NEW YORK — The stock’s way down, the image and inventories are a mess and the morale has been decimated. But if its bankruptcy can push it to become the smaller, leaner, more efficient operation that observers believe can be forged from its long series of recent calamities, there’s still a decent chance at survival for Kmart Corp., which filed for Chapter 11 bankruptcy protection in Chicago Tuesday.

First, Kmart must endure what’s expected to be a long, complicated bankruptcy period and painful downsizing — at the corporate and store level. And its vendors will need to hold their breaths to see if they make the cut in the biggest retail bankruptcy in U.S. history.

Then comes the tough part. The Troy, Mich.-based discounter must devise a compelling and unique strategy for the future that works against the seemingly nonstoppable Wal-Mart, Target and Kohl’s, and the growing competitiveness of Sears and J.C. Penney.

In filing its Chapter 11 petition Tuesday, the nation’s third-largest retailer said that it intended to reorganize on a “fast-track basis and has targeted emergence from Chapter 11 in 2003.” The action confirmed a WWD report last week that a bankruptcy could occur within days.

The bankrupt retailer also has attained a $2 billion senior secured debtor-in-possession (DIP) financing facility from Credit Suisse First Boston, Fleet Retail Finance Inc., General Electric Capital Corp. and J.P. Morgan Chase Bank. The DIP facility, upon bankruptcy court approval of an interim financing order, will give Kmart immediate access to $1.15 billion, with the full amount available pending final court approval at a later date.

Charles C. Conaway, chief executive officer, said in a statement, “I am confident that, with our tremendous resources and dedicated supplier and associate communities, Kmart will emerge from this process as a stronger, more dynamic, more profitable enterprise with a well-defined position in the discount retail sector.”

The chain’s 2,114 stores remain open, and the company’s credit cards, checks, gift certificates and store credits will be honored as usual.

Conaway said that that retailer was seeking bankruptcy court approval to end store leases for 350 sites that were closed previously or are currently being leased by other tenants at rents below Kmart’s obligations. However, he gave no word on how many more stores will close. Estimates range from 250 to 500.

Along with the main bankruptcy filing, 37 subsidiaries also filed for bankruptcy protection. According to court papers filed in Chicago, Kmart listed total liabilities of $10.3 billion and assets of $16.3 billion.

Just after the filing, WWD asked retailers, analysts, credit executives and suppliers their opinions on how to revive Kmart. The consensus was that Kmart can survive long-term, but only with radical surgery and by holding onto its exclusive brands. Their prescription:

Niche market to Hispanics, African Americans and seniors. These populations are growing and no retailer really caters to them adequately.

Hang onto the exclusive Martha Stewart Everyday collection and build up the brand even more by giving it a more defined space, rather than being spread out in the store.

Play up and improve the quality of other proprietary lines, including Jaclyn Smith, Sesame Street and Kathy Ireland, and bring in more exclusive products and lines so there’s greater harmony in the stores and so Martha Stewart doesn’t stand as the sole point of distinction.

Update the systems for better replenishment and execution to cut the cost structure and compete better on price. Abandon high-low pricing once and for all and don’t try to outprice Wal-Mart.

Hire a chief merchant soon. Mark Schwartz, president and chief merchandising officer, was fired last week.

Some even said Kmart should abandon the food business, which Wal-Mart and grocery chains have a lock on, and that it may be too late to catch up.

“Even with all their travails, the consumer spent $38 billion in Kmart last year. That suggests drawing power,” observed Arthur Martinez, former chairman and ceo of Sears, Roebuck and on the board of Martha Stewart’s company. “It’s absolutely possible to build a profitable business.”

As Martinez sees it, the Kmart bankruptcy won’t be a disaster for the manufacturing community, and by closing unproductive stores, Kmart will lose roughly $3 billion to $5 billion in volume. “That’s not cataclysmic,” he said. By investing in more productive locations, some volume could be made up.

According to Eric M. Beder, equity analyst at Ladenburg, Thalmann & Co. Inc., “the swing factor will be if Kmart keeps its licensed brands, such as Martha Stewart Everyday Living, Disney, Sesame Street and Thom McAn’s. There is some wiggle room for the licensors to break the licensing agreements. If I’m Martha Stewart, I’m going to be figuring out right now what’s best for Martha Stewart. Is it worth it for me to try to break the agreement and try to find something else? If Kmart loses those licenses, then what’s the point of Kmart? Without the brands, Kmart becomes a poor cousin of Wal-Mart.”

