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Red Lights Flashing: Kmart Net Hits $93M, But Hazards Lie Ahead

Despite a steep decline in same-store and total sales, investors keyed in on Kmart’s second consecutive profitable quarter to boost its stock.

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NEW YORK — When it comes to Kmart, earnings are better than sales — at least to Wall Street.

Well, that’s true for now before gas prices head toward $3 per gallon and potentially keep strapped shoppers out of Kmart — and perhaps Wal-Mart, Target and other stores, too.

Despite a steep decline in same-store and total sales, investors keyed in on Kmart Holding Corp.’s second consecutive quarter of profits. Shares of the discount retailer jumped 9.8 percent from the prior close to end Monday at $48.62 in Nasdaq trading, while the S&P Retail Index fell 1.2 percent and the Dow Jones Industrial Average plunged 105.96 points, or 1.1 percent.

Kmart delivered earnings of $93 million, or 94 cents a diluted share, for the three months ended April 28 compared with a loss of $862 million, or $1.63, in the same year-ago quarter. Sales dropped 25.3 percent to $4.6 billion from $6.2 billion, while same-store sales fell 12.9 percent.

Kmart said in its quarterly report that the declines in same-store and total-store sales were due to fewer midweek circulars compared with a year ago, as well as the closure of 316 stores during last year’s first quarter.

Adding to Kmart’s profitability, the company said in its Securities and Exchange Commission filing, was a more favorable gross margin rate. While gross margin decreased by $282 million to $1.14 billion from last year’s $1.42 billion, it rose to 24.6 percent as a percentage of sales versus 23 percent a year ago. Boosting the gross margin rate, the filing said there “were fewer clearance markdowns and reduced depreciation as a result of the write-off of long-lived assets in conjunction with the application of fresh-start accounting.”

Julian Day, president and chief executive officer, said in a statement that the company has been focused on “profitable sales with an improved gross margin rate, reducing operating costs through operational execution and working to improve the productivity of our assets.”

He added the retailer ended the quarter with $3.4 billion in inventories, a reduction of more than 23 percent from last year.

As reported, the Seventh Circuit Court of Appeals in Chicago in February decided that the bankrupt Kmart should not have paid $367 million to certain former key suppliers, which could have ranged from apparel firms to trash contractors, for pre-petition obligations. The SEC filing said Kmart recognized $7 million in recoveries during the quarter from vendors that received cash payments from the bankrupt entity. What is still unclear is who gets the cash, the new reorganized Kmart or the bankrupt entity for distribution to creditors.

Meanwhile, Martha Stewart, one of Kmart’s key branding partners, was convicted on March 5 of conspiracy, obstruction of justice and two counts of making false statements to federal investigators. Since then, Kmart and Stewart’s firm have renegotiated their agreement regarding the sale of Martha Stewart Everyday products in the discounter’s stores.

Stewart’s brand is extensive, ranging from the home and garden category to decorating products, storage, baby, candles and accessories. Kmart said in its quarterly report that, so far, it has not experienced any significant adverse impact on the Everyday brand line stemming from Stewart’s conviction. It noted, however, that, “although product sales have not been significantly affected by past events, the company is not able to determine the potential effects that these events may have on the future sales” of Stewart’s product lines. As reported, she is set to be sentenced on June 17 in a Manhattan federal court.

The retailer did not mention how well its apparel and accessories concepts fared in the quarterly report, such as its Joe Boxer label or its recent introduction of Thalia-branded merchandise.

For one analyst, there are other concerns looming aside from the sales of branded goods. The national average of gas is $1.94 a gallon, up 45 cents from a year ago, according to the U.S. Department of Energy. Richard Hastings, credit analyst at Barnard Sands, observed, “Value retailers such as Kmart and Wal-Mart cater to income groups that are vulnerable to deteriorating economic conditions. Gas prices at the national average right now are only marginally affecting consumers. While it is hurting some households in some markets, we’re not yet in the danger zone because in most of the country the costs are paid through debit or credit cards.”

He noted that, on an adjusted inflationary basis going back 30 years, current prices are not even at 50 percent of where gas prices were as a portion of disposable income when the energy crisis hit in 1979.

“When the national average hits $2.75 a gallon, that’s when all retail sales start to decline. When it hits $3 a gallon, then you’ll have instant recession,” Hastings said.

So far, Kmart’s stock price is up about 235 percent since it began trading in May 2003. Hastings pointed out that the public float is only about 37 million shares, a “very small number for a company that does $23 billion a year in revenue.” He noted that the shares — boosted by net operating losses carried forward, which in turn reduces the taxes paid on the profits and helps to raise the share price — are attractive to speculators who are “contrarian” players who “understand the business and aren’t afraid to take a chance. The rewards so far have been luscious.”

Ed Lampert, Kmart chairman and founder of ESL Investments, is the company’s largest stakeholder.

Also a potential media negative for Kmart could be more bad news about former management at the discounter. A contact within Kmart and special agent Dawn Clenney at the Detroit office of the Federal Bureau of Investigation both confirmed that the investigation concerning the events that led to the discounter’s filing for bankruptcy in January 2002 is still “ongoing.” Clenney, who said she “didn’t know” when the probe would be concluded, declined further comment on the matter.

The probe is being conducted by the U.S. Attorney’s Office in Detroit, which did not return phone calls for comment.

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