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Kmart an Endangered Species

by Jalexson

May, 2003

Multimillionaire hedge fund  manager Edward Lampert from Greenwich,  Conn., has rescued Kmart from bankruptcy by purchasing $2 billion worth of Kmart creditor claims and agreeing to pump $350 million in cash into the company.  It hasn't been disclosed how much he spent to purchase the debt.  He will control 49% of the company's stock, hold one of the seats on nine-member board of directors and name three others.  Julian Day will be the new president and CEO.

Lambert wants to attract customers back.  Unfortunately, many of those cannot come back because their Kmart was one of the 600 stores closed during bankruptcy.  The chain's 1,513 remaining stores have to find a way to compete with Walmart and Target which have been growing during the same period.  Walmart has been expanding existing stores as well as opening new ones while Kmart was closing stores.  For example, Walmart expanded its store in Newton, Ks., where Kmart closed its store and expanded its store in Hutchinson,Ks., where the much smaller Kmart remains open.

Lambert believes Kmart can survive.  I hope he's correct..   To do so it will first need to establish a good working relationship between labor and management as well as improve the quality of management including improving inventory control.

A good relationship between labor and management will facilitate good attitudes toward serving customers.  One of the biggest problems with American executives is they seem to think they solely responsible for successes but failures are someone else's fault.  Actually the situation is reversed.  Success requires everyone working together and doing their jobs well.  Management may encourage this process by treating workers with respect and consideration, but workers aren't interchangable parts as many managers seem to be believe.  They are individuals with individual needs and interests.  If management doesn't care about them, they may lose interest in making the business a success.

Top executives can create failures by many different actions.  Kodak almost went under a few years ago because some bright idiot decided the company could reduce costs by encouraging all its old technicians to retire and replacing them with people who would work for less.  Unfortunately for Kodak the "old guys" knew all the formulas.  The young guys didn't.

Many Americans suffer from the belief that profits are made by cutting costs.  Actually profits are produced by generating revenue. Controlling costs is a good idea, but a company with no costs will also have no revenue and no profit. Kmart ended up in bankruptcy court because it couldn't generate enough revenue.

The next steps will be harder.    Lambert wants to attract customers back.  However, many of them can no longer shop at Kmart because they don't have one nearby any more.  The closing of 28% of K-Marts over the last two years hurts the chain's ability to attract customers and forces the remaining stores to pay a higher portion of advertising and other regional and national costs, as noted in the following essay from last year.

Kmart reliance on leased stores puts it at a competitive disadvantage.  Store ownership would allow it to depreciate the cost of stores within a few years of opening.  Then the only store expense items would be taxes and maintenance.  Relying on someone else's store means building owners control an important part of the chain's operations.  They don't have to worry about whether Kmart can attract customers because they have a contract forcing Kmart to pay rent regardless of how successful a store is.  Building owners may be reluctant to incur the expense of expanding buildings to keep up with retail trends.

Kmart needs to find a way to acquire ownership of its stores.Ownership would allow it to move stores if changing demographics or land use makes a site less attractive to customers.  Stores need to be able to move to larger sites if the existing site is too small to allow needed expansion.

One way to acquire stores would involve issuing bonds to individual building owners that would be secured by their respective stores.  If Kmart eventually was unable to pay off the bonds the owner would get his/her building back.  The bonds should be convertible into Kmart stock on favorable terms to the owner.  The owner might be able to trade the bonds for stock at a future date with the amount of stock determined by the price in effect at the time the bonds were issued and the length of time the bonds had been held.

The best store size changes over time.  Defunct east coast discounter Korvettes once had stores in the 200k to 300k square foot range.  National chains for many years relied on stores that might be less than 100k sq. ft..  Today the size of competitive stores is increasing.  New super markets may have 30k-50k or more sq. ft..  Walmart is expanding to over 100k sq. ft. stores.  In a time of rising gasoline prices, the one-stop shopping of giant stores allows customers to reduce their transportation costs.  The larger size allows room for a broader range of different goods within a given class of goods.  Greater selection allows stores to appeal to a larger group of customers.

Kmart also needs a better way of evaluating which stores to keep.  The decision to close the Newton, Ks., Kmart last year was a mistake.  The city is growing because of its proximity to Wichita and is a place Kmart needs to have stores.  The recent decision to close the east Wichita store may also have been a mistake.  Wichita has a cyclic economy that rises and falls with the aircraft construction industry.  Sales in Wichita area stores have been hurt by the current down turn.  When employment goes up again sales will rise, but Kmart won't be able to take advantage of them.

February, 2002

Kmart is following the same path that old retailers like F. W. Woolworth and Montgomery Wards followed into oblivion. Large scale store closings will further reduce the Kmart’s ability to operate at a profit. If the new CEO decides not to rescind the store closing order, Martha Stewart would be advised to find another chain to handle her products.

Most chains have a few stores that are no longer functional because of land use changes in the vicinity, they are in dying cities, or have inadequate design features especially inadequate size. However, if 13% of Kmart’s stores are no longer viable the chain might as well close down. According to a local news article at least one of those stores, the one in Newton, Ks., is operating at a profit. Moreover Newton is a desirable site for a store because it is a growing community with a high potential for future growth.