Bill Sweedler, president of Westport, Conn.-based Windsong/Allegiance Apparel Group, which bought the Joe Boxer operation and its trademarks last year, said Tuesday that he was still planning to launch a Boxer collection at Kmart for fall 2002, with product hitting the stores in the middle of July. “We have a long-term contract with them and anticipate going forward with Kmart. They have expressed to us how important Joe Boxer is for them going forward. We think that as much as a bankruptcy was not needed now, since they’ve filed, Kmart now has the ability to deal with store closures and getting product onto the shelves. We’re anticipating adding to their bottom line revenues in the billions in sales.”

Sweedler explained that while it is standard in any licensing agreement to have an opt-out provision in the event of a bankruptcy, it is up to the debtor, with court approval, to determine whether to keep or reject the licensing arrangement.

“I feel very strongly that the company has a future,” said Gil Harrison, chairman of Financo, which has been an adviser to Kmart and Martha Stewart. “There is room in this country for Kmart as long as it differentiates. They can do it with special brands, such as Martha Stewart and Sesame Street. They also have to fix the stores.”

Although he applauded Conaway’s move toward exclusive brands, he noted that Kmart was hindered by inadequate systems and the unfortunate sidetracking of everyday low pricing.

“That sunk him,” Harrison continued. “Also, Kmart could not get goods from the warehouse to the stores in a timely manner and as long as the best-selling items remained out of stock or in short supply, the business could not grow.”

Jack Mulqueen of Jack Mulqueen Co., a supplier to department stores and private label contractor, said Kmart stores, with the DIP financing in place, can bring apparel inventories back to proper levels in the stores in about 10 days, and food supplies even faster, in a day or two. “Vendors would be more confident today, compared to the uncertainty of last week,” Mulqueen said. “They can at least feel comfortable with respect to forward shipments. I think the exposure to the factoring community would be larger. The exposure to vendors is not so much, at least on the apparel side.”

Mulqueen, who supplied roughly $40 million [at cost] in Jaclyn Smith sportswear to Kmart in the Nineties, said Kmart has powerful branding, but has to niche market to minorities: “They have a lot of stores that are inner city and were built 20 or 30 years ago.” He also suggested building on the corporation’s NASCAR sponsorship and could carry more NASCAR products.

One of the key factors leading to the bankruptcy filing so early in the year — credit sources and even some analysts on Jan. 2 thought Kmart had enough liquidity to get it through at least the first half of 2002 — was the reluctance of vendors in the last two weeks to ship merchandise because of fears concerning Kmart’s ability to pay.

Emanuel Weintraub, an industry consultant, said, “I have clients who are breathing a huge sigh of relief, because now they can ship and know that they will get paid. The only ones not happy about this are those taking a haircut.”

In the future, Weintraub said, “Kmart will be a much smaller company, without the purchasing clout to compete with Wal-Mart. Central to Kmart’s survival will be Martha Stewart, and its other large vendors. Kmart is likely to cast its lot with fewer suppliers, relying on mega-firms that will produce Kmart-only brands. Fleming, for example, will be Kmart’s only supplier of food and grocery. The big vendors are the ones that have the excellence in logistics and the corresponding balance sheet to provide Kmart with the terms it needs.”

Retail consultant Walter Loeb suggested that 350 to 400 underperforming Kmart units must be closed and a corporate downsizing is likely. “They’re lacking a merchant to remerchandise the stores, revitalize the supply chain and speed the deliveries. They have to replace Mark Schwartz. Chuck cannot do it all. But there is room for a small, well-defined, focused Kmart. It would have to be much smaller, with much better logistics, more exclusive product and special services. They need a strong merchandising team and a leaner operation. It will be a painful process getting there.”

“This is unlike the Federated bankruptcy,” added Isaac Lagnado, president of Tactical Retail Solutions. “Federated had a workable business model, with the right locations. In this case, the business model itself is deeply flawed. That demands drastic action. Number one is to forget about the food business. It does provide advantages, however it happens to be extraordinarily competitive and difficult to get into. For Kmart with limited capital, quite frankly, it’s too late to really pull off a 90,000-square-foot major supermarket operation.”

