DALLAS -- Fleming Cos. here faced new challenges in the wake of the cancellation of its supply arrangement with Kmart Corp., a deal once viewed as being the chief growth engine for the wholesaler.
Meanwhile, the bankrupt Kmart, Troy, Mich., inherited a suite of challenges of its own last week as it must now scramble for an alternate supply arrangement for its 60-store supercenter operation. Kmart said last week it intends to continue operating those supercenters, although their count has been sharply cut from 117.
Fleming and Kmart said last week their supply arrangement, first forged in July 2001, was terminated by mutual agreement. A difference of opinion erupted, though, about why the contract was terminated, with industry reports surfacing that Kmart forced the issue, claiming inadequate service levels from Fleming, inconsistent private-label products and failed quality tests.
Apparently, though, it was Fleming that first publicly broached the notion of voiding the supply contract, and its top executive told securities analysts as much last month (SN, Jan. 27, 2003, Page 1).
Shane Boyd, a Fleming spokesman, told SN last week the deal was terminated because Kmart was no longer the company it was at the time the contract took effect.
"The existing arrangements were based on assumptions that were no longer applicable and no longer relevant. At the time the contract was signed, Kmart was an investment-grade company with an aggressive growth program and an immediate need for $4.5 billion or more annually of products that Fleming would supply. Unfortunately, Kmart was never able to perform as it had originally indicated and after two rounds of store closings and lower volume requirements overall, the supply relationship did not reflect the current situation. It became clear termination was the right solution for both companies," he said.
Fleming is to continue to supply Kmart on a transitional basis. No date to totally end the relationship has been set, although observers told SN the transition is likely to last for several months.
According to Boyd, revenues from Kmart amounted to about $3.1 billion last year, or slightly less than 20% of Fleming's 2002 sales of approximately $15.5 billion. However, he said revenues were expected to dip below 15% this year had the contract not been terminated because of Kmart's decision to close additional stores and because Fleming has been diversifying its sales base over the past couple of years.
He said Fleming currently derives about one-third of its volume from conventional supermarkets, one-third from convenience-oriented formats and one-third from supercenters, limited-assortment stores and other alternative formats.
Chuck Cerankosky, a retail analyst with McDonald Investments, Cleveland, told SN the loss of the Kmart account will leave Fleming with serious challenges.
"Fleming made a major strategic decision two years ago that tied its growth to growth at Kmart. That obviously isn't going to happen, and that makes the outlook questionable for Fleming in terms of how much future earnings growth it loses."
Another challenge for Fleming, Cerankosky said, involves coping with the investment it made in inventory, leases and capital improvements at the two dedicated facilities it added to supply Kmart, in South Brunswick, N.J., and Fort Wayne, Ind. Fleming's Boyd said both facilities are leased and are operated by third parties, and their fate hasn't been determined.
According to Howard Davidowitz, an industry consultant with Howard Davidowitz & Associates, New York, the loss of Kmart's business puts Fleming "under the gun."
"Now Fleming is left with an infrastructure from the Kmart deal, plus a shrinking base of supermarket customers and a huge debt [of $1.9 billion] that limits its flexibility. Its efforts to diversify have been creative and good, but they may not be enough to keep it going. And the fact that the stock price continues to drop tells you Wall Street values Fleming as a company that may not have much of a future." Fleming's equity value dropped nearly 30% early last week upon the Kmart news.
Fitch Ratings downgraded Fleming's credit ratings last week and said the termination of the Kmart agreement is likely to result in significant one-time costs along with the loss of $3 billion in revenues. On a more positive note, Fitch reported, "Fleming has some financial flexibility to work through the significant changes to its business, as it has no debt maturities until 2007. Fleming is currently renegotiating its secured bank agreement [and] the new or amended facility is expected to have covenant levels based in part on the assets of Fleming that will provide the company with more flexibility."
For Kmart, the transitional supply agreement with Fleming will give it time to seek out alternate sources for perishables while stocking its existing facilities with non-perishable consumables.
Jack Ferry, a Kmart spokesman, told SN last week the discounter plans to begin self-distributing consumables out of its non-perishables grocery warehouse facilities while seeking out a third-party supplier to service its perishables needs. "We're in talks with a variety of vendors and wholesalers on that subject."