Closing stores that are operating at a profit would be extremely foolish because it would reduce the profitability of the remaining stores. Those stores would have to pick up the national and regional costs(e.g., upper management, distribution centers, advertising) the closed stores would no longer be helping to pay. Moreover, the reduced sales would mean Kmart would be buying lower quantities which would reduce the ability to obtain quantity discounts.

Both changes would increase marginal costs for the remaining stores and force them to choose between either raising prices with possible further reduced sales or reducing profits a difficult task for a company trying to emerge from bankruptcy.

Sebastian S. Kresge who founded the S.S. Kresge Co. In 1899 helped establish the formula for success in mass merchandising. Sell a lot of stuff at low profit margins. By the fifties Kresge “dime” stores were a fixture in downtown shopping centers across the nation. The chain expanded on that formula when it began transforming itself into Kmart in the sixties. Closing 13% of its stores would mean a retreat from that formula.

Those who don’t understand mass merchandising may think Kmart is cutting costs by closing stores, but in fact it is doing the opposite. The important cost issue in mass merchandising is the portion of costs assigned to individual items. As sales increase the cost is apportioned among more goods allowing all goods to be sold at lower prices. This is one of the reasons Walmart can continue to reduce its prices as sales increase. When sales decrease, such as by closing stores, the cost assigned to each item must increase forcing the chain to either accept lower profits or increase its prices.

Buffalo, NY, officials are trying to get Kmart to do what it should do before deciding which stores to close.  They are offering to assist Kmart in keeping its Buffalo store open.  Kmart should have sought such assistance from various communities as is often done by businesses facing financial problems that might cause loss of jobs in local areas.  It also would be prudent for Kmart to request owners of the stores it leases to agree to reduced rent or to deferred rent as Kmart seeks to define what changes will be made in its operations to return the store to profitabiliy.  Kmart might also offer them the option of stock in the company in exchange for ownership of stores once the store is in position to operate profitably.  One of Kmart's weaknesses is that it leases rather than owns stores.  Leasing means stores themselves remain a cost item.  Ownership means once construction is paid off the only store related costs are the portion of rent that would cover building maintenance and any property taxes.

Closing stores should be the last resort, not the first choice, in returning Kmart to profitability. The first step should be recognition that competing with Walmart on prices is much harder than guarding Michael Jordan. Kmart shouldn’t even think about that possibility without first adding another 1,000 stores.

Next Kmart should get rid of the meatheads in its executive ranks. The leading meathead has just left and the others should be shown the door. Kmart should hire people who are more interested in making the chain a success than in seeing how much money they can squeeze out of it. Considering that most shoppers are women, Kmart should look for more women executives. They have a better idea about what shoppers want from a store.

It’s the customers who ultimately determine the success of a business and price isn’t their only consideration. Store appearance is also important. Some Kmarts are having problems in this area according to comments I’ve seen on the web. The chain needs to do a better job of insuring that stores have sufficient quantities of sale items at the start of the sale – another problem people have mentioned on the web.

Executives need to keep in touch with what is going on in the stores by maintaining two way communications with store employees. The people in the stores have a better idea of what is going on in the “retail wars” than executives in their national offices. One of the problems the U.S. had in Vietnam was that the generals in Saigon and Washington didn’t understand what was going on in the field. The generals weren’t fighting the same war as the “grunts” or “11-boonies” on the front lines. The generals were too involved in looking at statistics that didn’t really show how the war was going. Store employees can tell whether what the chain is doing is working or not long before executives can learn from statistics.

On the subject of statistics, the reason given for closing stores is that they are “underperforming”. Executives should determine why a store is “underperforming” before deciding to close it. For example, the Newton, Ks., store is in a growing area hasn’t reached its full sales potential yet. Stores in growth areas need to be retained because they have the potential for increase in same store sales, an important consideration for many investors.

I store may be underperforming because of local conditions such as a temporary local economic downturn or street work in the area that makes the store less accessible. Such stores are likely to rebound and should be retained. Problems with store design or the local manager could reduce sales. Replacing the manager or arranging to remodel the store would eliminate the need to close such stores.

Stores may be underperforming because of changes in land use that make the site less attractive. These stores should be considered for closing as should stores in communities that are in a long term economic decline with little or no prospect for rebound. Another category of stores that could be closed are those that are too close to each other. Such stores might be competing with each other. If Kmart owned its own stores consolidating these stores at a new location between the stores might be an option, but this might not be practical with leased stores.

Another cause of underperformance is the chain’s lack of an adequate strategy for success. Kmart needs to decide where it wants to go as a retailer before it closes stores that might be needed to succeed with its new strategy.

Kmart cannot benefit from closing 13% of its stores. The only beneficiaries will be its competitors such as Walmart and Target. Their sales will go up allowing them to spread out their costs over more items and reduce prices to take even more sales from Kmart. They will be able to buy in larger quantities and take advantage of quantity discounts. Kmart will be buying in smaller quantities at a higher cost per item than before.

Martha Stewart’s sales will go down because she has fewer places to sell her goods and will no longer have access to some towns. She would be well advised to look for another retailer to market her goods.



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