Instead, suggested Lagnado, go after “affordable,well-designed private label soft goods. Kmart had that in its grasp 15 years ago, when it launched Jaclyn Smith, and let it go. There was one distraction after another,” like building specialty stores and management turnover. “If they stuck to their knitting they wouldn’t be in this mess. But Kmart is still workable with a lot of surgery. Martha Stewart has been marooned at Kmart. It’s an island of tasteful merchandise but there’s nothing approaching that taste level. Martha Stewart is a shrewd woman. No doubt she’s talking to Sears and Target. Wal-Mart, for all its glory, does a lousy job in soft goods. It’s very dowdy. Kmart should attack Wal-Mart where they could get them, but instead took on Wal-Mart in food, which is most challenging.”

But many Kmart stores are older, too small to support food and in need of rehabilitation. “That’s where the Chapter 11 will enable them to get out of leases,” Lagnado pointed out.

“I would do a complete analysis of its economic structure vis a vis Wal-Mart and Target. Kmart is consistently 7 points above in the cost structure,” said Fulton Macdonald, president of International Business Development Corp. “If they don’t get their cost structure down to 16 or 17 percent, there is no way they can survive so when they keep deep discounting, they go right into the bone.” Macdonald said distribution costs need to be cut, the stores have to be more productive, and headquarters beg to be downsized. “Kmart never put the systems in like Wal-Mart started to do 15 years ago. Target has always been good in systems,” he said.

In a statement, Martha Stewart, ceo of Martha Stewart Living Omnimedia, expressed confidence Kmart “will ultimately emerge from this situation as a stronger, more competitive company in keeping with its proud heritage.” Accounts receivable due from Kmart total about $13 million, including royalties and advertising in MSO media.

“The amount we ultimately realize from these payment obligations cannot currently be determined,” Stewart said. “However, we believe that Kmart values its relationship with MSO and expect that Kmart will take steps to ensure that we receive payment as fully and promptly as possible.”

Sharon Patrick, president of MSO, said the firm currently expects “that we will be with (Kmart) throughout the term of our contract. If for some reason that doesn’t happen, however, we are supremely confident in the strength of our Martha Stewart Everyday brand label and in our ability to realize full value for that brand label in the domestic mass market, whether at Kmart or other mass retail outlets.”

Fleming, which provides Kmart with food and consumable products, on Monday suspended shipments because of the discounter’s failure to make a regular weekly payment. The arrangement between the two includes a seven-day invoice and payment cycle. Fleming also filed a $78 million reclamation claim Monday to recover merchandise receivables shipped before the bankruptcy filing, but not yet paid. On Tuesday, Fleming said in a statement that it intends to resume the deliveries upon receipt of satisfactory assurances from Kmart, via the bankruptcy court.

Saul Berkowitz, an accounting partner at American Express Tax and Business Services, wondered aloud, “In addition to finding a niche, is Kmart too far behind the curve in store presentations and merchandising? Even with its financing, after it pays off the landlords for the store closures and takes into account the severance payments for the employees, will Kmart have enough money left for operations? I don’t know.”

Jim Rice, vice president for Sands Credit Services, said, “Once the court approves the funding, we will certainly recommend that our clients ship. Our expectation is that most vendors will go back in and start shipping again.” Rice observed that the bankruptcy should, at the very least, provide a vehicle for which vendors and creditor groups can obtain the financial information they need on a more timely basis. “The bankruptcy snowballed quickly because Kmart did a poor job communicating with the trade.”

As reported, bankruptcy was mentioned as a possibility on Jan. 2 in a research note by Wayne Hood of Prudential Securities. The analyst expressed concerns because holiday sales were below plan, but also wrote in his note that bankruptcy concerns wouldn’t likely be an issue for six months because of adequate liquidity. Factors in the last two weeks, however, stopped checking because Kmart became tight-lipped about its finances. Vendors followed suit, and even took the unusual step of stopping shipment on replenishment orders. Some private label manufacturers who are self-financed managed to obtain credit insurance early in the month, but by early last week, that avenue of protection for vendors also dried up.

Entities holding the power to vote 5 percent or more of the voting rights of Kmart are: Barrow, Hannley, Mewhinney & Strauss; Ronald Burkle; Dodge & Cox Inc.; FMR Corp., and Vanguard Windsor Fund.

