zellers, and a higher level of customer payments.

Consolidated Results In the following table, selected consolidated financial information for the Company for the last three years is shown. The following earnings and the related commentary reflect the adoption by the Company of the new accounting standards and the impact of changes to lease accounting practices described below:

(millions of dollars except per share amounts) 2004 2003 2002

(restated) (restated) Sales and revenue 7,070 7,295 7,304 EBIT 129 165 181 Net earnings 60 60 85 Earnings per share (EPS) – basic $ 0.86 $ 0.87 $ 1.23 EPS – diluted $ 0.86 $ 0.86 $ 1.19 Dividends per share $ 0.36 $ 0.36 $ 0.36 Total assets 4,009 4,022 4,175 Long-term debt, including current portion 594 693 830

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Management’s Discussion and Analysis

The following table summarizes the key statistics for the Company for the years ended January 31, 2005, 2004 and 2003 which are based on the restated results:

2004 2003 2002

Comparable store sales change (%) (1.4) (2.6) (1.9)

Return on equity (%) 2.8 2.9 4.2

Return on assets employed (%)** 4.7 5.6 6.1

Number of stores 547 562 556

Square footage (thousands) 47,358 48,193 47,875

Debt:Equity* 0.20:1 0.23:1 0.37:1 06 Debt:Equity (includes securitization funding)* 0.61:1 0.65:1 0.79:1

* Debt represents total debt net of cash and cash equivalents and portfolio investments as described in the Overview of Financial Condition – Net Assets section of the MD&A. The debt:equity ratio, including securitization funding, is described in the Overview of Financial Condition – Financing Activities section of the MD&A. ** Return on assets employed is calculated using EBIT and net assets as described in the Overview of Financial Condition – Net Assets section of the MD&A.

Changes in Accounting Principles During fiscal 2004, two accounting pronouncements and changes to lease accounting practices caused the Company to restate its financial statements retroactively. The two accounting pronouncements and the lease accounting changes are described below. For additional information on accounting for consideration received from vendors and on financial instruments – presentation and disclosure, see the section of this MD&A entitled “Recently Issued Accounting Pronouncements”.

During the third quarter of 2004, the Company restated its financial statements retroactively as a result of adopting the Canadian Institute of Chartered Accountants (CICA) Emerging Issues Committee (EIC) Abstract No. 144, “Accounting by a Customer (including a Reseller) for Certain Consideration received from a Vendor” as described in note 2(a) of the 2004 annual consolidated financial statements. See the Recently Issued Accounting Pronouncements: New Accounting Standards Adopted in fiscal 2004 section of the MD&A for the impact on previously reported net earnings and basic and diluted earnings per share (EPS) for the last two years.

During the fourth quarter of 2004, the Company restated its financial statements retroactively to reclassify its subordinated debentures from equity to long-term debt as a result of the early adoption of an amendment to the CICA standard, “Financial Instruments – Presentation and Disclosure”, Handbook section 3860 as described in note 2(b) of the 2004 annual consolidated financial statements. See the Recently Issued Accounting Pronouncements: New Accounting Standards Adopted in fiscal 2004 section of the MD&A for the impact on previously reported EPS and on long-term debt and shareholders’ equity classifications.

The Company conducts a substantial part of its business from leased premises as described in note 14 of the 2004 annual consolidated financial statements. Following the recent clarification of appropriate accounting policies under generally accepted accounting principles in the United States, the Company reviewed its lease accounting practices and concluded that adjustments were necessary to present its financial position and results of operations in accordance with Canadian generally accepted accounting principles. Accordingly, the Company has restated earnings for the year ended January 31, 2004 and retained earnings as at February 1, 2003 and 2004. For the year ended January 31, 2005, the correction has resulted in a decrease to net earnings of $3 million, and to basic and diluted earnings per share of $0.04. For the year ended January 31, 2004, the retroactive adjustment has resulted in a decrease to net earnings of $2 million, and to basic and diluted earnings per share of $0.02 and $0.03, respectively. The net book value of fixed assets was reduced by $35 million and $31 million for the years ended January 31, 2005 and 2004, respectively. Retained earnings was adjusted by $20 million and $18 million at February 1, 2004 and 2003, respectively. See details in note 2(c) of the 2004 annual consolidated financial statements.

Non-Recurring Transactions Operating results for fiscal years 2004, 2003 and 2002 were impacted by transactions that, in Management’s opinion, do not arise as part of normal day-to-day business operations and could potentially distort the analysis of trends. These transactions are:

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• Gain recorded in the fourth quarter of 2004 (Q4 2004) on disposal of the previously occupied Victoria store location ($12 million or $0.14 per share). • Costs recorded in Q4 2004 for severances related to the Company’s restructuring activities ($5 million or $0.05 per share). Additional severance costs will be recorded in Q1 2005 (approximately $7 million or $0.06 per share) to complete the restructuring program. • Loss recorded in the fourth quarter of 2003 (Q4 2003) of $2 million ($0.02 per share) related to the repurchase of $300 million of securitized credit card receivables and the refinancing of a similar amount. • Costs recorded in the first quarter of 2003 (Q1 2003) for the discontinuation of the Martha Stewart product line ($7 million or $0.06 per share). • Cost in Q1 2003 related to a sales tax assessment for prior years ($3 million, including $1 million of interest costs, or $0.03 per share). •Tax benefits recognized in the fourth quarter of 2002 of $14 million ($0.21 per share) resulting mainly from a favourable income tax decision related to prior year’s transactions.

The results shown above are reported in Canadian currency and are based on Canadian generally accepted accounting principles (GAAP). However, the following commentaries for fiscal years 2004, 2003 and 2002 are 07 based on the Company’s GAAP results excluding the transactions described previously; these amounts are referred to as normalized. The term normalized does not have any standardized meaning prescribed by GAAP and is therefore unlikely to be comparable to similar measures presented by other companies. In Management’s opinion, these transactions do not arise as part of normal day-to-day operations and by excluding these costs readers are provided with a more meaningful comparison of results for the fiscal years 2004, 2003 and 2002.

Adjustment to Normalize The following table reconciles the Company’s results for fiscal 2004 and fiscal 2003 on a GAAP basis and on a normalized basis.

Sales & Net EPS – (millions of dollars except per share amounts) Revenue EBIT Earnings Basic

Actual Results 2004 7,070 129 60 $ 0.86 2003 7,295 165 60 $ 0.87

Property Gain 2004 – (12) (9) $ (0.14) 2003 ––––

Restructuring Costs 2004 – 5 3 $ 0.05 2003 ––––

Securitization Loss 2004 –––– 2003 – 2 1 $ 0.02

Product Line Discontinuation Costs 2004 –––– 2003 – 7 5 $ 0.06

Sales Tax Assessment 2004 –––– 2003 – 3 2 $ 0.03

Normalized Results 2004 7,070 122 54 $ 0.77 2003 7,295 177 68 $ 0.98

For fiscal 2002, the following table shows net earnings and EPS on a GAAP basis and on a normalized basis.

Non-Recurring Normalized (millions of dollars except per share amounts) Actual Results Tax Benefits Results

Net earnings 85 (14) 71

EPS – Basic $ 1.23 $ (0.21) $ 1.02

The Company no longer adjusts its results for gains and losses arising from its ongoing securitization program since the results for these periods are presented on a consistent basis.

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Management’s Discussion and Analysis

The Company’s normalized results for the last three years are summarized in the following table:

(millions of dollars except per share amounts) 2004 2003 2002

Sales and revenue 7,070 7,295 7,304

Normalized EBIT: Major retail divisions (including Financial Services) 154 213 207 Other (32) (36) (26)

Total Normalized EBIT* 122 177 181

Normalized net earnings* 54 68 71

Normalized EPS* – Basic $ 0.77 $ 0.98 $ 1.02 08 * Excludes gain on Victoria property disposal and restructuring costs in Q4 2004, product line discontinuation costs and a sales tax assessment in Q1 2003, a securitization loss in Q4 2003, and non-recurring tax benefits recorded in Q4 2002.

Results for each of the Bay, Zellers and Financial Services are discussed separately under the heading “Review of Operations” following this section.

The quarterly sales and earnings of Hbc and other retail companies are significantly impacted by customer sales patterns, whereby, sales in the fourth quarter, due to customers’ holiday seasonal buying, are a much greater portion of the annual sales volume. The other quarters are also impacted to a lesser extent by sales patterns such as the back-to-school period in the third quarter. Since there is a large fixed expense component that does not fluctuate by quarter, earnings are much higher in the fourth quarter. In addition, certain costs, such as advertising and marketing, are not evenly incurred over the quarters in response to customer sales patterns.

Sales and revenue by quarter for the last three years are shown in the table below:

(millions of dollars) 2004 2003 2002

Sales and revenue: First quarter 1,498 1,512 1,511 Second quarter 1,627 1,664 1,675 Third quarter 1,685 1,688 1,695 Fourth quarter 2,260 2,431 2,423

Total 7,070 7,295 7,304

The percentage of retail sales derived from each of the four geographic regions of Canada for the last three years has been stable. The following table illustrates this:

Average 2004 2003 2002

Geographic regions: Western 32% 33% 32% 32% Ontario 44% 43% 44% 44% Quebec 17% 17% 17% 17% Maritimes 7% 7% 7% 7%

100% 100% 100% 100%

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EBIT on a GAAP basis and on a normalized basis by quarter for the last three years were as follows:

EBIT Normalized EBIT

(millions of dollars) 2004 2003 2002 2004 2003 2002

EBIT: First quarter* (22) (47) (2) (22) (37) (2) Second quarter (10) 12 18 (10) 12 18 Third quarter 1 19 (4) 1 19 (4) Fourth quarter* 160 181 169 153 183 169

Total* 129 165 181 122 177 181

* Normalized EBIT excludes gain on Victoria property disposal and restructuring costs in Q4 2004, a securitization loss in Q4 2003, and product line discontinuation costs and a sales tax assessment recorded in Q1 2003. 09 The Company’s gross margin rate represents gross margin (sales less cost of sales) as a percent of sales. The gross margin rate for Hbc decreased by 50 basis points reflecting margin decreases in the Bay and Zellers. The decrease in the Bay reflected mainly the impact of a lower markup percentage due largely to a change in product mix. In Zellers, the decrease was due mainly to higher markdowns, primarily to clear seasonal merchandise, offset partly by lower product costs due to improved supplier merchandise sourcing. The Company is targeting nominal improvements in the gross margin rate in fiscal 2005.

In 2004, normalized EBIT of $122 million decreased $55 million from normalized EBIT in 2003 of $177 million. Normalized EBIT comprises normalized EBIT in the major retail divisions and other activities. Normalized EBIT in the major retail divisions in 2004 of $154 million, which decreased $59 million or 28% from the year 2003 level, is discussed under the Bay and Zellers commentary sections. The Company’s lower normalized EBIT also reflected a $6 million increase in store closure and pre-opening costs and a $5 million increase in the net loss arising from the sales of receivables through the securitization program described in the Company’s Off-Balance Sheet Arrangements section of the MD&A and in note 3 of the Company’s consolidated financial statements for 2004.

Normalized “Other” EBIT represents items not directly attributable to the major retail divisions and Financial Services. Included in the “Other” category were unallocated corporate expenses and miscellaneous profits and losses from various ongoing and non-recurring secondary retail and other activities. The operations of Fields, Hbc’s chain of small general merchandise stores in western Canada, earnings from real estate activities, pension credits, Hbc Direct and customer relationship management program costs, and third party income from Hbc’s logistics and loyalty programs are also included. In 2004, 2003 and 2002, there were normalized losses from these items of $32 million, $36 million and $26 million, respectively. Compared to 2003, the decrease in the loss for 2004 reflected mainly lower general and administrative expenses, offset partly by a reduction in income related to Hbc’s loyalty program.

Interest expense was $46 million in 2004, a decrease of $14 million from the normalized 2003 level of $60 million. The decrease in interest expense reflected mainly the impact of lower long-term debt levels and lower interest expense on the asset-based credit facility. During 2004, the Company’s average interest rate decreased from 2003 by 0.4% to 7.6%.

For 2004, the Company’s normalized effective income tax rate was 30.5% compared to the 41.6% normalized effective income tax rate in 2003. The effective income tax rate in 2004 reflected lower statutory income tax rates, and the impacts of several tax reduction initiatives and capital dispositions. The effective income tax rate in 2003 reflected the impact on the fourth quarter of 2003 from an adjustment to future income taxes ($9 million or $0.13 per share) to account for the Ontario government’s repeal of previously announced corporate income tax rate reductions.

Normalized net earnings in 2004 were $54 million compared to normalized net earnings of $68 million in 2003. The decrease in normalized net earnings for 2004 was due to a lower EBIT, offset partly by reduced interest costs and a lower effective income tax rate. Compared to 2003, the lower normalized net earnings in 2004 was also due partly to an increase in store closure and pre-opening costs, net of tax, of $4 million ($0.06 per share) and a higher loss, net of tax, related to the Company’s securitization program of $3 million ($0.05 per share). Normalized EPS in 2004 was $0.77, a decrease of 21% from 2003’s normalized EPS of $0.98 and a reduction of 25% from 2002’s normalized EPS of $1.02.

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Management’s Discussion and Analysis

Net earnings on a GAAP basis and on a normalized basis by quarter for the last three years were as follows:

Net Earnings Normalized Net Earnings

(millions of dollars) 2004 2003 2002 2004 2003 2002

Net earnings: First quarter* (23) (41) (17) (23) (34) (17) Second quarter (15) (1) – (15) (1) – Third quarter (8) – (17) (8) – (17) Fourth quarter* 106 102 119 100 103 105

Total* 60 60 85 54 68 71

* Normalized EPS excludes gain on Victoria property disposal and restructuring costs in Q4 2004, a securitization loss in Q4 2003, 10 product line discontinuation costs and a sales tax assessment in Q1 2003, and non-recurring tax benefits recorded in Q4 2002. EPS on a GAAP basis and on a normalized basis by quarter for the last three years were as follows:

EPS Normalized EPS

(dollars) 2004 2003 2002 2004 2003 2002

EPS: First quarter* (0.33) (0.59) (0.23) (0.33) (0.50) (0.23) Second quarter (0.22) (0.02) 0.00 (0.22) (0.02) 0.00 Third quarter (0.11) (0.01) (0.25) (0.11) (0.01) (0.25) Fourth quarter* 1.53 1.48 1.72 1.44 1.50 1.51 Full Year* 0.86 0.87 1.23 0.77 0.98 1.02

* Normalized EPS excludes gain on Victoria property disposal and restructuring costs in Q4 2004, a securitization loss in Q4 2003, product line discontinuation costs and a sales tax assessment in Q1 2003, and non-recurring tax benefits recorded in Q4 2002.

Diluted EPS on a GAAP basis and on a normalized basis by quarter for the last three years were as follows:

Diluted EPS Normalized Diluted EPS

(dollars) 2004 2003 2002 2004 2003 2002

Diluted EPS: First quarter* (0.33) (0.59) (0.23) (0.33) (0.50) (0.23) Second quarter (0.22) (0.02) 0.00 (0.22) (0.02) 0.00 Third quarter (0.11) (0.01) (0.25) (0.11) (0.01) (0.25) Fourth quarter* 1.35 1.30 1.51 1.27 1.32 1.33 Full Year* 0.86 0.86 1.19 0.77 0.98 1.02

* Normalized diluted EPS excludes gain on Victoria property disposal and restructuring costs in Q4 2004, a securitization loss in Q4 2003, product line discontinuation costs and a sales tax assessment in Q1 2003, and non-recurring tax benefits recorded in Q4 2002.

Sales and Revenue Sales by Geographic Regions ($ millions) 2002 Maritimes 2,500 2003 2004 2,000 Quebec Western 44% 1,500 32% 17% 1,000 7% Ontario 500

0 Q1 Q2 Q3 Q4

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Normalized EBIT Normalized Earnings per Share-Basic ($ millions) ($) 2002 2002 200 2.0 2003 2003 2004 2004 150 1.5

100 1.0

50 0.5

0 0.0

-50 -0.5 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 11 Review of Operations Retail Environment Canadian Retail Environment For the calendar year 2004, Department Store Sales (DSS) were up 5.3% from the same period last year, while at the broader level, Large Retailer Commodity Survey (LRCS) increased by 5.9%.

The Canadian economy continues to be healthy with strong consumer confidence, near full employment and low interest rates.

Increased domestic and foreign retail competition during 2004 continued as retailers announced new store formats as well as store expansions within the Canadian marketplace and abroad. Department stores continue to test new specialty store concepts within off-mall locations. A U.S. mass merchandise competitor continues to expand internationally; however, expansion within Canada is likely to be much slower in 2005 and beyond as the market becomes more saturated.

International fashion, lingerie and cosmetic retailers entered into Canada in 2004 and are expected to add more stores in 2005. New European and U.S. apparel competitors are expected to enter the Canadian market in 2005 as increased domestic and international competition makes expansion to additional markets necessary.

Retail sales growth in 2005 is expected to be slightly higher than 2004, with year-over-year sales estimated to reach mid-single digits for both DSS and LCRS groups.

The Bay Business Profile At January 31, 2005, the Bay, Hbc’s fashion department store retail brand, had 98 department stores in operation across Canada. The Bay offers style and trend leadership in private and national brands to middle and upper income Canadians. The Bay also continues to expand its portfolio of exclusive brands which are executed and supported to deliver a consistent price and marketing message. Emphasizing fashionable soft goods and products for the home, the Bay provides its customers with traditional department store services.

Strategy The Bay will exceed the customer’s expectations by being Canada’s best department store chain, offering affordable style and trend leadership in private and national brands to middle and upper income Canadians.

The Bay’s strategic objectives will be achieved through the following initiatives: • Improve department store offerings: – Solidify and build on the Bay’s fashion and style leadership position. – Develop private brands to deliver value and a consistent fashion look. – Continue to re-position the Bay brand to stand for Stylish Ideas Made Easy and Affordable. – Differentiate suburban and urban stores to exceed customer expectations.

• Intensify utilization of space: – Improve the productivity per square foot in the Bay stores, particularly through expansions of major home fashion, jewellery, and cosmetics and through complementary licensed businesses.

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 12

Management’s Discussion and Analysis

• Increase investments in growth assets: – Continue to invest in Home Outfitters with 47 stores at January 31, 2005 and plans to open up to 9 stores during 2005 in major Canadian cities.

