OBSERVERS SEE KMART ENJOYING A FOODLESS RECOVERY

DAVID GHITELMAN

TROY, Mich. -- Kmart Holding Corp. here said last week it expects to report a profit for the holiday season, and the news sent the company's share price soaring, but none of the industry observers who spoke with SN said they believed that food would play a key near-term role at the mass merchant, and several said they expect the company gradually to phase out its Super Kmart supercenter format.

Kmart said it expects to generate a net income of $200 million for November and December, the first two months of its fourth quarter, after interest expense and taxes, not including after-tax gains of $50 million for real estate transactions. The news propelled the company's stock to a 26.6% single-day increase early in the week.

The company added that it expects to report complete fourth-quarter results March 18. If the company ends the three-month period in the black, it will be Kmart's first profitable quarter since emerging from Chapter 11 bankruptcy protection in May.

Kmart attributed the profits to "strong inventory management and the reduction of unprofitable promotions."

While the industry observers said they commended the company for instituting strong controls and cutting back on promotions, they noted that food appears to be playing a diminishing role in Kmart's recovery.

"Food clearly has a role in all the discount formats in driving traffic, but right now at Kmart it's largely confined to snack/beverage categories and not the full weekly shopping trip," said Neil Stern, senior partner, McMillan Doolittle, a Chicago retail consulting firm. "I'm guessing that's where they're probably going to stay in this business."

James McTevia, chairman, McTevia & Associates, an Eastpointe, Mich.-based turnaround firm, commented, "When you're talking about food, you need a whole new infrastructure. I don't think Kmart has the infrastructure now or the working capital to build one. I don't think Kmart will ever be a force in the food industry."

And the observers also said the odds are strong that the Super Kmart format will never be a major rival to the supercenters operated by Wal-Mart Stores or Target Corp. While Kmart was in Chapter 11, it closed all but 60 of its 117 supercenters.

"When you close half of all the supercenters you've got, you've given up," said David Rogers, president, DSR Marketing System, a Deerfield, Ill., retail consulting firm. "I don't think they're a factor any more, particularly in the face of the continued expansion of Wal-Mart and Target."

Stern noted that the closings leave Kmart unable to benefit from the economies of scale that typically make supercenters profitable. "I think they're caught in a no man's land with those stores," he said. "They don't have enough market concentration to be a meaningful player. I don't know what their long-term play is."

McTevia said the Super Kmarts could survive by changing their focus. "The Super Kmart format may turn into something less than a full-fledged supermarket," he noted.

But Richard Hastings, a Charlotte, N.C.-based retail sector analyst for Bernard Sands, a New York credit advisory firm, speculated that Kmart might soon start closing the remaining supercenters. When the company was closing stores during its Chapter 11 restructuring, he noted, "they couldn't propose closing too many at one time; that would have created too much resistance among leaseholders who were creditors in the bankruptcy. It's possible that very slowly we're going to see occasional store closings.

"Kmart's supercenters are vulnerable, but I don't think Kmart as a corporation is dependent on them for its long-term survival."

None of the observers said they were concerned about Kmart's net sales, which declined 26.1% to $5.1 billion in November and December. The company explained the falloff by noting that it closed 316 stores in the first quarter of the current fiscal year, and the closings came in for some high praise.

"I'm certainly impressed with their retrenching strategy, becoming a smaller, more profitable company," said Jon Hauptman, vice president at Willard Bishop Consulting, a Barrington, Ill., retail consulting firm. "Kmart has made tremendous progress."

And the observers were unanimous in noting how the company has improved since it entered Chapter 11 early in 2002.

"This is a company that has been dramatically reengineered," Hastings said. "Most of the middle and upper management is gone.

"The culture has dramatically changed. They went from being run on a lack of control and precision to being a culture of brutally realistic controls and expectations. The premises were overwhelmed with forensic accountants and federal investigators. Anybody that was a question mark is probably no longer there.

"In terms of bankrupt turnaround companies, there are few that are as fresh a start as this."

McTevia offered a similar assessment. "The impressive thing to me is not the $250 million in profit, but the time the company has bought to stabilize itself," he said. "They are spending a lot of time mending fences with suppliers, mending fences with their employees, spending money to upgrade their stores -- the kind of things that a company that's going to be around for a long time does."

Some noted that this new culture is evident in the stores as well as the financial results. "I think the stores are looking better," Stern said. "They've narrowed merchandise categories. They have some more focus in the stores."

However, reaction was mixed to the news that same-store sales in November and December declined 13.5%.

"You have to make money in November and December as a general merchandise retailer," Stern said. "The real question for them is: Are they getting more customers into the stores? There hasn't been any evidence of that."

Hauptman noted that the same-store sales decline presents Kmart with a serious long-term issue. "In the short term, you can increase profits by cutting costs and managing your pricing and promotions, which they've done well," he said. "However, the same-store sales decrease represents an erosion of shopper loyalty, which will be a very tough nut to crack."

In contrast, McTevia said the company was not yet ready to stem the same-store sales falloff. "You don't mend your fences with your customers first," he noted.

"You've got to get the markets behind you, your employees behind you. Those are all things that have got to get done so that when customers come into the store again, they aren't going to look around and then walk out."