WHY FLEMING AND KMART MADE THE DEAL

David Merrefield

A most intriguing sequence of events has played out in recent weeks. It concerns the decision of Kmart Corp. to award its considerable grocery business to one wholesaler. The saga has been chronicled on the front pages of the past few issues of SN.

In brief, here's the situation: For the past several years, Kmart has been sourcing consumables offered in its discount and supercenter stores from several wholesalers, most recently Supervalu and Fleming. Early this year, Kmart let it be known it wanted to "partner" with a single wholesaler and said it would entertain proposals that would lead to a single wholesaler picking up its entire $4.5 billion of annualized business in a 10-year supply arrangement.

As it turned out, not much of a contest for the business developed. Supervalu folded its cards and Fleming picked up the business.

Why would that happen? Let's take a look at the situation from three different directions to see, starting with Kmart. Clearly, Kmart had an interest in developing some sort of integrated supply arrangement. That's because Kmart needed to lower its acquisition costs so they would be more in line with what Wal-Mart Stores has developed over the years. Kmart needed a supplier that would be willing to develop a widespread supply infrastructure together with a a highly integrated, demand-driven replenishment system. And, the selected wholesaler would have to be willing to expend the capital required, including the construction of additional distribution centers if need be.

The Supervalu point of view seems to be that the Kmart prize simply wasn't worth the race.

Supervalu apparently came to the conclusion that it couldn't properly supply Kmart without expending huge amounts of effort and capital. Such expenditures of resources might have distracted the organization from its chief goal of supplying independent and corporate stores as efficiently as possible.

Lurking around all situations of this type is a fundamental conundrum: Volume helps allow a wholesaler to offer lower-cost goods to all accounts, but at some point volume starts to interfere with the process because it puts a wholesaler in competition with increasing numbers of the stores it supplies, and it starts to clog its infrastructure.

The Fleming point of view was that Kmart made a good fit because it had shed much of its corporate-store presence and had been working for a while to be a pure play wholesaler, one focused on the business of supplying product to high-volume stores as inexpensively as possible.

Lurking around the Fleming-Kmart deal was the presence of Ron Burkle, well known in investment, supermarket and Democratic Party circles. Ron, through his Yuciapa Cos., obtained a $50 million position in Fleming, or about 9% of its stock, as the deal was announced. He also has a 6% position in Kmart. That may have helped Fleming overcome any objections that a close alliance with Kmart might have triggered in the board room of a totally unaligned company. (Unlike some observers, I see no Fleming-Kmart merger ahead.)

That brings us to the final and perhaps paramount question: Can Fleming profitably supply Kmart, given the fact that Supervalu's action seems to imply that it would be exceedingly difficult to do so? We'll see, but Fleming has already overtly stated that its earnings per share will be on an upward march for the next three years. And its stock value has marched to new highs lately.