Financial Performance

(millions of dollars) 2004 2003 2002

Sales and revenue 2,682 2,689 2,648

Normalized EBIT* 69 78 100

Net assets** 1,188 1,198 1,225

* Excludes restructuring costs in Q4 2004 and a securitization loss in Q4 2003. 12 ** Net assets are described in the Overview of Financial Condition – Net Assets section of the MD&A. Performance measures for the last three years were as follows:

2004 2003 2002

Comparable store sales change (%) 0.2 (2.3) (3.9)

Retail sales per selling square foot (dollars) 170 169 173

Inventory turnover on cost basis (times) 2.44 2.57 2.67

Normalized return on assets employed (%)* 5.8 6.4 8.7

* Return on assets employed is calculated using EBIT and net assets as defined in the Overview of Financial Condition – Net Assets section of the MD&A.

Sales and revenue in 2004 of $2,682 million were down $7 million or 0.3% from 2003, with comparable store sales up 0.2%. Excluding the additional week in Q4 2003, sales in 2004 increased 0.8% from fiscal 2003. The Bay’s LRCS market share decreased to 2.9% in calendar 2004 from 3.0% in 2003. On a 52-week basis, average sales were $170 per square foot of retail selling space compared to $169 per square foot in 2003 and $173 in 2002.

In 2004, the Bay (excluding Home Outfitters) experienced sales declines in most product groups except for cosmetics and jewellery, offset partly by an increase in sales at Home Outfitters. The Bay’s sales decrease was due mainly to lower apparel, and soft home fashion sales. The decrease in apparel sales was mainly the result of price deflation and increased competition indicated by the increase of retail space allocated to apparel, while the decrease in soft home sales was the result of the transition to a new assortment and increased competition. Home Outfitters’ sales increase was the result of the strong comparable store sales increase of 5.3% and also reflected the impact of new stores opened during 2004.

Normalized EBIT for 2004 of $69 million decreased by $9 million or 12% from last year. The profit decline occurred mainly in the fourth quarter of 2004 reflecting the impact of a reduced sales volume and lower gross margin compared to the prior year. The lower gross margin reflected mainly a lower markup percentage due largely to a change in product mix. The decline in the Bay’s EBIT was offset partly by higher profits in Home Outfitters. In 2004, store pre-opening and closing costs were $1 million compared to $5 million in 2003.

Inventories at January 31, 2005 of $580 million were $46 million above the January 31, 2004 level of $534 million. Excluding Home Outfitters, the Bay’s inventory was higher than last year due mainly to increases in major home fashion, soft home and accessories. Home Outfitters’ inventory level was higher due largely to the opening of new stores in fiscal 2004. Inventory turnover on a cost basis at the Bay (excluding Home Outfitters) was 2.62 times compared to 2.74 times last year.

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The number of Bay stores in operation and aggregate gross areas in square feet by province at the last three year-ends were as follows:

Number Square Feet (thousands)

2004 2003 2002 2004 2003 2002

British Columbia 18 18 18 2,976 2,976 2,984 Alberta 15 15 15 2,404 2,404 2,404 Saskatchewan 3 3 3 429 429 429 Manitoba 3 3 2 965 965 758 Ontario 37 38 38 6,534 6,791 6,791 Quebec 18 18 19 3,004 3,004 3,142 New Brunswick 1 1 1 121 121 121 Nova Scotia 3 3 3 375 375 375 13 98 99 99 16,808 17,065 17,004

The number of Home Outfitters stores and aggregate gross areas in square feet by province at the last three year-ends were as follows:

Number Square Feet (thousands)

2004 2003 2002 2004 2003 2002

British Columbia 7 6 5 226 199 171 Alberta 8 8 7 312 312 278 Saskatchewan 2 2 2 66 66 66 Manitoba 2 2 2 78 78 78 Ontario 20 19 17 758 728 672 Quebec 7 7 4 254 254 158 Nova Scotia 1 1 35 35

47 45 37 1,729 1,672 1,423

The Company owns the land and buildings of six large downtown Bay stores in operation, including the Toronto downtown Queen Street store building and approximately 60% of the related land, and three other Bay stores, and the buildings (on leased land) of seven suburban Bay stores. The remaining stores are generally held under long-term leases. In 2004, the Bay closed one store, Cloverdale, in Toronto in the first quarter. During 2004, Home Outfitters opened two stores. The Home Outfitters stores are held under long-term leases.

Operating Highlights for 2004 During 2004, the Bay implemented a number of initiatives in support of its strategic objectives, including: • Introduced a number of new brands, including GlucksteinHome, Green Dog, Nine & Company, Jones Signature, Izod Ladieswear, J. Lo Intimates and First Impressions. These introductions represent the continued targeted growth of select national, private and captive brands throughout various merchandising categories. The private and captive brands represent internally and externally developed and sourced brands as well as brands available to the Bay through its arrangement with various global retailers and manufacturers. • Introduced “Style Outlet”, in-store boutiques, that are a pilot project in five Bay stores and will have up to 70% of their assortment as designer brands at reduced prices. • Launched its first Designer Depot on November 4, 2004, a 38,000 square foot stand-alone store in the new Vaughan Mills regional mall in Ontario, offering customers major savings on top-of-the-line designer brands. • Closed the Cloverdale, Toronto location and completed major renovations on the Bayshore, Ottawa location. Improvements were made in a variety of areas within flagship stores. • Opened two new Home Outfitters stores, bringing the total number of stores to 47 at January 31, 2005.

Outlook for 2005 In 2005, sales growth is targeted to occur through key strategic initiatives including its major home fashion business and an increase in Opportunity Buys with the addition of up to six Designer Depot stores and up to 20 Style Outlets in 2005, and the continued growth of the Home Outfitters business with up to 56 stores by January 31, 2006.

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Management’s Discussion and Analysis

In line with Hbc’s strategic initiatives, an extensive review of key lines of business will continue which is targeted to enable future sales and profit growth. During 2005, the Bay will continue the expansion of the Market Mall, Calgary store to 200,000 square feet with completion scheduled for the third quarter of 2005. In addition, the Masonville, London, Ontario store will be expanded to 100,000 square feet with completion planned for the fourth quarter of 2005.

Zellers Business Profile Zellers is Hbc’s mass merchandise retail brand with 298 stores at January 31, 2005. Zellers offers national and private brand merchandise at prices that provide value to its customers. During 2004, Zellers continued to renovate to the new prototype format featuring wide aisles, and improved presentation and selection of merchandise. As of January 31, 2005, Zellers had renovated 171 of its stores with various elements of its newest prototype format, representing approximately 64% of total store selling space. Included in the 298 stores are 53 former Kmart Canada locations, acquired by Zellers in 1998, which are at an early stage in the development to the prototype format. The former Kmart Canada stores comprise approximately 12% of total store selling space. 14 Zellers operates 15 of its smaller stores as “Zellers Select”. Of the stores with the new prototype format at the 2004 year-end, Zellers has 44 stores that operated the neighbourhood market concept, an expanded offering of grocery items.

Strategy Zellers’ strategic objective is to become the preferred store of Canadian “Moms” by offering a broad assortment of products including those that are unique and differentiated that respond to her needs and wants, including her family and home, with fast, friendly and convenient service.

The strategic objective will be achieved through the following initiatives: •A refined value proposition – anticipating Mom’s assortment needs and wants with a combination of priced- right national as well as exclusive private and captive brands. • An improved real estate portfolio – becoming a nation-wide chain with larger, conveniently located stores by market, positioned to effectively deliver the best assortment and service to Mom.

Financial Performance

(millions of dollars) 2004 2003 2002

Sales and revenue 4,301 4,520 4,576

Normalized EBIT* 85 135 107

Net assets** 1,326 1,365 1,476

* Excludes restructuring costs in Q4 2004, product line discontinuation costs and sales tax assessment in Q1 2003, and a securitization gain in Q4 2003. ** Net assets are described in the Overview of Financial Condition – Net Assets section of the MD&A.

Performance measures for the last three years were as follows:

2004 2003 2002

Comparable store sales change (%) (2.3) (2.9) (0.8)

Retail sales per selling square foot (dollars) 195 198 201

Inventory turnover on cost basis (times) 3.26 3.15 3.16

Normalized return on assets employed (%)* 6.4 9.3 7.3

* Return on assets employed is calculated using EBIT and net assets as described in the Overview of Financial Condition – Net Assets section of the MD&A.

Sales and revenue decreased 4.8% in 2004, with comparable store sales down 2.3%. Sales and revenue declined 3.6% from fiscal 2003, excluding the additional week in Q4 2003. LCRS market share for Zellers was 4.7% in calendar 2004, down from 5.1% in calendar 2003, due mainly to the new store growth of a key competitor in the marketplace. On a 52-week basis, Zellers’ average sales were $195 per square foot of retail selling space in 2004 compared to $198 in 2003 and $201 in 2002.

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The sales decline reflected lower softline sales, which were down in all categories due largely to the continuing industry trend of lower consumer spending on apparel as well as deflation in the category, competition and the unseasonably cold and wet weather conditions in the second quarter of 2004. Hardline sales were down mainly in home entertainment, toys, seasonal products and home fashions, offset partly by increases in grocery and stationary and hardware. Sales in 2004 were also unfavourably impacted by the net reduction in Zellers’ store portfolio over the last year.

Normalized EBIT of $85 million in 2004 decreased $50 million from normalized EBIT in 2003 of $135 million. Included in 2004 were store closure costs and pre-opening costs of new stores of $16 million compared with $6 million in 2003 and $16 million in 2002. The decrease in normalized EBIT for 2004 compared to normalized EBIT in 2003 reflected mainly the impact of lower sales volume, lower credit card income, higher store closure costs, and a lower gross margin reflecting mainly higher markdowns to clear seasonal goods. The lower credit card income was due mainly to a higher net loss ($6 million) related to the Company’s securitization program.

Inventory at January 31, 2005 was $810 million or $18 million below the 2003 fiscal year-end inventory level of $828 million, reflecting mainly the impact of the continued improvement of inventory management systems and 15 processes. Inventory turnover on a cost basis of 3.26 improved from the inventory turnover in 2003 of 3.15.

The number of stores and aggregate gross areas in square feet by province at the last three year-ends were as follows:

Number Square Feet (thousands)

2004 2003 2002 2004 2003 2002

British Columbia 37 38 38 3,491 3,537 3,499 Alberta 29 30 30 2,722 2,745 2,727 Saskatchewan 10 12 12 877 964 964 Manitoba 8 8 9 829 829 905 Ontario 123 130 132 11,845 12,188 12,240 Quebec 58 60 60 5,281 5,413 5,365 New Brunswick 12 12 12 1,017 1,017 992 Nova Scotia 14 14 14 1,302 1,302 1,302 Prince Edward Island 2 2 2 203 203 203 Newfoundland and Labrador 5 6 6 425 445 445

298 312 315 27,992 28,643 28,642

At January 31, 2005, Hbc owned four Zellers stores. The remaining Zellers stores are generally held under long- term leases. During 2004, Zellers opened one new store, expanded four stores, and closed 15 stores.

Operating Highlights for 2004 During 2004, Zellers implemented a number of initiatives in support of its strategic objectives to increase the business value. Highlights of the key initiatives include: •Launched Hilary Duff’s exclusive new line of merchandise, “Stuff by Duff”, at Zellers stores with coverage in fashion apparel and accessories, home accessories and cosmetics. • Introduced Très You, a collection of stylish, value-priced women’s wear-to-work clothing designed by Federated Merchandising Group, a division of Federated Department Stores, specifically for Zellers. • Introduced Bay moderate assortments in ladies wear, lingerie, ladies accessories and jewellery, footwear, and selected small kitchen appliances in 50 Zellers stores as part of Hbc’s merchandising initiative. • Launched an assortment of physical fitness equipment in 249 stores. • Expanded a number of product areas, as part of Hbc’s merchandising strategy, including candy, prestige fragrances and decorative storage. • Launched Digicentre, a new in-store merchandising concept providing customers with “picture to print” digital solutions. www.digilab.ca, a key component of the launch, encompasses an online photo processing website offering customers the convenience of uploading their pictures and picking up their prints at any Zellers store and select Bay locations. • Continued to invest in the real estate portfolio with the opening of one store in Quebec, the expansion of four stores in Ontario, and the completion of 19 store renovations. • Continued to rationalize Zellers’ real estate portfolio with the closing of three Quebec stores, seven Ontario stores, two stores in Saskatchewan and one store in each of Alberta, British Columbia and Newfoundland.

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 16

Management’s Discussion and Analysis

Outlook for 2005 During 2005, Zellers plans to grow sales and EBIT through the execution of its key strategic initiatives including the launch of new merchandise brands and assortments, the expansion of product assortments, an increase in Opportunity Buys and continued growth in the big ticket business currently operating out of select locations.

A number of targeted initiatives centred around the development of the four famous businesses (Women’s Wardrobe, Kid’s World, Home Décor and Wellness) are also expected to contribute to sales growth for Zellers in 2005.

The Company will also continue to rationalize and invest in its store portfolio in 2005. Zellers has announced the opening of two new Ontario stores, both of which are relocations, the expansion of four Ontario stores, the renovation of 16 stores and the closure of seven stores in 2005.

Financial Services Business Profile The Financial Services division’s primary function is to manage Hbc’s credit card portfolios for the Bay and 16 Zellers. Processing of the portfolio is handled by a single system, located in Toronto. The division operates three regional credit service centres in Vancouver, Toronto and Montreal. At January 31, 2005, there were 3.1 million active customer accounts in the combined portfolio, approximately 1.7 million Bay cardholders and 1.4 million Zellers cardholders.

Financial Services’ main activity is the issuance of revolving lines of credit to assist customers in purchasing Hbc merchandise and services. Included in this activity is credit product development, new accounts acquisition, portfolio risk management, marketing, reporting and balancing, and account management consisting of customer services and collection activities.

Strategy Financial Services’ strategic objective is to be the settlement vehicle of choice for Hbc’s customers and its retail operations.

The strategic objective will be achieved through the following initiatives: •Creating value propositions to the customer for use of Hbc’s credit card. • Initiating effective targeted marketing programs and providing ease of shopping that is more rewarding. • Operating credit services to realize a profit level that meets corporate hurdle rates.

Financial Performance

(millions of dollars) 2004 2003 2002

Sales and revenue 317 333 322

Normalized EBIT* 162 160 165

Credit card receivables at year-end 427 539 559

* Excludes a securitization loss recorded in Q4 2003.

Performance measures for the last three years were as follows:

2004 2003 2002

Average balance per active customer account (dollars) 443 466 430

Average volume per active account (dollars) 844 871 802

Average monthly active accounts (thousands) 2,925 2,925 3,025

Net bad debt expense for year (millions of dollars) 79 95 78

Gross bad debt expense as a percentage of average balance (%) 9.0 9.0 8.3

Percent of receivables 30 days past due or less (%) 95.2 95.0 94.7

Credit card blend (%) 28.2 28.7 27.6

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 17

Revenue and normalized EBIT of the Financial Services division are included with the results of the major retail divisions, the Bay and Zellers.

Financial Services revenue in 2004 was $317 million or 4.8% below the revenue level in 2003 of $333 million reflecting a reduction in service charge revenue due to lower credit card receivables.

EBIT in 2004 was $162 million, $2 million above 2003’s normalized EBIT of $160 million and $3 million below the 2002 level of $165 million. Compared to 2003, the decrease in net bad debt expense and securitization funding costs incurred by the Trusts were offset partly by the reduction in service charge revenue and higher net losses on the Company’s securitization program ($5 million).

Credit card receivables at January 31, 2005 totalled $427 million or 20.7% below 2003’s receivable balance of $539 million, which was 3.7% below 2002’s level of $559 million. Excluding the adjustments to account for the securitization of credit card receivables, the receivable balance at the 2004 fiscal year-end was $374 million or a 22.2% decrease from the 2003 year-end level, which was 4.4% lower than the 2002 year-end balance. The credit card receivables level at January 31, 2005 was below last year’s level due mainly to the impacts of reduced 17 store sales, lower credit card sales blend, and higher customer payments.

Over the past eight years, the Company has sold to independent Trusts, with limited recourse, $900 million of undivided co-ownership interests in its credit card receivables. In the fourth quarter of 2004, $200 million of this amount, which was scheduled for liquidation and payment beginning January 31, 2005, was renewed and the date scheduled to begin liquidation was extended to January 31, 2007 or later under certain circumstances. The securitized portion of the credit card receivables is not included in the year-end receivable balances disclosed in the above table. The Off-Balance Sheet Arrangements section of the Company’s MD&A describes in more detail the securitization of Hbc’s credit card receivables.

The average balance per active customer account was down, while the average monthly active accounts remained static resulting in an overall decrease in credit card receivables. Gross write-offs in 2004 of $117 million were lower than 2003 by $6 million reflecting the improvement in the quality of the credit card portfolio. The number of accounts charged off was 3.0% lower in 2004 compared to 2003. Net bad debt expense in 2004 of $79 million was $16 million below the 2003 level of $95 million due mainly to lower gross write-off levels and higher bad debt recoveries in 2004.

The quality of the credit card receivable portfolio at January 31, 2005, has remained relatively constant compared to the 2004 year-end with 95.2% of the receivable portfolio classified as current and 30 days past due which is consistent with the aging over the last two years.

Operating Highlights for 2004 During 2004, Financial Services implemented a number of initiatives in support of its strategic objectives. Highlights of the key initiatives include: • The further enhancements made to the delinquent account and authorization strategies to control the average charge-off balances. • The introduction of additional in-store, marketing programs and focused efforts on training to increase the credit blends in several opportunity stores. • The development of an anti-attrition campaign to re-activate customer accounts. • The launch of several new membership services, including Credit Alert, Home Advantage, Card Protector, MotorPlus, Shop@Home Book Club and two Pre-Need Funeral Programs.

Outlook for 2005 The focus of credit marketing efforts will be to increase the credit card blend at Zellers, as well as to increase third party acceptance. Credit risk management will concentrate efforts on further reducing the average charged- off account balance, as well as to reduce the dollar amount charged-off due to bankruptcy.

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 18

Management’s Discussion and Analysis

Overview of Financial Condition Net Assets The following summary shows details of the Company’s net assets as financed by debt, future income taxes, and equity for the last three years:

(millions of dollars) 2004 2003 2002

Net assets: The Bay 1,188 1,198 1,225 Zellers 1,326 1,365 1,476 Other 267 210 300

2,781 2,773 3,001

Financed by: 18 Net debt 442 506 785 Future income taxes 138 102 87 Equity 2,201 2,165 2,129

2,781 2,773 3,001

Total assets 4,009 4,022 4,175

Debt:equity ratio* 0.20:1 0.23:1 0.37:1

* Debt represents total debt net of cash and cash equivalents and portfolio investments.

