Kmart's decline and competitive challenges in retail

Kmart is one of America's most well-known retailing names, yet in the past ten years the company has fallen on hard times. Competition has come in multiple forms, from discounts like Wal-Mart and Costco, to category killers like Home Depot to online retailers like Amazon.com. Struggling with declining sales and mounting debt, Kmart was purchased by equally struggling Sears Holdings in the latter's attempt to reshape its business and improve buying power for both firms. Today, Kmart is a profitable operating unit for Sears Holdings, earning $333 million in net income on revenues of $15.593 billion from 1307 stores (Sears Holdings 2010 Annual Report).

This paper will analyze Kmart's financials, its business environment and its competitive strategies in the years leading up to its purchase by Sears. It is clear that the company's external environment changed significantly in that time, and Kmart struggled to adapt to those changes. The struggles were eventually reflected in negative outcomes -- declining sales and market share in particular. By the conclusion of this paper, an assessment will be made about the problems that plagued Kmart, what the company's response was and whether or not that response was appropriate or sufficient.

History

Kmart was founded by Sebastian Kresge in Detroit in 1899 as a five-and-dime store, the forerunner to the modern department store. The store was an immediate success, and by 1912 Kresge owned 85 stores and had annual sales of more than $10 million (SHC, 2011). From the beginning, the company operated using what today would be termed as a cost leadership strategy (QuickMBA, 2010). This involved selling ordinary goods to the mass market at low prices. Executing this strategy effectively requires that the firm have efficient operations and strong buying power so that the merchandise can be purchased at lower prices than the prices competitors receive. In addition, most successful retailers in the cost leadership sector are experts at merchandising, a skill that helps to maximize the average ticket and improve customer throughput.

Kmart was an industry leader for several decades but by the 1950s was already facing its first major challenge. The external environment had become much more competitive and Kmart was in tough to defend its market position. Its response evolved into the Kmart discount department store concept. This concept reinvigorated the company and became the model that Kmart still follows today. Sales increased rapidly and the company opened stores at a rapid pace for several years. By 1990, the store was beginning to lose its prestige and the company began an expensive revitalization process that involved modernizing the look of the stores and introducing the Kmart Superstore concept to counter an emerging Wal-Mart. The company entered e-commerce in 1999, late by Internet retailing standards but the site still signed up large numbers of customers.

Despite this, the company was struggling. Kmart entered into Chapter 11 bankruptcy in January 2002. At the time, the company had $37 billion in revenue and $17 billion in assets, but had severe cash flow problems that prevented it from making payments to suppliers (CNN, 2002). The company re-emerged from Chapter 11 as the smaller, leaner operation that analysts had predicted. It turned a profit for the 39 weeks ended January 26, 2005 (2005 Kmart Holdings Annual Report). Kmart purchased Sears, Roebuck & Co. In November 2004 in an $11 billion deal and merged the two companies (Bhatnagar, 2004). The deal was orchestrated by Edward Lampert, and at the time there were skeptics who felt that the cash Kmart was generating after its Chapter 11 would be put to better use, as the deal now resulted in one company trying to turn two giant retail names around (Berner & Weber, 2004). As of 2011, the deal has yet to pay off. While Kmart is profitable, it is still shrinking and Sears continues to struggle. Neither company has been able to revitalize itself and the real estate crash destroyed much of the combined entity's stock value, which reflected the value of Sears real estate as much as anything else (Heller, 2011).

Financial Condition End of January 2001 and January 2002

Conaway's efforts, while strategically reasonable, did not have the desired impact on the company. As a result, Kmart's financial condition continued to deteriorate. The company was ultimately undone by a cash crunch, so this portion of the financial analysis will begin with the liquidity ratios. In 1999, Kmart was liquid. It had a current ratio of 2.0 and a quick ratio of 0.26. While these figures are consistent with the company's model, they point to a key problem relating to Kmart's cash flow: most of its current assets are inventories. If the inventories do not move, the company's liquidity will decrease significantly and quickly. By the end of January 2001, the company's liquidity ratios appear to have improved significantly. There were, however, $8.06 billion in liquidities that were now classed as "subject to compromise." The company already knew that its financial condition was untenable.

For a company where inventories make up the bulk of current assets, the key to maintaining solvency is to have high rates of inventory turnover and accounts receivable turnover. As a baseline reference, the inventory turnover rate in 2000 was 4.38 times, or 83.3 days. The company did not list accounts receivable as a separate line item on its balance sheet at the time. That rate of inventory turnover, however, could not be considered good. The cost leadership strategy that Kmart is competing with demands high sales volumes to compensate for low margins. While the dollar value of sales at Kmart was high throughout this entire period, inventory turnover was simply not fast enough for the company's business model. By fiscal 2002, the company had improved its inventory turnover somewhat, to 4.9 times (74.6 days). This was not even to recover the business, and remained flat even after the Chapter 11 filing.

Given that the company suffered a cash flow problem, it is also worth considering the cash flow statements. Kmart's cash flows from operations were strong through 2000. The company lost money that year, but cash flows from operations were $1.039 billion, slightly higher than the year previous. In fiscal 2002, right before the filing, Kmart had cash flows from operating activities of $927 million. While this figure was steadily declining and the company had cost control issues, its operations were delivering positive cash flow. The company saw its cash position decline by $366 million in 1999, despite taking in $1 billion in cash from operations. The cash flow from investing activities that year was -$1.363 billion. The majority of this spending was attributed to capital expenditures including store upgrades and the bailout of the company's e-commerce site. Major capital expenditures continued in 2000 and right through the bankruptcy filing. With declining revenue and profits, the company was forced to borrow to pay for these expenditures.

