Kmart: Out of the Box?

Even if the company's accounting scandal was a one-off occurrence, Kmart must still overcome the legacy of what many see as major strategic misstep...
David KatzOctober 20, 2003

Compared with its weightier business woes, Kmart’s accounting scandal seems more of a nagging problem than a looming catastrophe.

Much more troubling is the question of whether or not the discount retailer, which emerged from bankruptcy in May, can resurrect its brand and explain to consumers why they should shop at its stores, Kmart watchers say.

To be sure, they credit the chain with bounding out of Chapter 11 two months ahead of schedule and with an impressive $2 billion in exit financing. They also praise its renovated management, merchandising logistics, and financial reporting. But they question whether it can put the brakes on its market-share slide and gain any ground at all on its vaunted competitors, Wal-Mart Stores and Target Corp.

To do that, Kmart Holding Co., as the parent organization is now called, must overcome the legacy of what many see as a major strategic misstep: Trying to compete with Wal-Mart on price.

The struggle to vie head-to-head with the formidable competitor put tremendous pressure on Kmart to maintain its profit margins in the years running up to bankruptcy, according to Gary Ruffing, a former Kmart vice president of sales and marketing. During that time, the company slashed both its everyday prices and the cost of goods featured in advertised sales, notes Ruffing, who says he left in February 2001 after thirty years the company because he disagreed with that policy. “You’ve taken two hits in the same year,” he says. “That’s very hard to manage.”

The strategy of slashing prices also meant that the company had to move many more products through its pipeline to maintain its gross-profit margins.

Besides increasing the need for cash to pay suppliers, the surge in inventory placed a crushing burden on out-of-date systems. “When goods moved from distribution centers to stores, it was not an optimal process,” says Richard Hastings, chief retail analyst at Bernard Sands, a credit advisory firm.

The supply-chain breakdowns threatened the credibility of the company’s financial reporting. “If you don’t know where the boxes are, you don’t know what they’re worth,” says Hastings, who noted that such problems created “a lot of questions about the validity of Kmart’s accounts-payable numbers.”

Apparently, the problems were longstanding. A software programming flaw in Kmart’s accounts-payable system involving one of the company’s vendors led to an understatement of the company’s cost of sales from 1999 through 2001. The error was one reason given by the company for a December 2002 restatement that boosted its net loss for that period by not quite $100 million. (At the time, the company also restated its results for the first two quarters of 2002, lowering its net loss for that period by roughly the same amount.)

Another reason Kmart gave for that restatement was the premature recording of vendor allowances, also called slotting fees, paid to Kmart (and many other retailers) by suppliers to keep their products on store shelves. Indeed, alleged improper reporting of vendor allowances have been the source of an accounting scandal at the company.

The same profit squeeze that damaged Kmart’s logistics seems to have played a big role in its accounting problems. In February, the Securities and Exchange Commission sued two former Kmart executives, Enio Montini and Joseph Hofmeister, charging them with improperly booking the entirety of a $42 million slotting fee paid by American Greetings in the fourth quarter of 2001, rather than over the five-year life of the deal. Their alleged motivation: to hit quarterly gross-margin performance targets on which their incentive pay was based.

Besides the SEC action, Montini and Hofmeister face criminal charges of securities fraud, lying to the commission, and conspiring to commit those offenses. The SEC and the U.S. Attorney’s office for the Eastern District of Michigan are also conducting broader investigations into how Kmart has accounted for vendor allowances.

Sprucing Up

Despite the investigations, however, the company has done an excellent job of pulling itself out of its operational and accounting quagmire, some observers say. Last month management signaled a willingness to repair its logistics, according to Ruffing, by naming Bruce Johnson senior vice president of supply chain and operations. Previously Johnson served as director of organizations and systems at grocery giant Carrefour, which has more than 9,500 stores in 30 countries.

Further, since filing for Chapter 11 protection, Kmart’s financial reporting has gone “from somewhat unreliable to highly credible and reliable today,” says Hastings, the credit analyst. Part of the reason for Kmart’s new transparency, he thinks, is that the bankruptcy occurred during a particularly robust period of regulatory reform that included the Sarbanes-Oxley Act. But he also credits Albert Koch, who served as Kmart’s temporary CFO during the bankruptcy, with sprucing up the company’s books.

The installation of Koch and temporary Kmart treasurer Ted Stenger, members of turnaround management firm Jay Alix & Associates, were part of a considerable housecleaning. Nearly all of the top executives who ran Kmart before its January 2002 Chapter 11 filing have left the company. Among the departed were a group executives granted retention loans by former chairman and CEO Charles Conaway as the company headed down the tubes. Conaway and Mark Schwartz, the former president and chief operating officer — and a Wal-Mart veteran — were the architects of the price-cutting strategy.

The new top executives, led by president and CEO Julian Day and chairman Edward Lampert, are given high marks for their roles in the company’s quick escape from the ranks of the bankrupt. The hands-on approach of Lampert — a hedge-fund manager whose firm, ESL Investments, owns more than 50 percent of the company’s shares — reportedly played a big part in the company’s swift emergence.

But was the fast track too fast? “There’s speculation that they could have benefited from a longer period in bankruptcy” to have more time to plot strategy, thinks Nancy Aversa, a research analyst with Victory Capital Management in Cleveland. She also questions whether Kmart’s closing of about 600 stores during the bankruptcy was enough to “rationalize its base.” If Kmart were to undertake a second round of closings, even of fewer stores, the public perception might be even more damaging.

Another potential problem is the vacancy where the CFO should be. In its complaint against Montini and Hofmeister, the SEC noted that the men were able to freeze out a key finance official — Montini’s direct report — from the vendor-allowance negotiations with American Greetings. If the company doesn’t come up with a strong replacement for Koch, whose role as interim CFO concluded when Kmart emerged from Chapter 11 in May, questions could arise about the company’s ability to enforce its internal controls.

To be sure, a fair number of Kmart watchers now see the accounting scandal as a one-off occurrence with no lasting impact on the company’s core business. But if the government investigations become prolonged, and “Kmart’s name keeps coming up in a negative way,” that would hurt its ability to attract loyal customers, thinks Ruffing. The former Kmart vice president, by the way, is now a now a senior director at BBK Ltd., a Southfield, Michigan-based firm specializing in turnaround advice.

Shopping — especially bargain-hunting — may be a favorite American pastime. But fail to restore a company’s good name, says Ruffing, and customers might well come to ask, “Why should I shop somewhere where people are taking advantage?”