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How Good a Buy Is Kmart?

By Amy Tsao On Jan. 5, Kmart did the unexpected. The discount retailer, which emerged from bankruptcy in the summer of 2003, said it would generate net income of $200 million for November and December. Investors seemed unfazed that sales at stores open at least a year, a key measure of retail health, fell 13.5% in those months. The promise of profits was enough for shares to jump 13% that day, to $30. The stock closed around $31 on Jan. 12.

Considering its last moneymaking quarter was three years ago, it's easy to see why investors got so excited. Newly appointed Chief Financial Officer Jim Donlon says Kmart's (KMRT) merchandise selection is better, so it doesn't have to discount as deeply to clear inventory. Plus, employee service levels are rising, and stores are cleaner and brighter. "We're in the process of retargeting our objectives and our focus toward the profits of our sales, and not the sales level itself," says Donlon.

Kmart may be getting back on track, but as an investment, it could still be a tough play. Since the stock began trading again in June, 2003, it has doubled, defying naysayers' expectations. From here on, though, gains could be harder to come by, some on the Street believe. Profits for the final two months of the year, while a definite positive, would come from the key holiday-shopping months, when nearly every retailer shows a boost.

STEERING CLEAR. Get past that good news, however, and the troubling fact is that revenues are still falling. Kmart's cost structure is certainly not that of Wal-Mart (WMT) or Target (TGT), both leaders in operating efficiency. So Kmart is wisely not trying to compete on price for the time being. But the trend of declining sales cannot continue indefinitely.

Limited updates from Kmart have made it more difficult for some investors to feel totally comfortable with its performance. Since the bankruptcy, it has issued only quarterly reports, vs. the monthly updates most retailers provide. No Wall Street analysts now cover it -- not surprising, experts say, since Kmart is a poor prospect for investment-banking deals. And some investors have a lingering fear of being burned yet again by another failed turnaround.

It'll take a continued period of solid financial performance to keep investors buying and spark the return of widespread analyst coverage, says George Whalen, president of Retail Management Consultants in San Marcos, Calif. Kmart can afford to put market share on the back burner, but Whalen would like some hard proof that it can keep on delivering profits. Says Whalen, who doesn't own Kmart stock: "I want to see that they've figured out a way to get costs in line where they are legitimately profitable for a sustained period."

MORE MARTHAS. Richard Hastings, retail analyst at Bernard Sands, is convinced Kmart will be around for the long haul. But he, too, advises caution. "Kmart over the next 18 to 24 months faces undetermined market-share risks," he says, adding that next to other retailers, it's a relatively high-risk investment. (Hastings doesn't own the shares, but his firm provides credit guidance to Kmart's trade vendors.)

Ultimately, Kmart needs to find a defining niche to drive top-line growth, industry observers say. Sales for fiscal 2003, which ended almost 12 months ago, totaled $30 billion, but Kmart is on track to post closer to $23 billion this fiscal year, which ends in about two weeks, a 23% decline. Granted, it has closed a lot of stores. But since it features only a few differentiating products or services that attract customers, at some point, Kmart could be "forced back to promotions mode to bring shoppers back," says Robert Passikoff, president of New York-based retail consultancy Brand Keys. "That's why profitability and sales are both very key." (Passikoff doesn't own Kmart shares.)

The popular Martha Stewart home products are still a primary driver of traffic to the 1,500 stores. Even assuming that fluffy towels and pretty sheets remain big sellers as the domestic diva's own personal controversies come to a head (see BW, 1/9/04, "What's Cooking at the Martha Trial"), Kmart needs to add to its lineup to bring in more customers, observers say.

IN THE BULLPEN. Kmart acknowledges the concerns, but execs are optimistic that analysts will pick up coverage by the time of its annual meeting on May 25. "Our financial position takes Kmart out of the category of a financially troubled corporation," says Donlon. The CFO promises that in 2004 he and the rest of Kmart management will be building "on this strong position we're in." He stopped short of providing details, but he did say that the goal is to lay out the next steps in advancing its "neighborhood store" strategy.

Leah Hartman, analyst at broker-dealer CRT Capital Group in Stamford, Conn., expects Kmart to announce new merchandising programs in time for the fall back-to-school shopping season -- envisioning changes to family apparel in particular. The balance sheet is in good shape to make these changes, Hartman adds. Kmart projects $1.8 billion in cash and less than $500 million in debt at the end of January. (Hartman doesn't own shares, but her firm makes a market in Kmart stock.)

Bulls like Hartman are looking for Kmart stock to keep advancing. She has a two-year price target of $40. "Once you get rid of unprofitable stores, rationalize inventory, bring in smart senior management, and have capital to reinvest in the stores, this is a pretty simple business that can be run profitably," she says.

That kind of positive sentiment about Kmart could grow in 2004 -- if it manages to pull off several consecutive quarters of improving performance. Over the long term, however, stemming the sales decline is a must. With Wal-Mart and Target continuing to attract customers, that remains a daunting challenge. Tsao covers financial markets for BusinessWeek Online in New York

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