Net assets and net debt consist of:

(millions of dollars) 2004 2003 2002

Net assets: Total assets (net of trade accounts payable and other accounts payable and accrued liabilities) 3,136 3,086 3,195 Cash and cash equivalents (241) (154) (38) Current portion of future income taxes (20) (65) (64) Portfolio investments (36) (35) (32) Employee future benefits other than pensions (58) (59) (60)

2,781 2,773 3,001

Net debt: Total debt (including short-term borrowings and long-term debt) 719 695 855 Cash and cash equivalents (241) (154) (38) Portfolio investments (36) (35) (32)

442 506 785

In the above table, net assets for the Bay and Zellers include credit card receivables that are also included in the assets of Financial Services, amounting to $427 million at January 31, 2005, $539 million at January 31, 2004, and $559 million at January 31, 2003.

Net assets at January 31, 2005 of $2,781 million were $8 million above last year’s net asset level due mainly to higher inventories, net of trade payables, increased other receivables and lower other current liabilities, offset largely by lower credit card receivables. The higher inventory level at the Bay, including Home Outfitters, was offset partly by lower inventories in Zellers. Home Outfitters inventory level was higher due largely to the opening of new stores in fiscal 2004. Other net assets of $267 million increased $57 million from last year’s level reflecting largely an increase in income taxes recoverable and higher mortgage receivables on disposal of properties.

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Total assets at January 31, 2005 of $4,009 million were lower than last year’s total asset level of $4,022 million reflecting primarily the effect of lower credit card receivables, reduced current portion of future income taxes, offset largely by higher inventories and increased other receivables.

Cash Flows Cash and cash equivalents at January 31, 2005 totalled $241 million compared to $154 million at January 31, 2004. Cash and cash equivalents represent unrestricted short-term deposits.

The following table provides an analysis of Hbc’s cash flows for the fiscal years of 2004 and 2003:

Year Ended January 31 (millions of dollars) 2005 2004

Cash Flow: Net cash inflow from operating activities 268 377 Investing activities: Capital expenditures (190) (115) 19 Fixed asset dispositions 60 66 Repurchase of credit card receivables – (300) Sale of credit card receivables – 300 Other (23) (25)

Net cash outflow for investing activities (153) (74)

Net cash inflow before financing activities 115 303

Financing activities: Debt (3) (162) Dividends (25) (25)

Net cash outflow for financing activities (28) (187)

Increase in cash and cash equivalents 87 116

Free cash flow: Net cash inflow before financing activities 115 303 Dividends (25) (25)

Free cash inflow 90 278

Cash and cash equivalents in 2004 increased $87 million compared to $116 million in 2003. The cash increase in 2004 reflected mainly the net cash inflow from operating activities of $268 million, cash proceeds from property sales ($54 million) and short-term borrowings, offset partially by the repayment on maturity to debenture holders of the 7.10% series F debentures ($125 million), dividend payments of $25 million, and capital and software expenditures of $213 million.

For 2004, net cash inflow from operating activities of $268 million decreased by $109 million from the 2003 net cash inflow of $377 million reflecting mainly higher inventories, net of trade payables, and higher other receivables, lower cash profits and higher cash income taxes, offset partly by lower credit card receivables. Net cash outflow for investing activities in 2004 of $153 million was $79 million higher than the 2003 net cash outflow of $74 million reflecting mainly higher capital and software expenditures, and lower cash proceeds from property sales in 2004.

The net cash outflow for financing activities in 2004 of $28 million was $159 million lower than the net cash outflow in 2003 of $187 million. In 2004, the Company paid $125 million to debenture holders of the 7.10% series F debentures (matured on May 13, 2004), made dividend payments of $25 million and increased short-term borrowings. During 2003, the Company paid $259 million to debenture holders of the 6.25% series D debentures (matured on March 14, 2003) and 6.35% series E debentures (matured on December 1, 2003), repaid short-term borrowings ($23 million), made dividend payments of $25 million, and issued $120 million of 7.5% unsecured medium term notes maturing on June 15, 2007.

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 20

Management’s Discussion and Analysis

To realize the optimum debt:equity structure and to minimize Hbc’s dependence on external borrowings, the Company focuses on maximizing its free cash flow which is defined as net cash inflow (outflow) before financing activities less sale or repurchase of credit card receivables, dividends paid and common shares issued or purchased (equity). In 2004, free cash flow of $90 million decreased by $188 million from the 2003 level. The reduction in 2004 reflected mainly the decrease in net cash inflow from operating activities, lower cash proceeds from property sales, and higher capital and software expenditures.

Financing Activities The Company obtains funds through various avenues. Funds are generated through cash from operations and improvements in working capital. The Company also has the ability to reduce capital spending to fund debt requirements, however, a long-term decline in capital expenditures may negatively impact profit growth. Other principal sources of funding are: the issuance of long-term debentures, the securitization of credit card receivables, the sale and leaseback of real estate properties, a syndicated loan arrangement with a group of lenders, the issuance of convertible subordinated debentures, and the issuance of common equity. The availability of sources of funding to the Company are dependent on a variety of factors including economic conditions, capi- 20 tal markets, and the Company’s financial condition.

To achieve the sales growth described in the Company’s five year strategic plan, additional working capital is projected to be required. However, the Company is targeting improvements in inventory management systems and inventory control processes that will offset the working capital increases supporting the sales growth plan. Working capital requirements follow a fairly consistent pattern during the year with the lowest working capital level usually occurring at the fiscal year-end.

At January 31, 2005, the Company’s net debt of $442 million, after deducting $277 million in unrestricted investments and short-term deposits, was $64 million below the 2003 year-end debt level of $506 million. Included in the 2004 year-end debt level was $594 million of long-term debt, including $102 million due within one year, which was at fixed interest rates. The $64 million decrease in debt levels in 2004 was due principally to the impacts of reduced credit card receivables, cash profits, and proceeds received from property sales in 2004, offset partly by higher inventories, net of trade payables and capital and software expenditures made in the year.

There are no legal or practical restrictions on the ability of Hbc subsidiary companies to transfer funds to the Company. In the reporting period, the Company has not been in default or arrears on any dividend payments, lease payments, interest or principal payments on debt.

Contractual Obligations At January 31, 2005, total committed payments for long-term debt and operating leases were as follows:

Payments Due by Period

Total Less than 2–3 4–5 After ($ millions) 1 year years years 5 years

Long-term debt 594 102 283 192 17 Operating leases 2,359 247 462 414 1,236

Total contractual obligations 2,953 349 745 606 1,253

The above table does not include purchase orders for merchandise that are part of normal course of business. In addition, the Company has non-pension employee benefit plans as described in note 6 to the consolidated financial statements. The estimated contributions from Hbc are in the range of $24 million to $27 million in each of the next five years. The Company had no significant non-merchandise purchase obligations and no capital lease obligations at the 2004 fiscal year-end.

The Company has long-term operating lease obligations that are not capitalized on the balance sheet in accordance with accounting principles generally accepted in Canada. These leases are primarily related to store locations and comprise 96% of total lease commitments in 2005. Leases typically have an original term ranging from 15 to 25 years and provide for renewal periods exercisable at the Company’s option. The Company also has long-term leases for transportation and other equipment with various lease terms.

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 21

On March 2, 2005, the Company announced an eight-year partnership agreement with the Vancouver Organizing Committee (VANOC), whereby, for exclusive rights related to the sponsorship of Canadian athletes at the next four Olympic games, the Company has committed $100 million in value to VANOC in a combination of cash, marketing support, value-in-kind support or budget relief, and participation in proceeds from sale of Olympic branded merchandise.

At January 31, 2005, the Company had $102 million of debt due within one year (excluding short-term indebtedness) which represents largely the 7.38% medium term notes (matures August 3, 2005). In the Company’s view, the funds to pay the amounts due within one year will be available through various sources of funding, as described in the first paragraph of the financing section of the MD&A, as well as utilizing the available cash at January 31, 2005 of $241 million.

The Company has $200 million of 7.5% convertible unsecured subordinated debentures which mature on December 1, 2008 but are redeemable after December 1, 2005. At January 31, 2005, $187 million of convertible subordinated debentures are classified as debt. For further details, refer to note 9 of the annual consolidated financial statements. 21

The Company’s debt:equity ratio at January 31, 2005, was 0.20:1 compared to last year’s ratio of 0.23:1. If the Company had financed its business by issuing $900 million of debt on the security of its credit card receivables, rather than by selling undivided co-ownership interests in the receivables, the Company’s debt:equity ratio at January 31, 2005, would have been 0.61:1 compared to 0.65:1 at January 31, 2004. The debt:equity ratio, including securitization funding, met the Company’s long-term financial objective of a debt:equity ratio below 0.85:1.

On May 13, 2004, the Company repaid $125 million of the 7.10% series F debentures.

On December 15, 2004, the Company renewed $200 million of its $900 million credit card receivables securitization program which had been scheduled for liquidation beginning January 31, 2005, and extended the date scheduled to begin liquidation to January 31, 2007 or later under certain circumstances.

On June 1, 2004, the Company renegotiated a new 364-day $650 million secured revolving asset-based credit facility, which is available by way of loans and letters of credit for general corporate purposes and is secured by the Company’s merchandise inventory. This new credit facility contains improved terms compared to the previous facility and bears interest at variable rates, which can be based on a blend of the Canadian prime rate, BA rate, Libor rate and US base rate. At January 31, 2005, the Company had not drawn on its $650 million asset- based credit facility (excluding letters of credit which serve as credit support for other ordinary course obligations of the Company) which is the same as the position at January 31, 2004. The asset-based credit facility expires in May 2005. Prior to May 2005, the Company plans to renegotiate a new asset-based credit facility. Over the last three years, the Company’s average draw on the operating lines, which excludes letters of credit, was $23 million in 2004, $104 million in 2003 and $50 million in 2002. Due to the seasonal nature of the retail business, the draw on the operating lines to fund normal operating activities peaks in the fourth quarter; the peak was $137 million in the fourth quarter of 2004 compared to $144 million and $235 million in the same periods of 2003 and 2002, respectively.

Under the terms of the new asset-based credit facility, the borrowing base availability, as defined by the asset- based Credit Agreement, must not fall below a specified minimum amount for ten consecutive days before the Company must comply with a fixed charge coverage ratio. Since the commencement date of the credit facility, the borrowing base availability has exceeded the specified minimum amount by a multiple of at least five times.

The Company’s debt is rated by Standard and Poor’s Canada (S&P) and by Dominion Bond Rating Service (DBRS). During the first quarter of 2004, credit reviews were held with both credit agencies. DBRS and S&P confirmed their existing ratings with a negative outlook trend. The Company’s debt is currently classified as non-investment grade which results in a higher cost to borrow funds in the future and potentially limits the Company’s ability to borrow funds in some markets. A summary of the Company’s ratings is provided in the following table:

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 22

Management’s Discussion and Analysis

April 2004 May 2003 April 2002

Ratings Outlook Ratings Outlook Ratings Outlook

S&P: Unsecured debentures BB+ Negative BB+ Negative BB+ Stable Convertible unsecured subordinated debentures BB Negative BB Negative BB Stable DBRS: Unsecured debentures BB (high) Negative BB (high) Negative BB (high) Stable Convertible unsecured subordinated debentures BB Negative BB Negative BB Stable

In February 2005, DBRS placed Hbc’s ratings under review with negative implications. In March 2005, S&P low- 22 ered its long-term corporate credit and senior unsecured debt ratings to BB from BB+, and lowered its BB debt rating to B+ on the 7.5% convertible unsecured subordinated debentures, with a negative outlook.

Outstanding Shares As at February 25, 2005, the Company had 69,351,687 outstanding common shares with a book value of $1,403 million.

The Company also has $200 million of 7.5% subordinated debentures which mature on December 1, 2008 and are classified as long-term debt on the Company’s consolidated balance sheet. These debentures are convertible to common shares at the option of the holder at any time prior to maturity date at a conversion price of $17.38 per common share, being a rate of 57.54 common shares for each $1,000 principal amount of debentures. If all of the subordinated debentures were converted by the holders, outstanding common shares would increase by 11.5 million shares. The 7.5% convertible subordinated debentures may not be redeemed by the Company prior to December 1, 2005. Subsequent to December 1, 2006, the Company may, at its option, redeem the debentures at any time to maturity through the issuance of common shares of the Company. The Company also has the right to deliver common shares to satisfy interest payments on the debentures.

The Company has reserved 7,261,457 common shares for issuance under its stock option plans. At January 31, 2005, 4,886,437 stock options were outstanding with 3,495,576 options exercisable. The options outstanding range in exercise price from $7.57 to $34.90. Refer to note 11 of the consolidated financial statements for details of stock options.

Off-Balance Sheet Arrangements Off-balance sheet arrangements, comprising the $900 million credit card receivable securitization, guarantees and derivative financial instruments, are described in the following commentary.

Credit Card Receivables Securitization Over the last eight years, the Company has sold, with limited recourse, $900 million of undivided co-ownership interests in its credit card receivables to independent Trusts under the Company’s securitization program. The Company indirectly benefits from the low funding costs incurred by the Trusts, which finance their ownership of undivided co-ownership interests by issuing highly rated commercial paper.

The undivided co-ownership interests purchased by the Trusts are created under co-ownership agreements. Under these agreements, the Company commits substantially all of its existing and future credit card receivables to the securitization program. The Company retains the unsold undivided co-ownership interest in the receivables. The aggregate outstanding amount of receivables under the securitization program varies depending on the volume of credit card transactions and payments.

Under the securitization program, the Company is permitted to sell undivided co-ownership interests up to the amount by which the amount of receivables satisfying certain eligibility criteria exceeds a required minimum retained interest amount. A portion of the current eligible receivables amount in excess of the $900 million of undivided co-ownership interests sold to the Trusts (in the range of 17% to 21% of the sold amounts), must be retained by the Company under the securitization program and cannot be sold by the Company. See consolidated financial statement note 3.

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The co-ownership agreements provide that the amount of the Company’s retained undivided co-ownership interest will be reduced to cover losses suffered as a result of credit card defaults, up to a specified amount. Accordingly, the Company incurs first losses on the receivables up to this amount before the Trusts incur any such losses.

Amortization events include covenant non-compliance by the Company (subject to applicable cure periods); Company insolvency events; a reduction in the aggregate amount of receivables below the minimum required amounts; a rating reduction of a Trust’s undivided co-ownership below specified rating levels (currently “AAA” in respect of each Trust); a rating reduction of the commercial paper issued by a Trust below specified rating levels (currently “R-1 (high)” for each Trust) as a consequence of the Trust’s ownership of the undivided co-ownership interests; or a failure of the receivables to meet certain minimum performance levels. 23 The scheduled liquidation commencement dates for the existing $900 million of undivided co-ownership interests sold to the Trusts are March 31, 2006 (as to $400 million), January 31, 2007 (as to $300 million) and January 31, 2007 or later under certain circumstances (as to $200 million). The liquidation of co-ownership interests would take a period of time to be completed. In the meantime, the Company may arrange for replacement financings by selling additional undivided co-ownership interests in the receivables pool or by issuing debt or through other financings, as described in the first paragraph of the financing activities section of the MD&A.

The Company currently manages the receivables and administers the credit card accounts included under the securitization program. In this role, the Company collects the receivables and applies amounts in accordance with the co-ownership agreements. To protect the Trusts in the event that certain adverse circumstances arise, including covenant non-compliance (subject to applicable cure periods); Company insolvency events; or Company rating reductions below specified minimums, a standby servicing arrangement has been established with a third party.

Guarantees The Company has guarantees and general indemnification commitments to counterparties which are disclosed in note 19 to the consolidated financial statements. Historically, the Company has not made any significant payments with respect to these guarantees and indemnification provisions, and Management believes that the risk of significant loss is low.

Derivative Financial Instruments Foreign exchange and floating rate interest rate risks are managed, as deemed appropriate, by forward rate agreements, interest rate swaps and caps under guidelines established and reviewed periodically by the Board of Directors of Hbc.

The Company enters into forward exchange contracts to lock in prices in Canadian dollars for future purchases of merchandise from foreign suppliers. As at January 31, 2005, the Company has US $20 million of outstanding foreign exchange contracts bought forward with settlement dates on these contracts in February and March 2005. All of these agreements have been made with Canadian chartered banks. The Company believes that its exposure to credit and market risks for these financial instruments is negligible.

Historically, the Company has purchased approximately $450 million in U.S. denominated purchases on an annual basis. Any income or loss on forward exchange contracts that are designated as hedges is treated as an adjustment to merchandise purchases. If the improvement of the Canadian dollar in fiscal 2004 continues into the following year, the Company’s product costs will continue to improve.

In addition, the Company has had in place a number of interest rate swap agreements in previous years. During 2004, the Company did not have any interest rate swap or cap agreements.

Additional financial information is disclosed in note 12 to the Company’s consolidated financial statements of the 2004 Annual Report.

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Management’s Discussion and Analysis

Capital Expenditures Capital expenditures, including software expenditures, were $213 million in 2004, $138 million in 2003 and $156 million in 2002. Of the 2004 capital expenditures, $60 million was incurred at the Bay, $124 million at Zellers and the majority of the remainder was invested in information systems.

In 2005, the Company expects to invest between $200 million and $260 million in capital expenditures. Zellers plans to open three new stores, expand six stores and renovate 19 stores. The Bay expects to open up to nine new Home Outfitters stores, six new Designer Depot stores, and complete the expansion of the Market Mall, Calgary store to 200,000 square feet. The Company will also commence the expansion of three stores in Ontario in Masonville, London and Newmarket, and one store in Guildford, B.C. and will renovate and downsize the Winnipeg Downtown store. The Company will continue to invest in critical information systems including the merchandise continuum infrastructure, a custom order fulfillment system, a gift registry system, and in the maintenance and upgrade of the existing information technology infrastructure. With the major systems investments made in prior years, technology investments in the future are expected to represent a lower percentage 24 of the total capital budget as more funds will be allocated to store expansions and renovations. The Company’s long-term strategies for each of its major retail divisions are to add profitable stores that improve market penetration and accessibility to its customers, and to renovate, enlarge and upgrade existing stores as required. The Company remains committed to continuing to expand in communities where there are suitable market opportunities and will close unprofitable or underperforming stores.

