Does Kmart Belong in the Bargain Bin?


By Sam Jaffe These are tough times for companies that rely on shoppers. Take Kmart, where consumers spent 1.8% less in September, the company's biggest one-month drop since 1987. Yet, despite the sharp and sudden fall-off, Kmart might actually be the right stock to buy in the midst of an economic downturn.

How so? Well, according to an Instinet Research report, general-merchandise buying has remained relatively unchanged through the past five recessions. Moreover, those same buying habits have been barely affected by acts of war, John Kennedy's assassination, and other national tragedies. "When the economy softens, consumers drop down the price chain to do their shopping. Kmart will be a big benefactor of that," says Buckman, Buckman & Reid analyst Ulysses Yannas, who adds that he will soon change his rating on the stock to buy from hold.

So far, Kmart's numbers have supported his theory. Despite massive discounting in the wake of the September 11 attacks, Kmart showed almost no change in same-store sales in September vs. the previous month, even though analysts expected a big drop-off. Kmart couldn't be reached for comment.

AT A DISCOUNT? If it's a potential bargain you're looking for, Kmart (KM) is a super special right now. At $6.58 as of the close of trading on Nov. 5, its price-to-sales ratio is a shocking 9 cents. Wal-Mart's stock, on the other hand, is worth $1.14 for every dollar in sales.

The current profit picture, however, is dismal. Wal-Mart (WMT), a chief competitor, towers over Kmart when it comes to the ability to earn profits. Wal-Mart has a gross profit margin of 21% and an operating profit margin of 5%. Kmart also musters a 21% gross profit margin, but its operating profit margin is 1.3%.

Little wonder the stock has floated around $6 or $7 over the past few months -- about half of August's 52-week high of $13.55. Yet some Wall Street pros are convinced that Kmart is on the road to recovery.

CUTTING COSTS. "This is a company that has been bad for a long time -- it's not going to turn around in a quarter," says Eric Beder, an analyst for Ladenburg, Thalmann & Co., who rates Kmart a buy. The key, Beder says, is patience.

CEO Charles Conaway has made his plan for reform well known on the Street. He started the process in 2000, when he joined the company and began a billion-dollar overhaul of its information-technology system. While this undertaking will require at least two more years to complete, it's all but certain to save the company millions of dollars.

On Sept. 10, Conaway announced that he would fix Kmart's accounts-payable problem. Wal-Mart holds off for months before paying its suppliers, analysts say. Kmart, however, almost always pays within 30 days -- sometimes a lot sooner -- and Conaway wants to change that. At the end of the second quarter, Kmart's payables stood at 35% of its inventory value. He expects that number to increase to 40% by the end of 2001, eventually reaching Wal-Mart's average of 70%.

"CONSTANTLY FLOWING." Why, when the goal is increasing profitability, is delaying payables such an important factor? Some rivals turn over their food inventory a dozen times a year and stretch payment over several months for each order. "That means you don't have to use any capital to buy merchandise," says Buckman's Yannas, who adds: "It means cash is constantly flowing. [The company] can utilize cash flow before it has to pay off suppliers."

Kmart's current inventory turnover on food is half that of Wal-Mart's, and it traditionally pays off suppliers before the end of each month. The longer waits have angered many suppliers, but, in the end, they'll likely accept the new terms -- especially in an environment of declining economic growth.

Yannas agrees that delaying payables will help profitability. But his main reason for upgrading his rating on the stock has more to do with the depths to which it has slumped. He points out that if management is able to increase operating margins 2 percentage points, to 3% in 2003, it will add $2 a share in earnings, which would give Kmart a price-to-earnings ratio for 2003 of about 3. "The hope has been wrung out of the price of this stock," Yannas says. That's exactly the time when value investors most like to buy.

A REAL SURVIVOR. No doubt, Kmart has a tough road ahead. Many analysts say the franchise has been in decline since the early '90s, when its stock sold in the range of $30 to $40, and the chain seemed to be on the top of the world. Then along came a little-known competitor named Wal-Mart, which did the same thing as Kmart -- just more cheaply.

Kmart sells about $35 billion worth of goods each year in 2,100 stores, vs. almost six times that amount for Wal-Mart's 3,200 stores. Wal-Mart also dominates at supercenters -- stores that carry general merchandise and groceries -- boasting more than 1,000 supercenters, vs. Kmart's 750.

It doesn't help that Kmart's management has attempted almost half a dozen failed turnarounds to date. Yet it's a survivor, unlike countless competitors that have gone bankrupt trying to outdo Wal-Mart. Kmart is on the right track, says Beder, noting that its stores "had their Halloween items out at the end of September. Last year they started highlighting candy a week before Halloween." If Kmart's reforms stay on track this time, its stock could be worth watching. Jaffe writes about the markets for BusinessWeek Online in our daily Street Wise column

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