Fleming's Truckload of Woes


By Amy Tsao When food distributor Fleming Cos. (FLM) landed a 10-year contract with Kmart (KM) in February, 2001, Wall Street saw it as a sign that Fleming was successfully expanding beyond its traditional supermarket client base. In 2002, Kmart generated $3.3 billion in revenues for Fleming, or 21% of its $15.5 billion total. In 2002, Fleming also thanked Kmart for $35 million to $40 million of its $322.3 million earnings before interest, tax, depreciation, and amortization (EBITDA).

Dallas-based Fleming, one of the nation's top food distributors, will see no more of that revenue: It and the bankrupt retailer, which was its top customer, agreed on Feb. 3 to end their pact. Fleming shares had already been tumbling before that news. At under $3 per share, the stock has plummeted 81% in the last 52 weeks, reflecting worry over Fleming's ability to make up for lost Kmart business. "I wouldn't even touch it at this price," says JP Morgan analyst Steve Chick, who gives the stock the firm's lowest rating of underweight.

SEC INQUIRY. Investors have good reason to be nervous about the stock's prospects. Losing sales from Kmart has left Fleming scrambling -- it must quickly sign on new customers to make use of the expensive distribution infrastructure that was expanded to serve Kmart. In addition, since November Fleming says it has been cooperating with an informal Securities & Exchange Commission inquiry into some of its accounting and trade practices.

No doubt Fleming's plan to sell its 110-store retail operation, announced in September, 2002, should improve its balance sheet. But so far, it has sold only one-third of the stores, which made up 11% of total revenues in 2002. Management has indicated that the sale is proceeding slower than expected, and it isn't likely to fetch as much as hoped for. Fleming was hoping to get $450 million for the assets by the middle of this year.

Furthermore, Fleming has $1.8 billion in long-term debt as of the end of 2002. "With a full debt load, the company is swimming with a heavy sweater on," JP Morgan Securities' Chick says.

LOWERED RATINGS. While no debt is coming due until 2007, high-yield debt analyst Andrew Ebersole at Kind, Duff & Phelps in Montpellier, Vt., notes that Fleming is "bumping up against" the terms of its credit agreement. Most analysts fear that constrained liquidity will hinder the distributor's ability to compete. On Feb. 5, Ebersole lowered Fleming's debt rating to a 6, which is one notch from the lowest possible rating of 7. He and other analysts see a growing likelihood that Fleming might eventually have to restructure. On the same day, debt-rating agency Standard & Poor's also reduced Fleming's corporate credit ranking to BB-, from B.

No way, Fleming says. A company spokesman insists that its finances are in order and that analysts' speculation of a bankruptcy filing are absurd, noting that Target (TGT) and supermarket chain Albertson's (ABS) have recently signed contracts. "We've been growing our business since signing with Kmart," says Shane Boyd, a Fleming spokesman.

Still, a glimpse into the Kmart-Fleming relationship through a court filing to terminate the contract worried some analysts. Kmart's list of complaints about Fleming included falling short on service levels and higher-than-expected logistic fees and other costs. Those claims are inaccurate, says Boyd. "Unfortunately, Kmart was the one that was never able to perform as originally indicated," he says. "Despite their underperformance, store closings, bankruptcy challenges, and other factors that led to declining volumes, Fleming has consistently supplied Kmart stores."

FATTER MARGINS. Ebersole is concerned that other Fleming customers may be "similarly disaffected with Fleming's performance," and he questions "to what degree the negative publicity surrounding the unhappy Kmart relationship will adversely impact Fleming's existing customer and vendor relationships."

Fleming also suffers in comparison to close rival Supervalu (SVU), which had $20 billion in sales in fiscal 2002. In the most recent quarter, the Minnesota-based food distributor's gross margin was 14.2%, while Fleming's was under 4%. Steve Sears, senior vice-president at BB&T Asset Management, figures that it costs Fleming an interest rate of 8.5% to 9% to borrow money to fund its operations, whereas Supervalu's cost is half that. (Sears owns Supervalu shares.)

Supervalu declined to comment on whether it's already gaining from Fleming's problems, but analysts expect that it stands to if nervous customers try to wriggle out of contracts with Fleming.

ENTER WAL-MART? Over the long term, already heated competition in the food-distribution business is going to intensify, analysts say, making it tougher for Fleming to win business as competitors like Eden Prairie and Supervalu get stronger. And increased consolidation in the supermarket business is a disturbing trend for distributors like Fleming. Large chains like Kroger (KR) and megastores that sell groceries and general merchandise like Wal-Mart (WMT) are fulfilling much of their distribution needs in-house.

Even worse for Fleming is the prospect of Wal-Mart entering the distribution business. The world's biggest retailer is already a highly efficient self-distributor. And through its McLane division, which it bought in 1990, Wal-Mart services convenience stores located near its discount outlets.

Analysts suspect that Wal-Mart is considering expanding its distribution capabilities to serve more third parties. "It's a natural extension for Wal-Mart to get into this business," says Herb Achey, senior equity analyst at wealth-management firm U.S. Trust. Wal-Mart declined to comment on the speculation. This may not come to pass for a few years yet, but "this is where Fleming needs to be more concerned," says Achey (he says his firm owns shares in both Supervalu and Fleming.)

For Fleming, the Kmart deal, which seemed so cushy two years ago, has turned into a bed of nails. And while the stock has already taken a thrashing, investors have little reason to believe it's poised for a rebound anytime soon. Tsao covers financial markets for BusinessWeek Online in New York as a Street Wise columnist


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