NEW YORK — Call it the Kmart surprise.

With its first profitable quarter in three years and a hot stock, Kmart Holding Corp. is back on the retail radar, which reignited speculation over a Kmart-Sears merger, while also raising another critical question: Where’s the chief merchandiser?

This story first appeared in the March 19, 2004 issue of WWD. Subscribe Today.

Asked if Kmart’s first profitable quarter in three years symbolized a turnaround, spokesman Jack Ferry characterized the news as the “first signs” of the company’s efforts to “build a professional management team and establish the fundamentals for an effective and efficient retail organization.” But that team apparently won’t include a chief merchant for now — Ferry ended months of industry speculation by saying the search for one is on hold.

Meanwhile, Kmart’s fourth-quarter results gave Wall Street something to chew on. Kmart, which operates more than 1,500 stores, said for the fourth quarter ended Jan. 28, income was $276 million, or $2.78 a diluted share, against a $1.1 billion loss a year ago, or $2.13. Sales fell 25.8 percent to $6.33 billion from $8.53 billion. Same-store sales for the period fell by 13.5 percent.

Investors applauded the retailer’s results by sending the stock up 6.9 percent in trading on the Big Board to close at $37.06, up $2.38. The stock reached a new 52-week high in intraday trading, hitting $39.31 a share.

Regarding Martha Stewart’s conviction, Kmart said in a government filing there’s been no adverse impact on its Martha Stewart-branded goods business.

On the merchandise front, the retailer has been busy. In the last six months, Kmart has brought on two Gap Inc. veterans — Lisa Schultz as senior vice president and chief creative officer, and John Goodman as chief apparel officer, both new positions that will apparently fill the “merchandise vision” quotient customarily supplied by a chief merchant. Schultz works from the retailer’s new Manhattan design offices, set to open Monday at 111 Eighth Street.

Outside apparel, Kmart also has recruited broadly from retail ranks, bringing in former Sears, Carrefour and Home Shopping Network executives.

Ferry characterized the retailer as working on basic blocking-and-tackling operations — for instance, widening the aisles and waxing the floors to create a brighter, airier store.

As for the firm’s “green logo” stores, Ferry said their role is more “laboratory” than prototype.

Kmart operates five such concepts, in White Lake, Mich., a Detroit suburb, and four others in Peoria, Ill. Asked about significant innovations in these doors, Ferry said the stores have shorter, broader aisles and convenience foods in back, which makes for easier replenishment.

Meanwhile, the scuttlebutt activity in the financial services community ticked up Thursday as the retailer’s results renewed speculation over a possible Kmart-Sears merger, which some say would be led by Ed Lampert, founder of ESL Investments and chairman of Kmart Holding Corp. ESL Investments, along with Third Avenue Trust, bailed Kmart out of bankruptcy and owns more than 50 percent of the retailer’s common stock. Lampert is also the largest stakeholder of Sears. This won’t be the first time speculators have put the two firms together in a marriage. It’s important to note that, of the eight board members of Kmart, aside from Lampert, two work for ESL Investments and one is with Third Avenue Management.

According to an investment banker, one reason a deal hasn’t happened yet is because “Kmart still has too many stores in not-so-great locations.”

Julian Day, president and chief executive officer, told Wall Street Thursday that, “by giving careful thought to the processes of sourcing, logistics, pricing, inventory management and in-store presentation, we have significantly improved the profitability of our market basket. Our store associates and store managers are committed to continuous improvements of customer service. Likewise, our employees based at headquarters are dedicated to supporting improvements in the store experience.”

The ceo also noted that Kmart’s inventory investment has been “prudently managed throughout the year, ending the fiscal year at a level below $3.3 billion, a reduction of more than 25 percent relative to the prior year on a comparable-store basis.”

He added that the company has significantly strengthened its cash position through improved inventory management, cash flow from operations and receipts from sales of surplus real estate. At yearend, Kmart had $2.1 billion in cash and cash equivalents and had not borrowed under its credit facility other than for letters of credit.