Retail Properties The number and aggregate gross areas in square feet of the Company’s retail stores and its distribution centres at the last three year-ends were as follows:

Number Square Feet (thousands)

2004 2003 2002 2004 2003 2002

Retail stores 547 562 556 47,358 48,193 47,875

Distribution centres 9 9103,507 3,507 3,622

The Bay’s and Zellers’ operating review sections describe the properties in each business. The Company also owns a chain of 103 small value-price general merchandise stores located in western Canada. In addition to those properties, the Company owns two distribution centres, the Zellers’ head office in Brampton and The Simpson Tower, a 32-floor office building in Toronto.

Total Taxes and Tariffs Over the last three years, the Company incurred taxes and tariffs totalling $301 million in 2004, $337 million in 2003 and $318 million in 2002. Of the $301 million incurred in 2004, 8.0% represented income taxes, compared to 13.1% in 2003 and 9.0% in 2002. The largest component of taxes and tariffs was charges by municipalities across Canada for realty and business taxes.

Risk Management Exposure to various risks is an integral part of carrying on business. The following table sets out major identified risk factors that are normal in the retail business and lists the principal external and internal Retail Risk Factors, grouped by five categories.

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Retail Risk Factors

Category External Internal

Financial Accounting standard changes Cash flow Capital risk Debt blend: fixed/floating, long-term/short-term Commodity prices Debt levels Financial instruments Occupancy costs Foreign exchange rates Rates charged on credit cards Interest rates Real estate portfolio Liquidity Taxes

Operational Consumer confidence Advertising strategy Consumer price sensitivity Asset management Marketing Business continuity plans 25 Natural disasters Change management Retail competitors Customer satisfaction Weather and other environmental factors Information reporting Inventory management Outsource management People management Technology Vendor management

Credit Credit card competitors Adjudication Default/settlement of customer accounts Measurement Economy Promotional strategies Rewards programs

Regulatory and Fiduciary Contractual arrangements Health and safety Fiduciary responsibilities Regulatory compliance

Strategic Acquisitions and divestitures Corporate reputation Government regulations and policies Brand protection Shareholder relations Corporate governance Societal changes Ethical merchandise sourcing Marketing strategies Risk tolerance Strategy implementation Succession planning

Competitive risk, the economy and consumer attitudes are each important risk factors which impact earnings. The Company monitors its market share and its place in the retail market, and adjusts strategy as appropriate. Typical adjustments might include re-locating stores, reviews of merchandise offerings or pricing, and changing marketing programs. While many competitors sell some of the same products as Hbc, no single retail chain covers the wide range of commodities that are sold in the Hbc family of stores. The Company has the option to change commodity allocation among store formats, and also within each store, in a relatively short time frame, as customer demand shifts, either nationally or in a particular market.

No company can fully protect against unknown events in the economy. Hbc sets budgeted inventory levels and promotional activity to be in accord with predicted Gross Domestic Product and consumer spending changes as well as strategic growth initiatives. Capital spending can be adjusted when retail sales growth changes.

Hbc, like most major retailers around the world, mitigates potential reputation risk through a program to monitor vendor partners with respect to compliance with fundamental human and labour rights in the manufacturing of goods sold by Hbc. Hbc has developed a Code of Vendor Conduct and a compliance verification program. Hbc

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Management’s Discussion and Analysis

requires all facilities manufacturing private brand merchandise sold in Hbc’s retail stores to be monitored for compliance with the Code by independent auditors.

In an era of increasing customer choice, corporate or brand reputation is assuming greater significance as a critical factor in evaluating the viability of retailers to attract and retain patrons. Trust has emerged as one of the attributes most often cited by consumers in evaluating their likelihood to shop with a retailer. The inputs into the reputation of a Company are varied and vast. Hudson’s Bay Company regularly monitors stakeholders’ assessment of the Company’s reputation through ongoing customer tracking studies and market research. The Company has a number of programs and procedures in place to ensure the reputation of Hbc is considered in conduct and response to issues or circumstances that give rise to scrutiny of the values and social responsibility considerations of Hudson’s Bay Company. These include product recall procedures; crisis and issue management protocols; the approach and disclosure of Company information in the Corporate Social Responsibility report released in conjunction with the Company’s Annual Report, as well as procedures and processes that govern all Company communication activities.

Public companies must ensure that all securities regulations are complied with and that appropriate corporate 26 governance practices are being followed throughout the Company. During 2004, and in early 2005, securities reg- ulators in Canada released a series of new rules and draft regulations to address investor confidence and uphold the reputation of Canada’s capital markets. The rules were adopted by the Canadian Securities Administrators (CSA). These rules, which are being phased in, closely parallel certain provisions of the Sarbanes-Oxley Act of 2002 in the United States. The rules require the Chief Executive Officer and Chief Financial Officer to certify their annual and interim filings, and also outline required criteria regarding audit committee practices. In an effort to increase transparency and accountability, Hbc is working to comply with the draft regulations proposed by the CSA. Over the past year, Hbc has commenced a comprehensive review of its key processes supporting disclosure and financial reporting. The review will support both the required certifications and the evaluation of internal control over financial reporting should the draft rules be approved.

Financial Services earnings comprise a significant portion of overall Hbc earnings. Bad debt expense and competition from other types of cards are the largest risks faced by the division. Hbc uses sophisticated software and behavioural scoring tables to manage bad debt risks. The Financial Services division meets card competition through in-store and other marketing programs, as well as by continuously improving the benefits available to cardholders.

Capital management risk, which involves Hbc’s access to capital markets and level of interest expense, is discussed under the financing activities and off-balance sheet arrangements sections of the MD&A. The Company must deal with foreign exchange risk because a significant portion of merchandise purchases are paid for in U.S. dollars; accordingly, unforeseen shifts in exchange rates impact the gross margin on imported goods. Hbc uses forward exchange contracts to reduce the impact of movements in the Canadian dollar.

The Company has a number of integrated programs in place to mitigate the financial impact from property losses or third party liability claims; each year Hbc reviews the level of risk that will be retained. These programs are secured by conventional insurance contracts. The total cost of risk management, including insurance premiums, fees, legal and self-retained losses, was approximately $18 million in 2004, $17 million in 2003 and $16 million in 2002.

Critical Accounting Estimates The Company’s significant accounting policies are described in note 1 to the consolidated financial statements. The Company’s discussion and analysis of its financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with Canadian generally accepted accounting principles. The preparation of these financial statements requires the Company to make estimates and judgements that affect the reported amounts of assets, liabilities, revenues and expenses. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances.

Some of the Company’s significant accounting policies involve a higher degree of judgement or complexity than its other accounting policies. The policies described below are considered to be critical accounting estimates, if they require significant estimation or judgement and a different estimate could have reasonably been used or changes in the estimate are reasonably likely to occur and if they can have a material impact on the Company’s financial condition, changes in financial condition or results of operations.

Inventory valuation Merchandise inventories are carried at the lower of cost and net realizable value less normal gross profit margins. The cost of inventories is determined principally on an average basis by the use of the retail inventory method.

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Under the retail inventory method, inventory is segregated into categories of merchandise having similar charac- teristics, and is initially stated at its current retail selling value. Inventory retail values are converted to a cost basis by applying specific average cost factors for each merchandise category. Cost factors represent the average cost- to-retail ratio for each merchandise category based on beginning inventory and the fiscal year purchase activity.

The valuation of merchandise inventories requires significant management judgement in certain areas, which can lead to different financial results. The areas requiring judgement include (1) setting the original retail value for the merchandise held for sale, (2) recognizing merchandise for which the customer’s perception of value has declined and appropriately marking the retail value of the merchandise down to the perceived value, and (3) esti- mating the shrinkage that has occurred between physical inventory counts, which are taken annually.

The judgements and estimates for the first two areas above are based on assumptions about anticipated demand, market conditions, customer preferences, and fashion trends. When a decision is made to permanently mark down merchandise, the resulting gross profit reduction is recognized in the period the markdown is recorded.

Shrinkage is estimated as a percentage of sales for the period from the last physical inventory count date to the 27 end of the fiscal period. Such estimates are based on experience and the most recent physical inventory results.

The accounting estimates used in the determination of inventory valuation have not changed significantly over the past two years.

Inventory valuation is determined at the Bay and Zellers segment levels. The assumptions used at each of the segments are specific to their situation. Each of the segments has different experiences for shrinkage, markdowns, and other factors. While the Bay has merchandise that is more predominantly susceptible to markdowns, Zellers is on the everyday lower pricing program, with a lesser need for markdowns.

Inventory and cost of sales are the most significant components of the consolidated balance sheet and consolidated statement of earnings, respectively. Any changes to assumptions can thus have a significant impact to both inventory and cost of sales.

Credit card receivables The Company recognizes gains or losses on transfers of receivables or interests in receivables that qualify as sales and recognizes as assets certain financial components that are retained as a result of such sales, which consist primarily of the retained rights to future interest income relating to the transferred assets.

The Company recognizes a gain or loss equal to the difference between the fair value of consideration to be received for the sale of receivables or interests in receivables and the allocated cost of the receivables or interests sold. Retained interests are initially recorded at an allocated carrying amount. Assumptions related to the future performance of the Company’s credit card portfolio have a significant impact on the calculation of the gain or loss on sale of the receivables and the carrying value of the retained interests.

The allocated cost of the receivables or interests in receivables sold and the allocated carrying amount of retained interests are estimated based upon the present value of the expected future cash flows, calculated using Management’s best estimates of key assumptions about yield, customer payment rates, net charge-off rates, securitization expense rates, and discount rates necessary to derive an estimate of fair value over the receivables’ expected life. The initial gain on sale of credit card receivables or interests in receivables is reduced by the fair value of the service liability estimated to manage the securitized portfolio.

Of the assumptions listed above, the following are the most sensitive. Any changes to these assumptions may impact the earnings recognized in connection with the transfer of receivables or interests in receivables. • The yield, or income generated by the receivables, is billed at a contractual rate monthly and does not require significant judgement or estimates. However, this is based on the expected balance of receivables, which is affected by the expected credit card customer payment rate. The estimate of payment rates is based on historical payment rates. However, if actual payments are significantly different than expected payments, the gains or losses can be expected to change from period to period. • Net charge-off rates, or bad debt, expected from the sold receivables are based on recent write-off trends. To the extent there are positive or negative factors affecting the customers’ ability or intent to pay off the outstanding balance (e.g. level of consumer debt, unemployment rates, etc.), the actual bad debts realized could exceed or be less than the amounts estimated.

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Management’s Discussion and Analysis

Any adverse changes to assumptions can have a material impact on retained interests, including the retained rights to future interest income from the serviced assets.

Refer to note 3 of the annual consolidated financial statements for an analysis of the sensitivity to adverse changes in the assumptions.

The Company does not believe that there are any trends that will materially impact the methodology or assumptions used in determining gains or losses from credit card securitization.

The assumptions used to account for the securitization of accounts receivable have not changed significantly from the initial application of the accounting standard in July 2001.

The assumptions used to determine securitization gains and losses are different between the banners, reflecting the demographics of their customer base. The Bay tends to have a lower yield, higher customer payment rates 28 and lower charge-off rates than does Zellers. Any gains or losses on the sale of securitized accounts receivable are reflected in the earnings before interest and income taxes, for both the Bay and Zellers, and can be material. Retained interests are included as part of credit card receivables in the consolidated balance sheets, while the service liability is included in other accounts payable and accrued liabilities.

Hbc Rewards Hbc Rewards is a loyalty program which allows enrolled card members to earn points that can be redeemed for a broad range of catalogue merchandise offers and other non-merchandise redemption offers. The Company establishes provisions to cover the cost of future redemptions of Hbc Rewards points based upon points outstanding that are ultimately expected to be redeemed by card members and the expected weighted average cost per point of redemption.

The ultimate points to be redeemed are based on many factors, including a review of past behaviour of card members by year of enrollment and future expected growth. Past behaviour is used to estimate the ultimate redemption rate of current card members. The weighted average cost per point of redemption is based on the expected point redemption patterns and their related costs.

In addition, the cumulative balance sheet liability for unredeemed points is adjusted over time based on actual redemption and cost experience as well as current trends with respect to redemptions. The liability for the Hbc Rewards program is included in other accounts payable and accrued liabilities in the consolidated balance sheets.

The liability associated with Hbc Rewards is significant. To the extent that the estimates differ from actual experience, the Hbc Rewards program cost could be higher or lower, as applicable. If the behaviour patterns change materially from the estimate used to determine the liability, this can affect income or loss. The cost of the Hbc Rewards program is allocated to each of the Bay and Zellers.

The estimates used to determine the Hbc Rewards liability can change over time, based on actual experience. In the past year, Hbc has changed some of the assumptions used to determine the liability to better reflect actual experience.

Income taxes Income taxes are determined using the asset and liability method of accounting. This method recognizes future tax assets and liabilities that arise from differences between the accounting basis of the Company’s assets and liabilities and their corresponding tax basis. Future taxes are measured using income tax rates expected to apply when the asset is realized or the liability settled. Certain assumptions are required in order to determine the pro- vision for income taxes, including the resolution of tax disputes and the realization of future tax assets.

The Company currently has future tax assets resulting from non-capital loss carry forwards, which will reduce tax- able income in the future. The Company assesses the realization of these future tax assets on a quarterly basis, to determine whether an income tax valuation allowance is required. Based on available information, the Company determines whether it is more likely than not that all or a portion of the remaining net future tax assets will be realized. The main factors considered in making this determination include expected future earnings determined through the use of internal forecasts, cumulative losses in recent years, the carry forward period associated with the future tax assets, and the nature of the income that can be used to realize the future tax asset. If actual experience were to differ from the Company’s estimate, future increases or decreases in the benefit of non-capital loss carry forwards

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could occur. Any changes in estimate would affect the income tax expense and the future tax assets shown in the consolidated statements of earnings and consolidated balance sheets, respectively. For the fiscal year ended January 31, 2005, the current portion of future tax assets recognized in the consolidated balance sheets amounted to $20 million, and is included in prepaid expenses and other current assets.

The Company is audited regularly by federal and provincial authorities in the areas of income taxes and the remit- tance of sales taxes. These audits consider the timing and amount of deductions and compliance with federal and provincial tax laws. In evaluating the exposures associated with various filing positions, the Company accrues charges for probable exposures. To the extent the Company were to prevail in matters for which accruals have been established or be required to pay amounts in excess of accruals, the Company’s effective tax rate in a given financial statement period could be materially affected.

For fiscal year ended January 31, 2005, the non-current portion of future income tax liability recognized in the consolidated balance sheets was $158 million.

Employee future benefits 29 The Company's pension asset and future benefits other than pension obligation and expense are dependent on the assumptions used in calculating these amounts. The assumptions are determined by management and are reviewed annually by management and its actuaries. These assumptions include the discount rate, the rate of compensation increase, the overall health care cost trend rate and the expected long-term rate of return on plan assets. Actuarial assumptions for mortality and employee turnover rates are based on standard tables, adjusted as necessary to reflect the Company’s experience in prior years, and reflecting actual provisions in the benefit plans. Expected trends in rates used are considered when determining the assumptions. Differences between actual experience and the assumptions made by management will result in increases or decreases in the Company's pension and future benefits expense in future years.

All costs relating to employee future benefits are allocated to the banners. There have been no significant changes to the assumptions used in determining the pension and future benefits obligation and expense over the past two fiscal years.

The current portion of the accrued benefit liability for non-pension benefit plans is included in other accounts payable and accrued liabilities in the consolidated balance sheets. The non-current portion of this liability has its own caption, as does pensions, in the consolidated balance sheets. See note 6 to the Company’s consolidated financial statements for more details on employee future benefits, as well as sensitivity analysis on certain assumptions for employee future benefits other than pensions.

The following table discloses the impact on earnings of a 1% increase or decrease in the following assumptions used to determine the pension obligation and expense. Effect of 1% change – expense (income)

Assumption (millions of dollars) Increase Decrease

Rate of return on plan assets (8) 8

Discount rate (3) 5

Compensation rate 3 (2)

Assessment of impairment of long-lived assets The Company’s long-lived assets consist mainly of fixed assets, deferred assets and goodwill. Long-lived assets are reviewed by the Company whenever events or changes in circumstances indicate that their carrying values are not recoverable, resulting in a potential impairment. A potential impairment has occurred if the projected future undiscounted cash flows are less than the carrying value of the assets. When this is the case, the impairment loss is measured as the excess of the carrying value of the assets over its fair value, which is determined as the present value of the cash flows being generated from the assets. The evaluation is performed for the lowest level of a group of assets and liabilities with identifiable cash flows that are independent of those of other assets and liabilities.

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Management’s Discussion and Analysis

The recoverability assessment requires judgement and estimates for future stores’ generated cash flows. The underlying estimates for cash flows include estimates for future sales, gross margin rates and store expenses, and are based upon the stores’ past and expected future performance.

In accordance with generally accepted accounting principles, the Company no longer amortizes goodwill. The Company performs an annual impairment review of goodwill, unless more frequent reviews are required as a result of specific events or circumstances. The assessment of recoverability requires management to make judgements and estimates regarding fair values.

To the extent that management’s estimates are not realized, future assessments could result in impairment charges. The Company does not believe that there are any trends that will materially impact the methodology or assumptions used in determining the recoverability of long-lived assets.

Fixed assets and goodwill make up a significant amount of the Company’s total assets. To the extent that there is a significant change to the Company’s assumptions, there may potentially be a significant impact on the bal- 30 ance sheet and income statement.

The assessments are done at the store level for the Bay and Zellers. Corporate assets are also assessed. The estimates are based on circumstances specific to each of the areas.

Recently Issued Accounting Pronouncements New accounting standards adopted in fiscal 2004 Financial Instruments – Presentation and Disclosure The CICA has amended the standards on presentation of financial instruments. The amendment will require obligations that must or can be settled by delivery of a number of the issuer’s own equity instruments, where the number depends on the amount of the obligation, to be presented as liabilities. The amendment is effective for years beginning on or after November 1, 2004. The Company has adopted the new accounting treatment in the fourth quarter of fiscal 2004. In accordance with the accounting standard, the new accounting treatment was applied retroactively, and all prior year figures have been restated. At January 31, 2005, the Company reclassified $180 million of its outstanding convertible unsecured subordinated debentures, plus related accretion of $7 million, from Shareholders’ Equity to long-term debt. This change has resulted in additional interest expense of $19 million and $18 million for the years ended January 31, 2005 and 2004, respectively. There was no impact to earnings per share as the subordinated debenture dividends and related accretion have always been deducted from net earnings in the calculation of earnings per share.

