K Mart's Blue Period

By Bill Saporito With Reporting by Bernard Baumohl/New York and Joseph R. Szczesny/Detroit

If turnarounds were fashion, K Mart would never go out of style. The discounter has spent the better part of a decade reorganizing itself. The latest--and maybe the last--effort is being led by Charles Conaway, 41, whom the company plucked from drugstore chain CVS 18 months ago. Late last week the company's stock was pummeled, dropping 14%, to $4.71, after Prudential Securities retailing analyst Wayne Hood suggested in a report that bankruptcy would not be a bad move for K Mart. A Chapter 11 filing would allow the company to walk away more easily from the leases of underperforming stores and warehouses and move ahead with construction of new facilities in more promising locations. Hood believes that's the only way K Mart can even begin to compete with No. 1 Wal-Mart, which amid the recession is gaining share, embarking on a record expansion and even considering a move into banking.

K Mart was not amused by Hood's report, but Conaway showed some bravado in the face of the onslaught: he refused to interrupt his vacation to respond to Hood's salvo. Said K Mart spokeswoman Lori McTavish: "We're confident we have enough resources and enough lines of credit to get through. We're implementing a major change in the company's operations and culture." Other analysts were surprised only by the reaction to Hood's report, which recommended that investors sell the stock. They did, driving it to a 30-year low of $3.89 before it recovered. "This report is not new news. Where was everyone over the last year?" asked Shelly Hale, an analyst with Bank of America Securities.

K Mart is a struggling firm caught between two pricing strategies while trying to solve a complicated supply-chain problem--and hold off Wal-Mart. And you think your company has problems? During the critical Christmas season, Wal-Mart increased sales by an estimated 6%; K Mart will probably report a 2% decrease.

K Mart has long used ad circulars touting hot specials and loss leaders to draw crowds. This approach used to work well, but promotional retailing is inherently inefficient--merchandise courses through the distribution system in massive waves. Pick the wrong products or suffer a supplier hiccup, and you are suddenly up to your ears in toasters and out of detergent. Despite improvements, K Mart is able to keep its goods fully stocked on shelves only 86% of the time. Anything less than 90% is considered unacceptable. Wal-Mart runs close to 100%. Wal-Mart and others have emphasized "everyday low price" selling, which is more predictable for both customers and the distribution pipeline.

K Mart is trying to wean itself from the weekly circulars, but in the third quarter the company cut back too fast. Some shoppers love those ads, and when the flyers didn't arrive at customers' doors, customers didn't show up at K Mart's stores. At the same time, K Mart cut prices on 38,000 items. Consumers didn't catch on fast enough, but Wal-Mart sure did, and it fired back with a vengeance. "Look at what this CEO has done!" says analyst Hale. "He's tried to go up against Wal-Mart by lowering prices, and it just didn't work because you can never just fight Wal-Mart on price." Why not? Wal-Mart is better at squeezing suppliers for better terms, and it has a lower overhead. Result: in the third quarter K Mart's sales dropped 2.2% from the same period a year ago, while Wal-Mart's rose 15.5%.

Also in the third quarter K Mart's inventories swelled by 5.6% as sales fell. Hood estimates that for each 1% increase in inventory this year, K Mart's cash flow will drop some $40 million. That's money the company needs to continue its program to remodel old stores and build new Super K supermarket-discount stores. If K Mart had been as efficient in selling as Wal-Mart, it could have earned $200 million in the third quarter instead of losing $224 million.

Meanwhile, Wal-Mart is looking for other markets to conquer. It would like to offer low-cost checking and savings accounts and other financial services in branches, managed by a division of Canada's Toronto Dominion Bank but staffed at least partly by Wal-Mart employees. Wal-Mart figures that perhaps 20% of its customers do not have bank accounts. It is trying to work its way around U.S. banking regulations that currently forbid entities such as retailers from running banks. That's where partner TD comes in. Who knows? Maybe K Mart will apply for a loan.

--With reporting by Bernard Baumohl/New York and Joseph R. Szczesny/Detroit