Richard Hastings, credit economist at Bernard Sands, said there “is so much misunderstanding about what is a comparable-store sale. Does it directly correlate to net profit? No, not at all. Kmart’s comps might be down, but the company is generating more dollars from the sales. The liquidity that Kmart has means it is not going anywhere anytime soon. “Possibly, one day down the road, Wal-Mart will hurt them terribly, but for the next 20 months, this retailer is not going anywhere.”

Hastings said Kmart “is not going to blow through $2 billion in 60 days. The retailer has the same Kmart name, but it is a totally new culture with new management.”

The economist, who recently chatted with Kmart officials, noted that the company’s focus is on carving out a niche as an ethnic merchandising discount department store, paying close attention to basic, high-margin goods.

Does he think Kmart is out of the woods?

Walter Loeb, a retail consultant of the firm that bears his name, isn’t so confident about Kmart’s future. “The quarter’s results disguise the true momentum at Kmart. One year from now it will be a different story. The numbers are good because it reflects the [ridding] of old inventory when it came out of bankruptcy,” Loeb pointed out.

Outside of cosmetic changes, retail consultant Therese Byrne said she has yet to see meaningful, coherent change in infrastructure — specifically personnel, sourcing and IT, a Kmart Achilles’ heel for decades. Without that, she said, Kmart’s operations are akin to a “Hollywood set.”

“It’s fake retail, like Montgomery Ward before they went under. They are still the old Kmart in that they think they can do without systems,” she said.

George Whalin, ceo of Retail Management Consultants, was willing to cut Kmart slightly more slack. He warned against overemphasis on the 13.5 percent comp-sales drop because pre-bankruptcy comparisons are inexact.

“At this point, comp sales aren’t terribly significant. The question is: Are they building on the business?” he said. “If they can show improving sales month to month, they have a chance of turning this thing around.”

He would like to see Kmart make two moves quickly — renegotiate its Martha Stewart license for more favorable terms and hire a chief merchant.

Overall, Whalin said holiday 2004 will be a do-or-die for Kmart. “I think they are on the right track, but they are moving slowly and this is an unforgiving business to move slowly in,” he noted. “They’ve got to make it happen in the next three quarters and they’ve got to go into holiday ready.”

The retailer said in its annual report, or Form 10-K, which it filed with the Securities and Exchange Commission on Thursday, that it has more than $23 billion in annual sales and more than two million customer visits a day. Among its top proprietary brands are Martha Stewart Everyday, Joe Boxer, Jaclyn Smith and Thalia Sodi. The company said in the filing that a disproportionate amount of revenues and operating cash flow are generated during the all-important holiday selling period, with fourth-quarter sales representing 28 percent of same-store sales in fiscal 2003.

While much has been written about the recent conviction of Martha Stewart and its potential impact on her brand, Kmart said in the SEC filing, “To date, we have not experienced any significant adverse impact from this matter on the sales of Martha Stewart Everyday brand products. 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 its Martha Stewart Everyday brand products.”

In a matter related to Stewart’s firm, Martha Stewart Living Omnimedia, the lawsuit filed by Kmart against a subsidiary of Omnimedia over a dispute in how royalty rates are calculated — Kmart is seeking to reduce royalty payments by $4.5 million to $47.5 million from $52 million — is still progressing.

The company was silent about the status of a federal investigation surrounding the circumstances of its bankruptcy that was started by the U.S. Attorney’s Office in Michigan, with the assistance of the Federal Bureau of Investigation, suggesting it was still in progress. Kmart did reference in its filing the 10-K filed last year for fiscal 2002, which had more information about the nature of the investigation and Kmart’s own stewardship review.

For the 39-week period, during which Kmart operated as a successor firm to the one that filed for bankruptcy, income was $248 million, or $2.52 a share, against a loss of $1.78 billion, or $3.50, last year. Sales fell by 23 percent to $17.07 billion from $22.17 billion, while comps declined by 9.5 percent.

For the year, incorporating the same 39 weeks and the $862 million loss sustained during the 13 weeks ended April 30, 2003, operated by Kmart’s predecessor firm, the discounter posted a $614 million loss.

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