Hedging Relationships Effective February 1, 2004, the Company adopted the new CICA Accounting Guideline 13, Hedging Relationships. This guideline addresses the identification, documentation, designation and effectiveness of hedging transactions for the purpose of applying hedge accounting. Under the new guideline, the Company is required to document its hedging transactions and demonstrate the effectiveness of the hedge in order to continue hedge accounting. If the instruments do not meet the hedging criteria, then the accounting should be in accordance with the EIC Abstract No. 128, Accounting for Trading, Speculative or Non-Hedging Derivative Financial Instruments, which requires that the instruments be recorded on the balance sheet at fair values with any changes in their fair values recognized in income in the period in which the change occurs. The adoption of the new accounting standard did not have a material impact on the results of operations or financial position for the year ended January 31, 2005.

Impairment of Long-lived Assets Effective February 1, 2004, the Company adopted the new CICA Handbook Section 3063, Impairment of Long- lived Assets. This accounting standard establishes principles for the recognition, measurement and disclosure of the impairment of long-lived assets. The new accounting standard outlines the impairment process and defines the impairment loss as being measured as the excess of the carrying value of the asset over its fair value. The evaluation is performed for the lowest level of a group of assets and liabilities with identifiable cash flows that are independent of those of other assets and liabilities. The adoption of the new accounting standard did not have a material impact on the results of operations or financial position for the year ended January 31, 2005.

Accounting for Consideration Received from Vendors Effective August 1, 2004, the Company adopted the new EIC guidance in Abstract No. 144, “Accounting by a Customer (including a Reseller) for Certain Consideration received from a Vendor” on a retroactive basis. The

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abstract establishes a presumption that cash consideration received from vendors is a reduction of the prices of the vendors’ products and services, and should be treated as a reduction of cost of sales and related inventory when recognized in a company’s income statement and balance sheet. Consideration received from vendors can be characterized as a reduction of expenses only if the amount received represents a reimbursement of specific, incremental and identifiable costs incurred by the customer in selling the vendors’ products or services. The abstract must be applied retroactively for annual and interim periods ending after August 15, 2004.

In accordance with the Company’s previous accounting policy, certain amounts received from vendors were recorded directly as a reduction of expenses in the Company’s earnings. However, under the new accounting guidance, with certain exceptions, these amounts are now recorded as a reduction of the prices of the vendors’ products and services.

As a result of adopting EIC 144 and its related implications, net earnings for the year ended January 31, 2005 decreased by $3 million and net earnings for the year ended January 31, 2004 increased by $5 million. The adoption of the abstract also resulted in a decrease to basic and diluted earnings per share of $0.05 for the year ended January 31, 2005 and an increase to basic and diluted earnings per share of $0.07 for the year ended 31 January 31, 2004.

Variable Interest Entities The CICA has issued guidance on accounting for variable interest entities, titled Accounting Guideline 15, Consolidation of Variable Interest Entities. The Company has adopted the accounting guideline, effective November 1, 2004. The Accounting Guideline provides guidance on consolidation and disclosure of variable interest entities. The Company has assessed the impact of the accounting guideline, and determined that the Company is not a primary beneficiary of any variable interest entities, and accordingly there was no impact from the adoption of this standard.

New accounting standards not yet adopted New standards which may impact the Company in 2005 are:

Accounting by a Purchaser for a Vendor Rebate EIC Abstract No. 144 has been amended to include guidance on how to account for those types of rebates that are payable only if the customer completes a specified cumulative level of purchases or remains a customer for a specified period of time. When there is a binding agreement with a vendor that requires payment of these types of rebates, the rebates should be recognized as a reduction of the cost of purchases for the period, provided it is probable and reasonably estimable. The amount recorded should be based on the estimated amount of the rebate that is expected to be received for the underlying transactions that have occurred and that result in progress towards achieving the specified requirement. The amendment is effective for annual and interim periods commencing on or after February 15, 2005. The new guidance should only impact the volume of vendor rebates recognized in the interim periods; however, there should be no impact on earnings for the fiscal year. Hbc is currently assessing the impact on the interim periods of this new guidance.

Earnings per Share The CICA has proposed changes to the earnings per share accounting standard, which will change the method of calculating incremental shares to be included in diluted earnings per share under the treasury stock method, as well as require the inclusion in the basic earnings per share calculation, of shares to be issued on a manda- torily convertible instrument. It is expected that the changes will be effective for fiscal 2005. The proposed changes are not expected to have an impact on Hbc’s earnings per share.

Forward-Looking Statements This report contains statements about expected future events that are forward-looking and subject to risks and uncertainties. Accordingly, Hbc’s actual results, performance or achievements could differ materially from those expressed or implied by such statements, and such statements are qualified in their entirety by the inherent risks and uncertainties surrounding future expectations. These statements do not reflect the potential impact of any acquisitions, mergers or divestitures completed after the date of issuance of this report. In addition, factors that could cause actual results to differ materially from future expectations are the following: general business and economic conditions in Canada and competition within the Canadian retail industry generally.

Additional Information Additional information, including the Annual Information Form, is available on SEDAR at www.sedar.com.

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Management’s Statement on Financial Reporting

The Management of Hudson's Bay Company is responsible for the preparation, presentation and integrity of the consolidated financial statements contained on pages 34 to 36 of this Annual Report and of financial information, discussion and analysis consistent therewith, presented on other pages. The accounting principles which form the basis of the consolidated financial statements and the more significant accounting policies applied are described in note 1 on page 37. Where appropriate and necessary, professional judgments and estimates have been made by Management in preparing the consolidated financial statements.

In order to meet its responsibility, Management has established a code of business conduct and maintains accounting systems and related internal controls designed to provide reasonable assurance that assets are safe- guarded and that transactions and events are properly recorded and reported. An integral part of these controls 32 is the maintenance of programs of internal audit coordinated with the programs of the external auditors. Ultimate responsibility for financial reporting to shareholders rests with the Board of Directors. The Audit Committee of the Board, all members of which are outside and unrelated directors, meets quarterly with Management and with the internal and external auditors to review audit results, internal accounting controls and accounting principles and procedures. Internal and external auditors have unlimited access to the Audit Committee. The Audit Committee recommends to the Board the accounting firm to be named in the resolution to appoint auditors at each annual meeting of shareholders. The Audit Committee reviews the consolidated financial statements and the other contents of the Annual Report with Management and the external auditors and reports to the directors prior to their approval for publication.

KPMG LLP, independent auditors appointed by the shareholders, express an opinion on the fair presentation of the consolidated financial statements. They meet regularly with both the Audit Committee and Management to discuss matters arising from their audit. The Auditors’ Report to the Shareholders is presented on the following page.

“George Heller” “Michael Rousseau”

George Heller Michael Rousseau President and Chief Executive Officer Executive Vice-President and Chief Financial Officer

Toronto, Canada March 10, 2005

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Auditors’ Report to the Shareholders

We have audited the consolidated balance sheets of Hudson’s Bay Company as at January 31, 2005 and January 31, 2004, and the consolidated statements of earnings, retained earnings and cash flows for the years then ended. These financial statements are the responsibility of the Company’s Management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with Canadian generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance 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.

In our opinion, these consolidated financial statements present fairly, in all material respects, the financial posi- 33 tion of the Company as at January 31, 2005 and January 31, 2004 and the results of its operations and its cash flows for the years then ended in accordance with Canadian generally accepted accounting principles.

“KPMG”

KPMG LLP Chartered Accountants

Toronto, Canada March 10, 2005

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Consolidated Financial Statements

Consolidated Statements of Earnings

2005 2004 Restated – Years ended January 31 (thousands of dollars except per share amounts) Notes Note 2

Sales and revenue The Bay 2,681,587 2,689,478 Zellers 4,301,128 4,519,706 Other 87,021 85,881

7,069,736 7,295,065

Earnings before interest expense and income taxes The Bay 67,856 75,778 34 Zellers 84,644 126,257 Other (23,133) (37,388)

129,367 164,647 Interest expense 16 (45,681) (60,962)

Earnings before income taxes 83,686 103,685 Income taxes 4 (23,948) (43,732)

Net earnings 59,738 59,953

Earnings per share – basic 17 $ 0.86 $ 0.87

Earnings per share – diluted 17 $ 0.86 $ 0.86

(See accompanying notes to the Consolidated Financial Statements)

Consolidated Statements of Retained Earnings

2005 2004 Restated – Years ended January 31 (thousands of dollars) Notes Note 2

Retained earnings at beginning of year, as reported 772,904 740,853 Impact of new accounting standards – consideration received from vendors 2 (63,904) (68,789) – reclassification of convertible debentures 2 (5,730) (5,509) Lease accounting adjustment 2 (19,825) (18,117)

Retained earnings at beginning of year, as restated 683,445 648,438 Net earnings 59,738 59,953 Dividends – common shares (24,963) (24,946)

Retained earnings at end of year 718,220 683,445

(See accompanying notes to the Consolidated Financial Statements)

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Consolidated Balance Sheets

2005 2004 Restated – January 31 (thousands of dollars) Notes Note 2

Current assets Cash in stores 7,713 8,033 Short-term deposits 254,908 168,943 Credit card receivables 3 427,443 538,734 Other accounts receivable 119,497 64,811 Merchandise inventories 1,412,320 1,386,097 Prepaid expenses and other current assets 65,439 115,086 2,287,320 2,281,704 35 Fixed assets 5 1,049,505 1,058,789 Goodwill 1(i) 143,215 152,294 Pensions 6 365,196 365,175 Other assets 7 163,585 164,074

4,008,821 4,022,036

Current liabilities Short-term borrowings 9 124,710 1,309 Trade accounts payable 417,376 415,350 Other accounts payable and accrued liabilities 455,699 520,581 Long-term debt due within one year 9 101,660 125,436

1,099,445 1,062,676 Long-term debt 9 492,622 567,882 Employee future benefits other than pensions 6 57,964 59,112 Future income taxes 4 158,126 167,328 Shareholders’ equity Capital stock 10 1,402,756 1,402,563 Convertible debentures 9 20,000 20,000 Contributed surplus 59,688 59,030 Retained earnings 718,220 683,445

2,200,664 2,165,038

4,008,821 4,022,036

(See accompanying notes to the Consolidated Financial Statements)

On behalf of the Board:

“L. Yves Fortier” “James B. Hume”

L. Yves Fortier, C.C., Q.C. James B. Hume Director Director

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Consolidated Financial Statements

Consolidated Statements of Cash Flows

2005 2004 Restated – Years ended January 31 (thousands of dollars) Notes Note 2

Operating activities Earnings before income taxes 83,686 103,685 Net cash income taxes (18,454) (4,348) Items not affecting cash flows: Amortization 15 190,669 198,768 Pension expense (credits) 5,500 (4,000) Net loss (gain) on sale of credit card receivables 3 4,373 (980) Accretion of convertible debentures 2,601 2,371 36 Gain on sale of fixed assets (11,835) – Net change in operating working capital 13 10,974 81,625

Net cash inflow from operating activities 267,514 377,121

Investing activities Capital expenditures (189,982) (114,830) Disposition of fixed assets 60,110 66,151 Other assets (12,068) (17,775) Repurchase of credit card receivables 3 – (300,000) Sale of credit card receivables 3 – 300,000 Miscellaneous (10,879) (8,009)

Net cash outflow for investing activities (152,819) (74,463)

Net cash inflow before financing activities 114,695 302,658

Financing activities Long-term debt: Issued – 340,000 Redeemed (126,077) (478,870)

(126,077) (138,870) Increase (decrease) in short-term borrowings 9 123,401 (23,435) Capital stock: Common shares issued 10 371 556 Common shares purchased for cash and cancelled 10 (148) – Dividends paid – common shares (24,963) (24,946)

Net cash outflow for financing activities (27,416) (186,695)

Increase in cash and cash equivalents 87,279 115,963 Cash and cash equivalents at beginning of year 153,521 37,558

Cash and cash equivalents at end of year 240,800 153,521

January 31 (thousands of dollars) 2005 2004

Short-term deposits 254,908 168,943 Less: restricted funds (14,108) (15,422)

Cash and cash equivalents at end of year 240,800 153,521

(See accompanying notes to the Consolidated Financial Statements)

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 37

Notes to Consolidated Financial Statements

Years ended January 31, 2005 and January 31, 2004

Note 1. Accounting Principles and Policies

These consolidated financial statements have been prepared by Management in accordance with accounting principles generally accepted in Canada. The significant accounting policies are as follows:

(a) Fiscal year The Company reports its year end as January 31. Retail sales and related activities are reported on a retail calendar basis ending on the nearest Saturday prior to January 31. The year ended January 31, 2005 contains 52 weeks and the year ended January 31, 2004 contains 53 weeks. 37 (b) Foreign currency translation Foreign currency assets and liabilities are translated into Canadian dollars at exchange rates in effect at the balance sheet dates.

Foreign currency costs and earnings are translated into Canadian dollars at exchange rates in effect at the time they are incurred or earned.

(c) Income taxes Income taxes are determined using the asset and liability method of accounting. This method recognizes future tax assets and liabilities that arise from differences between the accounting basis of the Company’s assets and liabilities and their corresponding tax basis. Future taxes are measured using tax rates expected to apply when the asset is realized or the liability settled.

(d) Credit card receivables Credit card receivables, of which a portion will not become due within one year, are classified as current assets. They represent open-ended revolving credit card customer accounts and are shown after deducting an allowance for doubtful accounts. Revenue earned on credit card receivables is accrued at the end of each billing cycle based on revolving outstanding receivable balances.

The Company recognizes gains or losses on transfer of receivables that qualify as sales and recognizes as assets certain financial components that are retained as a result of such sales, which consist primarily of the retained interest in receivables sold and the retained rights to future interest income from the serviced assets. Retained interests are initially recorded at an allocated carrying amount, which is estimated based upon the present value of the expected future cash flows, calculated using Management’s best estimates of key assumptions about account repayment rates, securitization interest expense rates, discount rates and other factors necessary to derive an estimate of fair value over the receivables’ expected life of 19 months. Subsequently, retained interests are evaluated for other than temporary impairments. The initial gain on the sale of credit card receivables is reduced by the fair value of the service liability estimated to manage the securitized portfolio.

(e) Cash and cash equivalents Cash and cash equivalents consist of short-term deposits with maturities of less than three months and exclude restricted funds. Cash in stores is considered restricted, as it is required as a cash float for store operations.

(f) Merchandise inventories Merchandise inventories are carried at the lower of cost and net realizable value less normal gross profit margins. The cost of inventories is determined principally on an average basis by the use of the retail inventory method.

(g) Fixed assets Fixed assets are carried at cost. The costs of buildings and equipment are amortized on the straight-line method over their estimated useful lives. The cost of property for sale or development is not amortized, since it represents either land or vacant properties.

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Notes to Consolidated Financial Statements

The amortization periods applicable to building and equipment are as follows:

Asset Amortization Periods

Buildings 20–40 years 1 Equipment 3–12 /2 years Equipment held under capital leases 5–8 years

Long-lived assets are reviewed for impairment when events or circumstances indicate that their carrying value exceeds the sum of the undiscounted cash flows expected from their use and eventual disposition. The evaluation is performed for the lowest level of a group of assets and liabilities with identifiable cash flows that are independent of those of other assets and liabilities. An impairment loss, if required, is measured as the excess of the carrying value of the asset over its fair value. This policy was adopted effective February 1, 2004 (see note 2 (f)). 38 (h) Leased premises The Company conducts a substantial part of its business from leased premises (see note 14).

Leasehold improvements are amortized over the lesser of their economic life or the “lease term”, representing the initial lease term and including renewal periods only where renewal has been determined to be reasonably assured. At January 31, 2005, the average amortization period was approximately 12 years. During the year ended January 31, 2005, the Company has changed its accounting practices and restated its results for the year ended January 31, 2004 (see note 2(c)).

Leasehold improvements are reviewed for impairment, and impairment losses are measured, as described in note 1(g).

The Company also uses this lease term to evaluate whether its leases are operating or capital leases. At January 31, 2005 and 2004, all of the Company’s leases on premises were accounted for as operating leases.

Inducements received from landlords, including leasehold improvement allowances, are amortized over the lease term (as defined above).

Total rent to be paid over the lease term (as defined above) is amortized on a straight-line basis over the lease term. Accordingly, reasonably assured rent escalations (or step rent increases) are amortized over the lease term, and free rent periods are allocated a portion of rent expense.

(i) Goodwill Goodwill comprises the unamortized balance of the excess of the cost to the Company over the fair value of its interest in the identifiable net assets of Zellers Inc., Towers Department Stores Inc. and Kmart Canada Co. at their respective dates of acquisition.

Goodwill is not amortized. On an annual basis, the Company evaluates and, if necessary, adjusts goodwill for any impairment.

During the year ended January 31, 2005, the Company reduced goodwill in the amount of $9,079,000 as a result of the utilization of previously unrecorded acquisition tax losses.

(j) Employee future benefits The Company maintains both defined contribution and defined benefit (including career and final average earnings formulas) pension plans.

Employee future benefits other than pensions represent medical and dental care and life insurance commitments to certain employees and retirees of acquired companies, long- and short-term disability payments and compen- sated absences. The Company accrues its obligations under these plans net of any plan assets. Certain of the defined benefit pension plans are subject to periodic increase adjustments to their pension benefits.

The most recent actuarial valuation of the principal pension plan for funding purposes was as at January 1, 2004. The next actuarial valuation of the principal pension plan for funding purposes will be due as at a date no later than January 1, 2007. The most recent actuarial valuation of the non-pension post-retirement benefits was as at July 1, 2003 and of the post-employment benefits was as at September 30, 2004. For reporting purposes, assets and liabilities are measured as at December 31.

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The accrued benefit obligations for the defined benefit plans have been determined using the projected benefit method pro-rated on services, including the impact of future salary escalation, based on Management’s best estimate of discount rates, salary escalation and retirement ages of employees. For benefit expense purposes, a market-related value of assets and Management’s best estimate assumption of investment returns have been used to determine the expected return on plan assets.

Actuarial gains and losses related to both assets and liabilities are amortized on a straight-line basis over the expected average remaining service lifetime of the membership to the extent that they exceed 10% of the greater of the accrued benefit plan obligation and the market-related value of the benefit plan assets. Past service costs and transitional assets are amortized on a straight-line basis over the expected average remaining service lifetime of affected members.

With respect to the defined contribution plans, the expense is equal to the Company contribution.

(k) Other assets Other assets include systems development costs which are amortized on the straight-line method over periods 39 of up to seven years.