Among those on the list of top 50 unsecured creditors, financial institutions are the overwhelming majority of holders of claims. The Bank of New York as trustee for a number of different series of notes and debentures holds a $2.4 billion claim. Other top nontrade creditors include: BankBoston, $120 million; Chase II, $118 million; Bank of New York, $104.5 million, and Credit Suisse First Boston, $83.2 million.

Absent from the top 50 list were factoring firms. Among the trade, Fleming Cos. holds a $75.8 million claim, while Sara Lee Corp. holds a $28.4 million claim.

As part of its reorganization effort, Kmart named Ronald B. Hutchison executive vice president and chief restructuring officer. The company also hired Skadden, Arps, Slate, Meagher & Flom as bankruptcy counsel and Dresdner Kleinwort Wasserstein Inc. as its investment banker. Rockwood Gemini Advisors has been retained as real estate consultant.

Kmart chairman James B. Adamson said in a statement the DIP lending banks had agreed to allow vendors an opportunity to receive a second lien on the retailer’s collateral for their post-petition accounts payable provided that they resume normal trade terms and full merchandise shipments within 60 days of the bankruptcy filing.

The discounter said that its pension plan and savings plans are maintained independently of the company and are protected under federal law, and retiree benefits are expected to continue without disruption. However, total Kmart share holdings in its 401K savings plan, which represent employee purchases and company matches to employee investments, are about 6 percent of Kmart’s total outstanding common shares. In a bankruptcy, equity shareholders often see their shares extinguished.

Some financial experts in the apparel industry expect that among the hardest hit will be many of Kmart’s 4,000 vendors. Richard Oleszewski, first vice president at Bank Leumi, observed, “Depending on their individual exposures, some of the smaller vendors will sustain losses. Many will be fortunate enough not to go out of business. However, the store closures will impact the vendors. Where will they go to replace the lost orders from the shuttered stores? Many are already selling to Wal-Mart and Target.”

Adam Winters, senior vice president at Merchant Factors Corp., “This is not a good time to go bankrupt. Kmart’s bankruptcy has the potential of putting the small companies out of business, as well as apply more pressure on lending institutions regarding credit risks and checks on creditworthiness.”

Officials at some of Kmart’s top suppliers said they didn’t think the bankruptcy filing would devastate them financially. Sources said the retailer continued to pay its major suppliers normally up to the filing and that no major receivables backlogs had developed.

A spokeswoman for VF said the company expects the bankruptcy to have “no material impact on its financial results or current receivables position with Kmart. In addition, until more detailed information about Kmart’s future plans becomes available, the company believes it is too early to predict what impact if any the filing may have on VF’s sales in 2002 and beyond.”

In a statement, chairman and ceo Mackey McDonald added, “Kmart has been a valued partner of ours for many years and we’re committed to working with them.”

Kmart represents less than 10 percent of VF’s sales. The spokeswoman added that the company had continued to ship Kmart until the filing and anticipates resuming regular shipments as soon as the retailer lines up its DIP financing.

At The Bonjour Group, the New York vendor that produces Kmart’s Route 66 private label brand, ceo Charles Dayan said his company had continued to ship Kmart regularly right until the filing and was confident that his outstanding invoices would be paid despite the bankruptcy filing.

“We believe that we will be treated fairly. We’re not too concerned,” he said Tuesday. “We’re standing behind them. They have to adjust a couple of things and they have a bright future.”

According to sources, the Route 66 brand is believed to have done about $1.2 billion in retail sales at Kmart last year.

Procter & Gamble said it expects that Kmart’s bankruptcy would have no material impact on sales or earnings results, while Joseph Campinell, president of L’Oreal Retail, said the division “will find a way to work with Kmart through these difficult times.”

At Kellwood Co., chairman, president and ceo Hal J. Upbin said, “Our exposure with Kmart is negligible. Once the court approves Kmart’s plan, we will resume shipments. Unfortunately, the retailing landscape is still over-stored. Kmart has been a good customer for many years, so we hope this restructuring plan allows them to survive. With Kellwood’s channel-diversification strategy the company is well positioned. We sell all channels of distribution — which is the best strategy for an apparel marketer today.” – Vicki M. Young and David Moin with contributions by Scott Malone and Kristin Larson.