Kmart's Response

Conaway's strategic response to the company's problems failed to turn around its fortunes. During the late 1990s and the Conaway period, capital expenditure spending was at a relatively stable level. The company did not curtail such spending even when profits declined at the company was forced to borrow. As a result, the value of the shareholders' equity declined and the firm's degree of leverage increased, putting it at greater risk of default. Kmart's approach was largely qualitative in nature. The feeling among management was that if the company modernized a bit, then the customers would visit the stores more and spend more when they did. The moves did not make a dent in the company's cost structure. By the time Kmart began cutting costs, its revenues were in steep decline and the cost reductions were insufficient. The response was woefully inadequate, leading to the Chapter 11 crisis.

The move into Chapter 11 was a reflection of the need to dramatically restructure the company as much as it was a reflection of Kmart's lack of solvency. According to both the 2002 and 2003 Annual Reports, over $8 billion in liabilities were classified as subject to compromise. This left the company with a much improved capital structure and free cash flow. The move also gave Kmart the opportunity to shed underperforming units and properties. The leaner Kmart that emerged from bankruptcy had an improved gross margin of 25.8%, though it still had a high level of overhead with SGA expense accounting for 20.9% of revenues. But the changes allowed Kmart to return to profitability, with net income in fiscal 2005 of $1.015 billion. The company still had a sluggish inventory turnover of 4.5 times. Of critical importance, however, is that the company dramatically reduced its capital expenditures, which were just $230 million in fiscal 2005.

The Chapter 11 was the most significant response that Kmart had to its problems, from both a financial and operational perspective. The reforms under Conaway were mainly in the "too little too late" category, as Kmart had lost its competitive edge. The company needed many of the investments that were made during that era, but it simply could not afford to make them given the competitive environment and the relatively lack of competitive advantage that the company faced. Something had to give, and the Chapter 11 was it.

From a strategic point-of-view the Chapter 11 filing was a huge success. The company that emerged had the benefit of the capital expenditures and the reforms that Conaway had introduced. It still had some issues, most notably with respect to inventory turnover, declining revenues and spiraling overhead costs, but other key issues were resolved. Underperforming properties were jettisoned, leaving only the most profitable stores behind. Kmart was able to restore relationships with its old suppliers and find newer, better ones as well. This served to improve the store selection a little and to improve the company's margins. Remember that the generic strategy of cost leadership requires Kmart to sell high volumes and low margins, so the ability to extract higher margins, either from suppliers or customers, is critical when the volumes simply are not there. The Chapter 11 also provided the impetus to reduce dramatically the capital expenditures, as the ongoing spending had been one of the key causes of the company's bankruptcy.

The Kmart that emerged was not a fierce competitor. It still lacks the buying power of Wal-Mart and it has not yet been able to recover its reputation, which suffered during its down times. The company was, however, generating a substantial amount of free cash flow, a consequence of walking away from the lion's share of its debts. This cash flow brought Edward Lampert to the organization in the first place, buying its bonds when it had no credit, and the cash flow as then used to acquire Sears. This acquisition was the next strategic step in the recovery of Kmart in theory. That the company has not been able to leverage its partnership with Sears or the combined buying power of the two companies is an issue for another discussion.

Conclusion

Kmart's financial difficulties began long before the company found itself in trouble. The company had made the ill-advised decision in 1990 that upgrading its stores was the best way to counter the emerging threat of major discounters. This was the wrong approach, and it put Kmart at a competitive disadvantage from which it still suffers today. Kmart was forced into dramatic action in the late 1990s, a period in time when it was still profitable and with growing sales. The actions taken at that time cost billions, but did not deliver the desired results. Kmart was too far behind. The drain on cash that these expenditures represented was sustainable in the late 1990s when the company was earning over $1 billion per year in cash flow from operations and in net income. By 2000, however, the company was unable to sustain its spending and its financial measures began to suffer.

The cash conversion cycle at Kmart was always poor -- most of its current assets are in inventories. This meant that when sales began to decline, the number needed to borrow in order to finance both its operational reforms and its burgeoning cost base. Faced with declining revenues, declining margins and the inability to turn inventory faster, Kmart borrowed to cover its losses and eventually ran out of money. The Chapter 11 filing was inevitable, but it was a better response to the crisis that the strategic moves made by CEO Conaway, which were insufficient to address the problem. Chapter 11 allowed Kmart to shed financial obligations, leaving it a company with strong operating cash flow, few obligations and much leaner operations, in addition to the initiatives that Conaway had started to try and modernize the company's management. While these efforts have not allowed Kmart to thrive, they have allowed it to survive, something that many observers would not have expected in 2001.

Works Cited:

2005 Kmart Holdings Annual Report. Retrieved October 21, 2011 from http://www.secinfo.com/dsvR3.z1Am.htm#2aew

Berner, R. & Weber, J. (2004). Eddie's master stroke. Business Week. Retrieved October 21, 2011 from http://www.businessweek.com/magazine/content/04_48/b3910041_mz011.htm