(l) Hbc Rewards Hbc Rewards is a loyalty program that allows enrolled cardmembers to earn points that can be redeemed for a broad range of catalogue merchandise offers and other non-merchandise redemption offers. The Company establishes a liability to cover the cost of future redemptions of Hbc Rewards points at the time of sale when the points are earned by cardmembers. The liability is based upon points outstanding that the Company estimates will be redeemed by cardmembers and the expected weighted average cost per point of redemption.

The estimated points expected to be redeemed are based on many factors, including a review of past behaviour of cardmembers by year of enrollment and future expected growth. The liability for the Hbc Rewards program is included in other accounts payable and accrued liabilities in the Consolidated Balance Sheets.

(m) Vendor allowances The Company receives cash or allowances from vendors, the most significant of which are in respect of markdown allowances, volume rebates, and advertising and marketing. The Company has retroactively adopted the new Canadian Institute of Chartered Accountants (CICA) Emerging Issues Committee Abstract No. 144, as described in note 2(a), which affected the accounting for vendor allowances. In accordance with the abstract, subject to certain exceptions, these amounts are now recorded as a reduction of the prices of vendors’ products. The exceptions include markdown allowances, which are applied to reduce cost of sales only if they meet the specific, incremental and identifiable cost criteria discussed in note 2(a).

Rebates that are based on purchase volumes are recognized only when earned and applied against the cost of inventory.

(n) Stock-based compensation plans The Company has six active stock-based compensation plans, as described in note 11. Compensation expense is recorded under the stock ownership plan, the share appreciation rights agreement and the phantom stock plan.

In accordance with generally accepted accounting principles, the Company applies the fair value-based method to all stock options granted on or after February 1, 2003. Accordingly, compensation cost is measured at fair value at the date of grant and is expensed over the vesting period.

The Company continues to use settlement accounting to account for stock options granted prior to February 1, 2003. No compensation expense has been recorded for the stock options granted during this period. Transactions under these plans are reflected in the financial statements only upon exercise of the options, at the exercise price. Consideration paid by employees on the exercise of stock options is recorded as share capital. The Company provides additional note disclosure, which presents, on a pro-forma basis, certain financial data determined using the fair value-based method of accounting for stock options (see note 11).

(o) Off-balance sheet financial instruments To hedge its interest rate risks, the Company utilizes interest rate swaps and caps, as deemed appropriate. To hedge its foreign exchange risks, the Company utilizes forward foreign exchange contracts. Foreign currency is purchased at a foreign exchange rate established by these contracts, at a predetermined date.

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Notes to Consolidated Financial Statements

The Company documents its hedging transactions and demonstrates the effectiveness in order to treat these instruments as hedges for accounting purposes. Gains or losses on settlement of forward foreign exchange contracts are recorded as part of the cost of the hedged item, generally merchandise inventories. Amounts paid or received in respect of interest rate swaps are recorded as an adjustment to interest expense. The cost of interest rate caps are amortized over their terms and recorded as an adjustment to interest expense. Unrealized gains and losses on these instruments are not recorded.

If the instruments do not meet the hedging criteria, then the instruments are recorded on the balance sheet at fair values with any changes in their fair values recognized in income in the period in which the change occurs.

The Company has met the hedging criteria for the forward foreign exchange contracts, and is thus applying hedge accounting in accordance with the new CICA Accounting Guideline 13 (see note 2(g)).

(p) Use of estimates The preparation of financial statements in conformity with Canadian generally accepted accounting principles 40 requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the year. These estimates and assumptions are based on Management’s historical experience, knowledge of current events and conditions and activities that the Company may undertake in the future. Certain estimates, such as inventory valuation, credit card receivables, employee future benefits, Hbc Rewards, income taxes, and assessment of impairment of long-lived assets, depend upon subjective or complex judgments about matters that are uncertain and changes in those estimates could materially impact the consolidated financial statements. Management reviews these estimates on an on-going basis.

(q) Comparative figures Where necessary, certain of last year’s figures have been reclassified to conform with this year’s presentation. Also, other comparative figures have been restated due to new accounting requirements and to the lease accounting change, as discussed in note 2.

Note 2. Accounting Changes

a) Consideration received from vendors Effective August 1, 2004, the Company adopted, on a retroactive basis, the new CICA Emerging Issues Committee Abstract No. 144, Accounting by a Customer (including a Reseller) for Certain Consideration received from a Vendor. The abstract establishes a presumption that cash consideration received from vendors is a reduction of the prices of the vendors’ products and services, and should be treated as a reduction of cost of sales and related inventory when recognized in a company’s income statement and balance sheet. Consideration received from vendors can be characterized as a reduction of expenses only if the amount received represents a reimbursement of specific, incremental and identifiable costs incurred by the customer in selling the vendors’ products or services.

Previously, in accordance with the Company’s accounting policy, certain amounts from vendors were recorded directly as a reduction of expenses in the Company’s Consolidated Statements of Earnings. However, under the new accounting guidance, subject to certain exceptions, these amounts are now recorded as a reduction of the prices of vendors’ products.

As a result of adopting EIC 144 and its related implications, net earnings decreased by $3.1 million, and basic and diluted earnings per share decreased by $0.05 for the year ended January 31, 2005. It has also resulted in a decrease to merchandise inventories of $103.0 million for the year ended January 31, 2005.

Comparative figures for the year ended January 31, 2004 have been restated to reflect the retroactive adoption of this abstract, as follows: net earnings and basic and diluted earnings per share for the year ended January 31, 2004 was increased by $4.9 million, $0.07 and $0.07, respectively, retained earnings as at February 1, 2004 and 2003 was decreased by $63.9 million and $68.8 million, respectively, and merchandise inventories as at January 31, 2004 was decreased by $99.0 million.

b) Reclassification of convertible debentures The CICA has amended the current accounting standard, Financial Instruments – Presentation and Disclosure, Handbook Section 3860. The amended guidance is effective for fiscal years beginning on or after November 1, 2004, and retroactive application is required. However, the Company has elected to adopt the amended guidance for the fiscal year ended January 31, 2005. The amended standard requires that securities giving the issuer

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 41

the unrestricted right to settle the principal amount in cash or in the equivalent value of its own equity instruments no longer be presented as equity.

As a result of the new amended guidance, the Company has reclassified the liability element of the convertible debentures of $180 million, along with the related accumulated accretion of $7.4 million as at January 31, 2005 and $4.8 million as at January 31, 2004, from shareholders’ equity to long-term debt. The adoption of the new guidance has also resulted in an increase to interest expense of $18.5 million for the year ended January 31, 2005, and had no impact on basic earnings per share as the interest had always been deducted from net earnings to determine earnings per share. The retroactive adoption has also resulted in an increase to interest expense of $18.3 million for the year ended January 31, 2004, with no impact on basic and diluted earnings per share. The adoption has resulted in an adjustment to opening retained earnings as at February 1, 2004 and 2003 of $5.7 million and $5.5 million, respectively.

c) Leased premises – accounting change Following the recent clarification of appropriate accounting policies under generally accepted accounting principles in the United States, the Company has reviewed its lease accounting practices and concluded that 41 adjustments were necessary to present its financial position and results of operations in accordance with Canadian generally accepted accounting principles. Accordingly, the Company has restated earnings for the year ended January 31, 2004 and retained earnings as at February 1, 2003 and 2004.

For the year ended January 31, 2005, the correction has resulted in a decrease to net earnings of $3.0 million, and to basic and diluted earnings per share of $0.04. For the year ended January 31, 2004, the retroactive adjustment has resulted in a decrease to net earnings of $1.7 million, to basic earnings per share of $0.02 and to diluted earnings per share of $0.03. The net book value of fixed assets was reduced by $35.2 million and $30.5 million for the years ended January 31, 2005 and 2004, respectively. Retained earnings was adjusted by $19.8 million and $18.1 million at February 1, 2004 and 2003, respectively.

The restatement was required because the Company determined that the amortization period previously being used for leasehold improvements was longer than the lease term, as defined in note 1(h).

d) Variable interest entities The CICA has issued guidance on accounting for variable interest entities, titled Accounting Guideline 15, Consolidation of Variable Interest Entities. The Company has adopted the accounting guideline, effective November 1, 2004. The Accounting Guideline provides guidance on consolidation and disclosure of variable interest entities. The Company has assessed the impact of the accounting guideline, and determined that it is not the primary beneficiary of any variable interest entities.

As described in note 3, the Company has sold, with limited recourse, $900 million of undivided co-ownership interests in its credit card receivables to independent Trusts under the Company’s securitization program. These multi-seller Trusts held investments in various assets which were acquired from the Company and other entities, including credit card receivables and leases.

e) Generally accepted accounting principles Effective February 1, 2004, the Company adopted the new CICA accounting standard 1100, Generally Accepted Accounting Principles (“GAAP”). The new standard clarifies what constitutes Canadian GAAP, identifies its sources and describes the order of authority of these sources. It requires the Company to identify and apply every primary source of GAAP and to adopt policies and disclosures that are consistent with the primary sources of GAAP. The adoption of the new accounting standard did not have a material impact on the results of operations or financial position for the year ended January 31, 2005.

f) Asset impairment Effective February 1, 2004, the Company adopted the CICA Handbook section 3063, Impairment of Long-lived Assets. The new accounting standard outlines the impairment process and defines the impairment loss as being measured as the excess of the carrying value of the asset over its fair value. Under the Company’s previous accounting policy, impairment loss was measured as the excess of the carrying value of the asset over its net recoverable amount. The adoption of the new accounting standard was applied prospectively, with no impact on the results of operations for the year ended January 31, 2005.

g) Hedging Effective February 1, 2004, the Company adopted the new CICA Accounting Guideline 13, Hedging Relationships. This guideline addresses the identification, documentation, designation and effectiveness of hedging transactions

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Notes to Consolidated Financial Statements

for the purpose of applying hedge accounting. Under the new guideline, the Company is required to document its hedging transactions and demonstrate the effectiveness of the hedge in order to continue hedge accounting. If the instruments do not meet the hedging criteria, then the accounting should be in accordance with the Emerging Issues Committee Abstract No. 128, Accounting for Trading, Speculative or Non-Hedging Derivative Financial Instruments, which requires that the instruments be recorded on the balance sheet at fair values with any changes in their fair values recognized in income in the period in which the change occurs. There was no impact from applying this new accounting guideline.

Note 3. Credit Card Receivables

January 31 (thousands of dollars) 2005 2004

Managed credit card portfolio 1,273,782 1,380,692 Securitized receivables (900,000) (900,000) 42 Retained interest in receivables sold 53,661 58,042 Net credit card receivables 427,443 538,734

Managed allowance for doubtful accounts 27,720 31,521

Over the last eight years, the Company has sold, with limited recourse, $900 million of undivided co-ownership interests in its credit card receivables to independent Trusts under the Company’s securitization program. The Company indirectly benefits from the low funding costs incurred by the Trusts, which finance their ownership of undivided co-ownership interests by issuing highly rated commercial paper.

The co-ownership agreements provide that the amount of the Company’s retained undivided co-ownership interest will be reduced to cover losses suffered as a result of credit card defaults, up to a specified amount. Accordingly, the Company incurs first losses on the receivables up to this amount before the Trusts incur any such losses.

Under the co-ownership agreements, payments from cardholders are divided between the Trusts and the Company on a pre-agreed basis. At the time of liquidation or an amortization event for an undivided co-ownership interest, a portion of the collections otherwise paid to the Company will be paid to the Trusts. Amortization events include covenant non-compliance by the Company (subject to applicable cure periods); Company insolvency events; a reduction in the aggregate amount of receivables below the minimum required amounts; a rating reduction of a Trust’s undivided co-ownership interest below specified rating levels (currently “AAA” in respect of each Trust); a rating reduction of the commercial paper issued by a Trust below specified rating levels (currently “R-1 (high)” for each Trust) as a consequence of the Trust’s ownership of the undivided co-ownership interest; or a failure of the receivables to meet certain minimum performance levels.

The scheduled liquidation commencement dates for the existing $900 million of undivided co-ownership interests sold to the Trusts are March 31, 2006 (as to $400 million), January 31, 2007 (as to $300 million) and January 31, 2007 or later under certain circumstances (as to $200 million). The liquidation of co-ownership interests would take a period of time to be completed. In the meantime, the Company may arrange for replacement financings by selling additional undivided co-ownership interests in the receivables pool or by issuing debt or through other financings.

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 43

The Company currently manages the receivables and administers the credit card accounts included under the securitization program. In this role, the Company collects the receivables and applies amounts in accordance with the co-ownership agreements. To protect the Trusts in the event that certain adverse circumstances arise, including covenant non-compliance (subject to applicable cure periods), Company insolvency events, or Company rating reductions below specified minimums, a standby servicing arrangement has been established with a third party.

The following table provides information on earnings derived from the financial services business including net gains and losses on sale of receivables to the Trusts:

January 31 (thousands of dollars) 2005 2004

Profit on service charges and other revenue 190,904 186,902 Securitization expense (24,990) (28,830) Net (loss) gain on sale of credit card receivables (4,373) 980 43 Net financial services earnings 161,541 159,052

Net bad debt expense for managed portfolio included above 79,335 95,229

The net loss on sale of credit card receivables is net of $53 million of amortization of service liability and $53 million service liability initially recognized in the year ended January 31, 2005. In the year ended January 31, 2004, the net gain on sale of credit card receivables was net of $53 million of amortization of service liability, $54 million of service liability initially recognized and $0.8 million loss on the replacement and sale of $300 million of credit card receivables as described below. The balance of the service liability was adjusted by a negligible amount to reflect the replacement and sale of credit card receivables.

During the year ended January 31, 2004, the Company replaced $300 million of its $900 million credit card receivables securitization program that was scheduled for liquidation beginning January 31, 2004, by selling an equivalent amount of undivided co-ownership interests (scheduled for liquidation beginning January 31, 2007) under the securitization program to a highly rated, independent Trust. A net loss of $0.8 million was recognized, reflecting both the accounting for the termination of the portion of the securitization program scheduled for liquidation and the introduction of the replacement transaction.

Years ended January 31 (thousands of dollars) 2005 2004

Balance of service liability 25,927 25,935 Sale of credit card receivables – 300,000 Proceeds from collections 1,856,683 1,770,400

The table below shows the key economic assumptions used in measuring the Company’s right to interest income due on sold receivables, called an interest only strip, and securitization gains based on the current fair value of future cash flows. The table also displays the sensitivity to adverse changes in the following assumptions:

Effects of Adverse Changes (in millions of dollars)

Assumptions 10% 20%

Yield (annual rate) 25.0% 2.0 4.0 Average payment rate (monthly) 18.8% – 1.0 Net charge-off (annual rate) 6.1% 1.0 1.0 Securitization expense rate 2.6% – – Discount rate 14.5% – –

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 44

Notes to Consolidated Financial Statements

Note 4. Income Taxes

The major components of income tax expense and the income tax rates for the years ended January 31, 2005, and January 31, 2004, are as follows: 2005 2004 Restated – Years ended January 31 (thousands of dollars) Note 2

Current tax expense (recovery) (11,690) 19,118 Future income taxes 35,638 24,614

Income tax expense 23,948 43,732

Average Canadian income tax rate 35.1% 36.4%

44 Reconciliations of the income tax provisions at the above rates with the amounts shown in the Consolidated Statements of Earnings are as follows: 2005 2004 Restated – Years ended January 31 (thousands of dollars) Note 2

Earnings before income taxes 83,686 103,685

Income tax expense calculated at average Canadian income tax rates 29,374 37,741 Change in income taxes resulting from: Large corporations tax 5,417 7,360 Net capital gains and losses (5,350) (1,431) Other (non-deductible items and prior year tax reduction) (5,493) (9,252)

23,948 34,418 Adjustments in future income tax balances – 9,314

Income tax expense 23,948 43,732

The components of future income tax balances are as follows: 2005 2004 Restated – January 31 (thousands of dollars) Note 2

Future income taxes – current: Consideration received from vendors (note 2) – 36,417 Deferred items 10,710 12,431 Tax losses carried forward 17,445 24,143

28,155 72,991 Valuation allowance (8,288) (7,363)

19,867 65,628

Future income taxes – non-current: Tax losses carried forward – 8,500 Non-current future income tax assets – deferred items 20,315 20,733 Pensions (127,994) (128,072) Other assets and accrued liabilities (57,368) (65,775) Buildings and equipment 6,921 (2,714)

(158,126) (167,328)

The current portion of future income taxes of $19,867,000 and $65,628,000 as at January 31, 2005 and 2004, respectively, is included in prepaid expenses and other current assets.

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 45

The Company has tax losses carried forward of $50 million. Of this total, $46 million is available until January 2009, and $4 million until January 2010. The benefit of tax losses has been reflected in the Consolidated Financial Statements.

Note 5. Fixed Assets 2005 2004 Restated – January 31 (thousands of dollars) Note 2

Accumulated Net Book Accumulated Net Book Cost Amortization Value Cost Amortization Value

Land 61,189 – 61,189 54,082 – 54,082 Buildings 326,821 (156,743) 170,078 317,979 (158,515) 159,464 Equipment 1,651,574 (1,124,316) 527,258 1,610,122 (1,043,880) 566,242 Equipment held under 45 capital leases 8,131 (8,131) – 8,131 (7,798) 333 Leasehold improvements 578,169 (287,189) 290,980 535,204 (266,014) 269,190 Property for sale or development – – – 9,478 – 9,478

2,625,884 (1,576,379) 1,049,505 2,534,996 (1,476,207) 1,058,789

Note 6. Employee Future Benefits

Aggregate information about the Company benefit plans is presented in the table below.

2005 2004

Other Other Pension Benefit Pension Benefit January 31 (thousands of dollars) Plans Plans Plans Plans

Plan assets Market value at beginning of year 1,329,062 13,495 1,234,985 13,422 Actual return on plan assets 107,954 896 131,234 73 Employer contributions 1,028 25,635 8,309 21,353 Associate contributions 20,257 – 19,030 – Benefits paid (70,811) (23,947) (63,809) (21,353) Settlement payment – – (687) –

Market value at end of year 1,387,490 16,079 1,329,062 13,495

Plan obligation Accrued benefit obligation at beginning of year 1,000,198 99,500 919,000 92,482 Total current service cost 49,737 19,436 45,137 16,392 Interest cost 68,505 5,275 55,400 5,505 Benefits paid (70,811) (23,947) (63,809) (21,353) Actuarial losses 10,421 89 44,962 6,474 Settlement of obligations – – (492) –

Accrued benefit obligation at end of year 1,058,050 100,353 1,000,198 99,500

Plan surplus (deficit) End of year market value less accrued benefit obligation 329,440 (84,274) 328,864 (86,005) Employer contributions after measurement date – 1,081 – 1,188 Unamortized net actuarial loss 126,312 12,204 142,026 13,015 Unamortized past service cost 3,784 1,483 4,433 1,780 Unamortized transitional asset (94,340) – (110,148) –

365,196 (69,506) 365,175 (70,022) Less: current portion – 11,542 – 10,910

Accrued benefit asset (liability) 365,196 (57,964) 365,175 (59,112)

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 46

Notes to Consolidated Financial Statements

The current portion of the accrued benefit liability is included in other accounts payable and accrued liabilities. Market values of plan assets are based on quoted market prices.

Benefit Plan Expense 2005 2004

Other Other Pension Benefit Pension Benefit Years ended January 31 (thousands of dollars) Plans Plans Plans Plans

Company current service cost 29,480 19,436 26,107 16,392 Interest cost 68,505 5,275 55,400 5,505 Actual return on plan assets (net of expenses) (107,956) (896) (131,234) (73) Actuarial loss 10,421 89 44,962 6,474 Settlement loss – – 338 – 46 450 23,904 (4,427) 28,298 Adjustments to recognize long-term nature of benefit costs Differences between: Expected and actual return on plan assets 18,719 53 56,230 (780) Recognized and actual actuarial loss (3,006) 758 (44,183) (5,872) Amortization of past service costs 649 297 650 297 Amortization of transitional asset (15,806) – (15,781) –

556 1,108 (3,084) (6,355)

Net expense (income) recognized 1,006 25,012 (7,511) 21,943

Actuarial Assumptions 2005 2004

Other Other Pension Benefit Pension Benefit Years ended January 31 Plans Plans Plans Plans

Discount rate 5.70% 5.21% 6.00% 5.44% Expected long-term rate of return on plan assets (net of expenses) 6.50% 6.25% 6.17% 6.75% Rate of compensation increase 4.00% 4.00% 4.00% 4.00% Health care inflation rate: Initial/ultimate – Benefit expense – 7.54%/4.47% – 7.70%/4.30% Initial/ultimate – Benefit obligation – 7.46%/4.50% – 7.54%/4.47%

Both the Company and the members contribute in equal amounts to the defined contribution plans. The defined benefit plans are funded by employee contributions as a percentage of salary and by the Company to support the actuarial based pension benefits. The defined benefit provisions provide benefits based on members’ earnings and service.

The Company’s pension and future benefits obligation and expense are dependent on the assumptions used in calculating these amounts. These assumptions include the discount rate, the rate of compensation increase, the overall health care cost trend rate and the expected long-term rate of return on plan assets. The assumptions are of a long-term nature, consistent with the nature of employee future benefits.

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 47

Sensitivity of Health Care Trend 2005 2004

Other Other Benefit Benefit Years Ended January 31 (thousands of dollars) Plans Plans

Effect of 1% increase in health care trend rate Service cost and interest cost 223 233 Accrued benefit obligation 3,848 3,830 Effect of 1% decrease in health care trend rate Service cost and interest cost (188) (197) Accrued benefit obligation (3,266) (3,254)

Supplemental information regarding the asset allocation of the assets of the largest pension plans and other benefit plans is presented below. 47 Asset Mix Asset Mix of of Other Class Pension Plans Benefit Plans

Cash/short-term investments 4% – Real estate 2% – Bonds 39% 68% Canadian equities 26% 32% Foreign equities 29% –

100% 100%

Note 7. Other Assets 2005 2004 Restated – January 31 (thousands of dollars) Note 2

Systems development costs, net of amortization 106,906 108,165 Portfolio investments 33,552 31,970 Other 23,127 23,939

163,585 164,074

The portfolio investments represent marketable securities that mature at various dates beyond the next fiscal year. Refer to note 12 for the fair value of the portfolio investments.

Note 8. Asset Retirement Obligations

The Company has some operating leases that require it to remove leasehold improvements and replace or remove other structures at the end of the lease term. The Company also has obligations to dispose of materials in accordance with relevant legislation. For the year ended January 31, 2005, the Company has recorded asset retirement obligations of approximately $0.6 million with respect to the leases. At January 31, 2004, the Company had recorded asset retirement obligations of $0.1 million. The total amount of undiscounted cash flows required to settle the obligations has been estimated to be $2.5 million at January 31, 2005; this estimate factors in the effect of inflation and the dates that the leases are expected to end, which range from April 2007 to December 2082. In determining the amount of the obligation, the Company has assigned probabilities to the lease end dates to arrive at the expected cash flows.

The Company has other obligations to remove certain tunnels and encroachments. However, there is no firm date on which these obligations are to be met. As a result, the Company cannot reasonably estimate the asset retirement obligation.

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 48

Notes to Consolidated Financial Statements

Note 9. Debt

At January 31, 2005 and January 31, 2004, the short-term borrowings comprise the following:

January 31 (thousands of dollars) 2005 2004

Bank indebtedness 124,710 1,309 Asset-based credit facility – –

124,710 1,309

In June 2004, the Company negotiated a new 364-day $650 million secured revolving asset-based credit facility, which replaced the previous 364-day $650 million secured revolving asset-based credit facility. This credit facility bears interest at variable rates, which can be based on a blend of the Canadian prime rate, BA rate, LIBOR rate and US base rate. The new credit facility includes a letter of credit capacity and is secured by the 48 Company’s merchandise inventory. The facility is available for general corporate purposes. The credit facility expires in May 2005.

Long-term debt comprises the following: 2005 2004 Restated – January 31 (thousands of dollars) Note 2

Secured: 14% mortgage due 2009 3,107 3,543 7% mortgage due 2014 23,799 –

26,906 3,543 Unsecured: 7.10% debentures series F due May 13, 2004 – 125,000 7.38% medium term notes due August 3, 2005 100,000 100,000 7.40% debentures series G due April 5, 2006 160,000 160,000 7.50% medium term notes due June 15, 2007 120,000 120,000 7.50% convertible subordinated debentures due December 1, 2008 187,376 184,775

Total unsecured 567,376 689,775

594,282 693,318 Less amounts due within one year (101,660) (125,436)

492,622 567,882

The 7.50% convertible unsecured subordinated debentures were issued on November 26, 2001, when the Company received $200 million before deducting $6.5 million in issue costs. The value of the conversion option for the convertible debentures had been estimated at $20 million, and is recorded in Shareholders’ Equity in the Consolidated Balance Sheets. The liability element of the convertible debentures is being accreted over an 84- month period to an amount of $200 million, which is the face value of the convertible debentures, by a charge to interest expense.

The Company has the right at any time prior to maturity to purchase the unsecured debentures, other than the convertible debentures, in the market, or by tender or by private contract.

The convertible debentures are convertible at the option of the holder at any time prior to the maturity date at a conversion price of $17.38 per common share, being a rate of 57.54 common shares for each $1,000 principal amount of debentures. The debentures may not be redeemed by the Company prior to December 1, 2005. Thereafter, and on or before December 1, 2006, the debentures may be redeemed by the Company according to a pre-defined formula. Subsequent to December 1, 2006, the Company may, at its option, redeem the debentures at any time to maturity through the issuance of common shares of the Company. The Company also has the right to deliver common shares to satisfy interest payments on the debentures.

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 49

Maturities of long-term debt are as follows:

Years ending January 31 (thousands of dollars)

2006 101,660 2007 161,816 2008 121,987 2009 202,176 2010 2,161 Subsequent periods 17,106

606,906 Less: amount to be accreted on convertible debentures to maturity (12,624)

594,282 49

Note 10. Capital Stock

The authorized classes of shares of the Company consist of unlimited numbers of preferred shares and common shares, all without nominal or par value.

There are no outstanding preferred shares. The changes in common shares issued and outstanding during the years ended January 31, 2005 and January 31, 2004 are as follows:

Number Thousands of Shares of Dollars

Issued and outstanding at January 31, 2003 69,270,716 1,402,007 Issued: Under dividend reinvestment plan 53,946 556

Issued and outstanding at January 31, 2004 69,324,662 1,402,563 Issued: Under dividend reinvestment plan 9,544 126 Under stock option plan 28,481 245 Stock option compensation transferred from contributed surplus –45 Purchased for cash and cancelled (11,000) (148) Excess of carrying value of shares purchased over purchase price transferred to contributed surplus – (75)

Issued and outstanding at January 31, 2005 69,351,687 1,402,756

In December 2004, the Company announced a normal course issuer bid, under which the Company proposed to purchase, if considered advisable, up to 3,460,000 of its outstanding common shares during the 12 months ending December 19, 2005.

Note 11. Stock-Based Compensation Plans

The Company has six active stock-based compensation plans: two stock option plans, a share ownership plan, a share appreciation rights agreement, a phantom stock plan and a restricted stock unit plan. The Company also has an inactive stock ownership plan, known as the senior executive share purchase plan.

a) Stock option plans Under these plans, outstanding options to purchase common shares are at exercise prices equal to the fair market value per share on the dates on which the options were granted. A percentage of the options become exercisable each year and any unexercised options expire at the latest on the tenth anniversary of the date of grant. At January 31, 2005, 7,261,457 common shares are reserved for issuance under these plans.

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 50

Notes to Consolidated Financial Statements

In accordance with the CICA Handbook Section 3870, the Company has prospectively applied the fair value- based method to all employee stock options granted on or after February 1, 2003. Accordingly, options granted prior to that date continue to be accounted for using the settlement accounting method.

On a pro-forma basis, if the Company had used the fair value-based method of accounting for the stock options granted from February 1, 2002 to January 31, 2003, the Company’s net earnings for the years ended January 31, 2005 and 2004 would have been $59 million and $59 million, respectively. The basic and diluted earnings per share would have been $0.85 for the year ended January 31, 2005. The basic and diluted earnings per share would have been $0.85 for the year ended January 31, 2004.

The fair value of each option grant was estimated on the date of grant using an option pricing model with the following weighted average assumptions for options granted in the fiscal years ended January 31, 2005 and 2004:

Assumptions 50 Years ended January 31 2005 2004

Expected dividends $ 0.36 $ 0.36 Expected volatility 35% 34% Risk-free interest rate 4.53% 5.02% Expected life 10 years 10 years

The changes in outstanding stock options for the years ended January 31, 2005, and January 31, 2004, are as follows:

2005 2004

Weighted Weighted Number Average Number Average Years ended January 31 of Options Price of Options Price

Outstanding options at beginning of year 5,059,343 $ 16.51 5,246,212 $18.76 Granted 181,900 12.68 739,750 8.32 Exercised (28,481) 8.56 – – Cancelled or expired (326,325) 21.93 (926,619) 22.72

Outstanding options at end of year 4,886,437 $ 16.05 5,059,343 $16.51

Reserved for future grant at end of year 2,375,020 2,230,595

Exercisable 3,495,576 $ 17.59 3,034,443 $18.99

Of the exercisable options, 315,358 had an issue price lower than the closing price of $13.09 at January 31, 2005, and consequently were “in the money” as of that date.

As at January 31, 2005, the table below summarizes the distribution of these options within meaningful ranges and the remaining contractual life.

Options Outstanding Options Exercisable

Weighted Average Remaining Weighted Weighted Number Contractual Average Number Average of Options Life Exercise of Options Exercise Range of Exercise Prices Outstanding in Years Price Exercisable Price

$7.57 to $10.00 917,119 8.0 $8.40 290,533 $8.52 $10.01 to $15.00 746,275 7.5 13.69 293,525 14.13 $15.01 to $20.00 2,583,718 4.9 16.65 2,381,693 16.65 $20.01 to $25.00 190,950 1.3 20.84 81,450 20.84 $25.01 to $30.00 227,575 1.9 27.74 227,575 27.74 $30.01 to $34.90 220,800 3.1 32.61 220,800 32.61

$7.57 to $34.90 4,886,437 5.5 $ 16.05 3,495,576 $17.59

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 51

Details of common shares issued under the stock option plans during the years ended January 31, 2005 and January 31, 2004 are shown in note 10.

b) Employee share ownership plan Under this plan, the Company contributes $1 for each $6 contributed by employees to acquire common shares. If earnings per share increase over prescribed targets, the Company contribution may increase to a maximum of $1 for each $1 contributed. Employee and Company contributions are used to purchase common shares on the open market. The Company contribution is included as an expense in the Consolidated Statements of Earnings and amounted to $628,000 in the year ended January 31, 2005 and $598,600 in the year ended January 31, 2004.

c) Senior executive share purchase plan Under this plan, certain employees were eligible to apply for a loan to purchase common shares at market value provided that the aggregate amount of all loans outstanding under the plan did not exceed that employee’s current annual salary. Loan offers under this plan have been suspended since December 1998. Loans are repayable in monthly installments over a maximum term of 10 years and are included in other assets in the Consolidated 51 Balance Sheets. The Company pays a bonus in respect of each loan two years after the granting thereof, to be applied to the repayment of the loan. The bonus is an amount which, after adjusting for income taxes in respect of the bonus, is equal to the greater of (1) 10% of the original amount of the loan and (2) the excess, if any, of the original principal amount of the loan over the market value on the bonus date of the shares purchased with the proceeds of the loan. For the years ended January 31, 2005 and January 31, 2004, no bonuses were paid or accrued under this plan, resulting in no expenses being included in the Consolidated Statements of Earnings.

d) Share appreciation rights agreement Under this agreement, the Governor of the Board was granted 62,500 units at an issue price of $28.80 per unit. Of these units, 50% are currently exercisable and the remainder on the retirement of the Governor.

Amounts payable are based upon the excess of the market value of the Company’s common shares at the exercise date over the issue price of $28.80. As of January 31, 2005 and 2004, there is no liability under this agreement, since the market price of the Company’s common shares is below $28.80.

e) Phantom stock plan Under this plan, certain directors of the Company receive their annual retainers and other fees in the form of units in the plan, and the Company records a liability. The number of units issued is based upon the market value of the Company’s common shares at each allocation date during the year. After retirement, these directors receive a cash payment equal to the market value of their accumulated phantom stock units. The number of units issued each year, multiplied by the market value of common shares at the Company’s year-end, is recorded as an expense by the Company. As a result of the fluctuation in market value, the amounts included in the Consolidated Statements of Earnings were an expense of $246,114 in the year ended January 31, 2005 and an expense of $664,214 in the year ended January 31, 2004.

f) Restricted stock units This is a new plan which became effective in March 2004. Under this plan, certain employees receive annual grants of Restricted Share Units (“RSU”). The value of Restricted Share Units is linked to the market value of the Company’s common shares, and at the option of the Company, is ultimately paid out in either cash or common shares of the Company, or any combination thereof, at the end of the three-year vesting period. The plan is performance-based, and the total compensation will be dependent on the Company’s three-year strategic and financial objectives. Compensation cost is measured based on the change in market value of the Company’s common shares, and is expensed on a straight-line basis over the three-year period. For the year ended January 31, 2005, there was no expense recorded under this plan.

Note 12. Financial Instruments

a) Fair values of financial instruments The Company has estimated the fair values of its financial instruments as of January 31, 2005 and January 31, 2004, using quoted market values, where available, and other relevant information. These estimates are not nec- essarily indicative of the amounts the Company might pay or receive in actual market transactions and do not include transaction costs and income taxes.

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 52

Notes to Consolidated Financial Statements

2005 2004 Restated – Note 2

Book Fair Book Fair January 31 (thousands of dollars) Value Value Value Value

Financial assets Portfolio investments 41,780 42,694 39,140 39,878 Financial liabilities Fixed rate long-term debt (614,282) (636,669) (713,318) (720,814) Off-balance sheet financial instruments Forward foreign exchange contracts – 604 – (207)

52 The portfolio investments consist of both current and long-term marketable securities. The portfolio investments that are classified as current are included with prepaid expenses and other current assets in the Consolidated Balance Sheets.

The fixed rate long-term debt also includes the $20 million conversion value, related to the convertible debentures, which is classified as Shareholders’ Equity (note 9).

The above table does not include cash, short-term deposits, credit card receivables, other accounts receivable, short-term borrowings, trade accounts payable, other accounts payable or income taxes payable because, due to the immediate or short-term maturity of these financial instruments, their book values approximate fair values.

The fair values shown in the above table, which are estimated as at January 31, 2005 and January 31, 2004, change daily as they approach maturity and as interest and foreign exchange rates increase or decrease.

These fair values are estimated as follows: • Portfolio investments – based upon quoted market prices • Fixed-rate long-term debt – based upon quoted market prices or discounted future cash flows using discount rates that reflect current market conditions for instruments having similar terms and conditions • Forward foreign exchange contracts – based upon the estimated net cost of terminating the agreements.

b) Off-balance sheet financial instruments As at January 31, 2005 the Company did not have any interest rate swap agreements in place. For the year ended January 31, 2004, the Company had in place a number of interest rate swap agreements on notional principal amounts totalling $75 million of floating rate debt, which had expired during the fiscal year. Under these agreements, the Company agreed with a counterparty to exchange, at specified intervals and for a specified period, its floating interest for fixed interest calculated on an agreed upon notional principal amount.

The following table indicates the average interest rates on interest rate swaps while they were in effect:

Years ended January 31 2005 2004

Pay-fixed swaps Average pay rate – 5.78% Average receive rate – 3.16%

The Company enters into forward foreign exchange contracts to lock in prices in Canadian dollars for future purchases of merchandise from foreign suppliers. At January 31, 2005, there were US$20 million of outstanding forward foreign exchange contracts. The settlement dates of these contracts range from February 2005 to March 2005, and the forward foreign exchange rates range from 1.1963 to 1.2362. At January 31, 2004, US$46 million of forward foreign exchange contracts were outstanding.

The Company believes that its exposure to credit and market risks for these financial instruments is negligible. All of these agreements were made with Canadian chartered banks.

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 53

Note 13. Statement of Cash Flows

The net change in operating working capital appearing in the operating activities section of the Consolidated Statements of Cash Flows comprises the following: 2005 2004 Restated – Years ended January 31 (thousands of dollars) Note 2

Decrease (increase) in: Cash in stores 320 (725) Credit card receivables 106,908 22,346 Other accounts receivable (20,946) 52,601 Merchandise inventories (26,223) 58,743 Prepaid expenses and other current assets 5,047 2,400 53 Increase (decrease) in: Trade accounts payable 2,026 (21,018) Other accounts payable and accrued liabilities (56,158) (32,722)

10,974 81,625

During the year ended January 31, 2005, the Company acquired real estate property and assumed debt on the property in the amount of $24,440,000 at an interest rate of 7%, which matures February 2014. In accordance with Canadian generally accepted accounting principles, the amount of the assumed debt was excluded from investing and financing activities as it is a non-cash transaction.

Note 14. Leases

a) As lessee The Company conducts a substantial part of its operations from leased stores in shopping centres. All shopping centre leases have been accounted for as operating leases.

The Company’s leases typically have an original term, ranging from 15 to 25 years, and provide for renewal periods exercisable at the Company’s option. For leases in place at January 31, 2005, the Company’s leases typically provide for several renewal periods beyond the original lease term. In a limited number of cases, the renewals are at the landlord’s option.

Generally, the Company’s leases require equal monthly rent payments over the lease term. However, certain of the Company’s lease agreements require rent increases during the original lease term and certain of the Company’s lease agreements provide free rent periods. Generally, upon renewal the rent is reset to a current market rate set at the time of renewal.

The Company receives cash incentives from landlords which generally take the form of leasehold improvement allowances. During the year ended January 31, 2005 such allowances amounted to $12 million (year ended January 31, 2004 – $11 million).

Rental expenses related to operating leases charged to earnings in the years ended January 31, 2005 and January 31, 2004, were $282,378,000 and $273,259,000, respectively.

The future minimum rental payments required under operating leases having initial or remaining lease terms in excess of one year are summarized as follows:

Years ending January 31 (thousands of dollars)

2006 247,036 2007 236,184 2008 225,940 2009 213,044 2010 201,066 Subsequent periods 1,235,645

2,358,915

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 54

Notes to Consolidated Financial Statements

In addition to these rental payments (and, in a few cases, relatively minor contingent rentals), the leases generally provide for the payment by the Company of real estate taxes and other expenses.

b) As lessor Fixed assets in the Consolidated Balance Sheet include an office tower with a cost of $22,100,000 at January 31, 2005 and January 31, 2004, and related accumulated amortization of $12,252,000 and $11,679,000, respectively. Revenue for the years ended January 31, 2005 and January 31, 2004 include third party rental revenue arising from this property of $4,364,000 and $4,652,000, respectively.

Note 15. Amortization 2005 2004 Restated – Years ended January 31 (thousands of dollars) Note 2

Deducted in arriving at earnings before interest expense and income taxes: 54 Fixed assets 161,693 167,634 Systems development costs 25,140 25,720 Other 1,040 2,671

187,873 196,025 Included in interest expense: Debt discount and expense 2,796 2,743

190,669 198,768

Note 16. Interest Expense 2005 2004 Restated – Years ended January 31 (thousands of dollars) Note 2

Interest expense on long-term debt 50,746 61,443 Interest expense on short-term debt 7,606 13,713 Interest income (12,671) (14,194)

45,681 60,962

Interest paid in cash amounted to $53,815,000 and $77,391,000 in the years ended January 31, 2005 and January 31, 2004, respectively. Cash interest received was $7,180,000 and $9,661,000 in the years ended January 31, 2005 and 2004, respectively.

Note 17. Earnings per Share

Basic earnings per share is based on the weighted average number of common shares outstanding during the year.

Diluted earnings per share is calculated using the treasury stock method for those stock options, both vested and unvested, that have option prices below the average market price in the reporting period, and the if-converted method for the convertible debentures that are included in long-term debt.

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 55

The following table reconciles the numerators and the denominators of the basic and diluted earnings per share calculation. 2005 2004 Restated – January 31 Note 2

Numerator for basic earnings per share (thousands of dollars) 59,738 59,953

Weighted average common shares 69,339,048 69,295,364 Effect of dilutive options outstanding – 136,656

Denominator for diluted earnings per share 69,339,048 69,432,020

Diluted earnings per share $ 0.86 $ 0.86

The computation of diluted earnings per share for the year ended January 31, 2005 does not include convertible 55 debentures and stock options, and for the year ended January 31, 2004, does not include convertible debentures because doing so would have been anti-dilutive.

Note 18. Segmented Information

The Company has three reportable operating segments: the Bay, Zellers and Financial Services. The Bay operates traditional department stores and Zellers operates mass merchandise stores. The Company’s Financial Services group finances credit card receivables resulting from sales charged on the Hudson’s Bay Company credit card at the Bay and Zellers, and provides credit card insurance. Revenues and profits of Financial Services are included in the results of the Bay and Zellers.

Segmented information as at and for the years ended January 31, 2005 and January 31, 2004 is as follows:

2005

The Financial All (thousands of dollars) Bay Zellers Services Other Eliminations Total

Earnings Sales and revenue 2,681,587 4,301,128 317,079 87,021 (317,079) 7,069,736

EBIT 1 67,856 84,644 161,541 (23,133) (161,541) 129,367

Amortization 68,745 86,226 2,190 35,698 (2,190) 190,669

Capital expenditures 60,088 124,133 80 5,681 189,982

Net assets Credit card receivables 228,587 198,856 427,443 (427,443) 427,443 Merchandise inventories 580,108 809,927 22,285 1,412,320 Other current assets 2 25,179 61,657 5,311 72,301 164,448 Fixed assets 432,784 514,321 1,080 101,320 1,049,505 Goodwill 143,215 143,215 Other assets, net 3 229,273 37,846 6,186 183,366 456,671

1,495,931 1,765,822 440,020 379,272 (427,443) 3,653,602 Current liabilities 4 (307,710) (439,617) (10,292) (115,456) (873,075)

Net assets 1,188,221 1,326,205 429,728 263,816 (427,443) 2,780,527

1 Earnings (loss) before interest expense and income taxes. 2 Excluding short-term deposits and current portion of future income taxes. 3 Excluding portfolio investments. 4 Excluding short-term borrowings and long-term debt due within one year.

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page 56

Notes to Consolidated Financial Statements

2004 Restated – Note 2

The Financial All (thousands of dollars) Bay Zellers Services Other Eliminations Total

Earnings Sales and revenue 2,689,478 4,519,706 331,903 85,881 (331,903) 7,295,065

EBIT 1 75,778 126,257 159,052 (37,388) (159,052) 164,647

Amortization 75,045 86,384 2,169 37,339 (2,169) 198,768

Capital expenditures 55,629 43,580 15,621 114,830

Net assets 56 Credit card receivables 301,527 237,207 538,734 (538,734) 538,734 Merchandise inventories 533,912 827,659 24,526 1,386,097 Other current assets 2 28,008 56,457 130 30,534 115,129 Fixed assets 438,197 501,551 1,439 117,602 1,058,789 Goodwill 152,294 152,294 Other assets, net 3 226,787 47,190 7,639 176,022 457,638

1,528,431 1,822,358 547,942 348,684 (538,734) 3,708,681 Current liabilities 4 (330,885) (457,661) (9,892) (137,493) (935,931)

Net assets 1,197,546 1,364,697 538,050 211,191 (538,734) 2,772,750

Note 19. Guarantees

As part of normal operations, the Company regularly reviews its real estate portfolio and store locations. Based on the reviews conducted in prior years, the Company has closed certain store premises that it deemed to be non-strategic. Where these premises were leased, the Company assigned its leases to other retail operators, but remained obligated to the landlord on those leases as the original tenant thereunder despite the assignment. If the assignee were to default on the lease agreement, the Company would remain obligated to the landlord for payment of amounts due under the lease. The terms of these assigned leases can extend up to the year 2063. As of January 31, 2005, these leases have future minimum lease payments of $43 million in addition to other lease-related expenses, such as property taxes and common area maintenance. The Company’s obligation would be offset by payments from existing or future assignees and their obligations to the Company to comply with the assigned leases. Potential liabilities related to these guarantees may be subject to certain defences by the Company. Historically, the Company has not made any significant payments with respect to these lease obligations, and believes that the risk of significant loss is low.

The Company has entered into an operating lease agreement, which requires that the Company guarantee the recovery by the lessor of the book value of the leased equipment at the end of the lease term. The minimum lease term is one year, and can be extended at the Company’s option. As of January 31, 2005, the total maximum future payments under this guarantee totals $25 million, which represents the guaranteed portion of the book value of the equipment at this date. The Company’s obligation decreases over time, and is partially offset by guarantees made by manufacturers to repurchase the leased equipment at an amount that approximates book value. Historically, the Company has not made any significant payments with respect to these lease obligations, and believes that the risk of significant loss is low.

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In the normal course of business, the Company has entered into agreements, pursuant to which the Company provides indemnification commitments to counterparties. These indemnification commitments require the Company to compensate counterparties for costs incurred as a result of breaches of representations or warranties, changes in laws or regulations, or as a result of litigation claims that may be suffered by the counterparty as a result of the transaction. The Company also has director and officer indemnification agreements. The terms of the indemnification commitments will vary based on the contract. Given the nature of these indemnification commitments, the Company is unable to estimate the maximum potential liability. To the best of Management’s knowledge, the Company has not made any significant payments with respect to these indemnification commitments.

Note 20. Contingencies

As of January 31, 2005, there are a number of claims against the Company in varying amounts and for which provisions have been made in these consolidated financial statements, as appropriate. It is not possible to determine the amounts that may ultimately be assessed against the Company with respect to these claims but Management believes that any such amounts would not have a material impact on the business or financial position of the Company. 57

In addition to these claims against the Company is a statement of claim dated August 6, 2002, which named the Company, Royal Trust Corporation and Investors Group Trust Company Limited as defendants in a proceeding commenced in the Superior Court of Justice (Ontario) under the Class Proceeding Act by an active Hudson’s Bay Company employee and a retired Hudson’s Bay Company employee in relation to surplus assets in the Dumai Pension Plan. This matter has been certified by the Court as a class proceeding but documentary production has not been made by any of the parties nor have examinations for discovery commenced. Accordingly, it is prema- ture to comment on the merits of the claims. The Company is vigorously defending this claim.

On October 2, 2003, the Company and four other companies were served with a motion seeking authorization from the Superior Court to institute a class action in relation to the mailing dates of the credit card statements. This motion alleges that certain provisions of the Quebec Consumer Protection Act relating to grace periods were not respected. This matter has now been settled and appropriate provisions have been made in the consolidated financial statements, which did not have a material impact on the Company.

Note 21. Subsequent Events

As a result of the recent re-organization of the Company’s leadership team and merchandising structure, severance costs of approximately $7 million were accrued in February 2005. This is in addition to approximately $5 million of severance costs, which were recorded at January 31, 2005.

On March 2, 2005, the Company announced an eight-year partnership agreement with the Vancouver Organizing Committee (VANOC), whereby, for exclusive rights related to the sponsorship of Canadian athletes at the next four Olympic Games, the Company has committed $100 million in value to VANOC in a combination of cash, marketing support, value-in-kind support or budget relief, and participation in proceeds from sale of Olympic- branded merchandise.

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Five Year Financial Summary

(As a result of accounting changes, comparative figures have been restated. See Note 2 of the annual consolidated financial statements.)

Years ended January 31 2005 2004 2003 2002 2001 Number of weeks 52 53 52 52 52 Operations (millions of dollars) Total sales and revenue 7,070 7,295 7,304 7,380 7,338 The Bay 2,682 2,689 2,648 2,667 2,703 Zellers 4,301 4,520 4,576 4,627 4,545 EBIT for the Company 129 165 181 171 282 EBIT – The Bay 68 76 100 60 153 58 EBIT – Zellers 85 126 107 125 148 EBITDA for the Company 320 363 374 374 475 Interest expense (46) (61) (67) (75) (80) Income taxes (24) (44) (29) (48) (103) Net earnings 60 60 85 47 99 Cash flow from operating activities 268 377 161 175 453 Capital expenditures (190) (115) (133) (144) (241) Financial position (millions of dollars) Credit card receivables 427 539 559 487 500 Inventories 1,412 1,386 1,445 1,394 1,490 Total assets 4,009 4,022 4,175 4,446 4,310 Working capital 1,145 1,119 1,227 1,096 1,087 Net debt 442 506 785 837 890 Shareholders’ equity 2,201 2,165 2,129 2,079 2,045 Financial ratios Return on average shareholders’ equity (%) 2.8 2.9 4.2 2.3 5.0 Interest coverage 2.8 2.7 2.7 2.3 3.5 Debt:equity 0.2:1 0.2:1 0.4:1 0.4:1 0.4:1 Pre-tax margin (%) 1.2 1.4 1.6 1.3 2.8 Share data Common shares outstanding (millions): Year-end 69.4 69.3 69.3 70.1 70.6 Weighted average 69.3 69.3 69.7 70.2 71.9 Range in common share price (high-low) 15–13 13–8 16–6 20–13 19–13 Price: earnings ratio (year-end) 15.2 14.7 7.4 22.4 12.2 Price: book ratio (year-end) 0.4 0.4 0.3 0.5 0.6 Per common share (dollars) Net earnings Basic 0.86 0.87 1.23 0.67 1.37 Diluted 0.86 0.86 1.19 0.67 1.29 Dividends 0.36 0.36 0.36 0.36 0.36 Statistics Gross leasable area (thousands of square feet) The Bay 18,575 18,737 18,427 18,000 17,533 Zellers 27,992 28,643 28,642 28,996 29,165 Comparable store sales increase (decrease) (%) The Bay 0.2 (2.3) (3.9) (4.8) 5.6 Zellers (2.3) (2.9) (0.8) 1.0 0.4 Sales per selling square foot The Bay 170 169 173 180 188 Zellers 195 198 201 201 199 Average number of associates 62,394 69,659 71,445 71,730 71,700 Canadian economy (% change) Department store sales (DSS) 5.3 3.4 6.0 7.9 2.0 Large Retailer Commodity Survey (LRCS) 5.9 2.3 6.1 5.6 5.6

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Board of Directors

David W. Colcleugh Barbara R. Hislop Corporate Director, President & Chief Executive Officer, Mississauga, Ontario Genus Resource Management Elected 2000 2, 3, 4 Technologies Inc. Vancouver, British Columbia L. Yves Fortier Elected 1993 4, 5 Governor, Hudson’s Bay Company James B. Hume Chairman & Senior Partner, President & Chief Executive Officer, Ogilvy, Renault Kanesco Holdings Ltd. Montreal, Quebec Calgary, Alberta Elected 1993 2, 3 Elected 2003 1, 5 59

David A. Galloway Donna Soble Kaufman Corporate Director, Lawyer and Corporate Director, Toronto, Ontario Toronto, Ontario Elected 2003 2, 4 Elected 2000 2, 5

Paul Gobeil Peter T. Kaursland Vice Chairman of the Board, Corporate Director, Metro Inc. & Chairman of the Board, Oxfordshire, England Export Development Canada (EDC) Elected 2002 1, 5 Montreal, Quebec Elected 2003 1, 4 Thomas A. Knowlton Dean, Faculty of Business, Kerry L. Hawkins Ryerson University President, Cargill Limited Toronto, Ontario Winnipeg, Manitoba Elected 2003 1, 4 Elected 1998 2, 3, 4 Peter W. Mills George J. Heller Company Director & President & Chief Executive Officer, Business Consultant, Hudson’s Bay Company Toronto, Ontario Toronto, Ontario Elected 1985 1, 2, 3 Elected 1999 3 1 Audit Committee 2 Corporate Governance Committee 3 Executive Committee 4 Human Resources Committee 5 Pension Committee

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Senior Officers

L. Yves Fortier, C.C., Q.C. Donald C. Rogers Governor Senior Vice President, Hudson’s Bay Company Real Estate & Development Hudson’s Bay Company George J. Heller President & Chief Executive Officer J. Gregory Armstrong Hudson’s Bay Company Vice President, Audit Services Michael S. Rousseau Hudson’s Bay Company Executive Vice President & Chief Financial Officer Gary B. Davenport 60 Hudson’s Bay Company Vice President & Chief Information Officer Marc R. Chouinard Hudson’s Bay Company Executive Vice President & President, Hbc Merchandising Group James A. Ingram Hudson’s Bay Company Vice President, Secretary & General Counsel Thomas Haig Hudson’s Bay Company Executive Vice President & President, Hbc Stores & Specialty Stephen F. Knight Hudson’s Bay Company Vice President, Credit & Loyalty Management Peter A. Kenyon Hudson’s Bay Company Executive Vice President, Managed Services Arthur N. Mitchell Hudson’s Bay Company Vice President & Controller Hudson’s Bay Company Deborah A. Edwards Senior Vice President, Robert R. Moore Total Brand Management Vice President, Hudson’s Bay Company Corporate Communications Hudson’s Bay Company Robert M. Kolida Senior Vice President, Michael J. Thomas Human Resources Vice President, Hudson’s Bay Company Logistics Hudson’s Bay Company

Kenneth C. Wong Treasurer, Hudson’s Bay Company

Hudson’s Bay Company 2004 Annual Financial Report HBC04_Book2E_sedar 4/20/05 3:50 PM Page BC1

Corporate Information

Registered Office Transfer Agents and Registrar 401 Bay Street, Suite 500 Investors are encouraged to contact Toronto, Ontario M5H 2Y4 our Transfer Agent and Registrar, CIBC Mellon Trust Company, for Auditors information regarding their security KPMG LLP holdings. They can be reached at:

Principal Bankers CIBC Mellon Trust Company General Electric Capital Canada Inc. P. O. Box 7010, Adelaide Street Bank of America, NA (Canada Branch) Postal Station CIT Business Credit Canada Inc. Toronto, Ontario M5C 2W9 HSBC Bank Canada AnswerLine™: Investor Relations (416) 643-5500 or 1-800-387-0825 Contact: (Toll-free for North America) Michael S. Rousseau Executive Vice-President Fax: (416) 643-5501 & Chief Financial Officer Website: www.cibcmellon.com Tel: (416) 861-4935 Email: [email protected] Fax:(416) 861-4720 Internet Rob Moore Hudson’s Bay Company provides up-to- Vice-President, date financial information to investors on Corporate Communications the performance section at www.hbc.ca. Tel: (416) 861-4419 Investors have access to news releases, Fax:(416) 216-7887 financial reports, stock charts, audio webcasts and Hbc executive profiles. Stock Exchange Listings Common shares are listed on the Toronto Annual Meeting of Shareholders Stock Exchange under the The 336th Annual Meeting of Shareholders trading symbol “HBC.” will be held at the Arcadian Court, 8th Floor, 401 Bay Street, Toronto, Ontario

Wednesday, May 25th, 2005 at 3:00 p.m.

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Hudson’s Bay Company Hbc.ca 401 Bay Street, Suite 500 Toronto, ON M5H 2Y4 Canada