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Attention Kmart Shareholders: Bluelight Deal No Bargain

Haven't we heard this story before?

A dot-com slated for greatness runs deep losses, forcing its parent to buy its stock back in. It gets an absurd valuation, permitting early-stage investors to cover their costs while sticking public shareholders with the bill. We're talking about Staples.com, right?

Wrong. Kmart (KM) Wednesday unveiled a plan to buy back the 40% of its online offshoot Bluelight.com that it doesn't already own, completing a deal it revealed last week. Kmart will also take a $120 million charge to write down the value of Bluelight on its balance sheet. Its shares rose fractionally to $11.63.

Kmart's buyout, for $84 million in cash and stock, was praised as being more shareholder-friendly than the now-infamous Staples arrangement, which spurred shareholder lawsuits and blanket press coverage. But is it really?

The Kmart plan ensures that partners Martha Stewart Living Omnimedia and Softbank of Japan escape with few, if any, losses, while Kmart shareholders take a bath. And the deal values Bluelight at a level that will lead to more losses in coming years, observers say.

Value Added?

Kmart will shell out $15 million in cash and 6 million shares to buy out its partners. With Kmart shares trading at around $11.50, the deal values the partners' chunk at about $84 million, which is about $3 million less than Stewart and Softbank invested in Bluelight.

The buyout puts a value of $210 million on Bluelight.com, which is about $40 million below the unit's valuation at its December 1999 creation. Kmart and Softbank invested an added $80 million last year, meaning the total investment in Bluelight came to $330 million. The unit lost $107 million last year. (The valuation figures were assembled from the sketchy information Kmart and its partners have disclosed. A Bluelight.com representative declined to offer details on how the unit was valued.)

While the company would not discuss how the $84 million was doled out, a note in Kmart's 2000 annual report says that Softbank and Martha Stewart are preferred shareholders and are thus guaranteed to recoup their combined initial investment of $62.5 million. Thus, it appears that Martha Stewart walked away without losing a dime; for its part, Softbank may have lost some of an additional $25 million it pitched in during a secondary round of financing. But the $120 million charge shows who's really paying for Bluelight's losses -- Kmart shareholders.

If a valuation of $210 million for a money-losing business isn't exactly sensible, at least it's not outlandish. Recall that Staples.com's bankers tried to pin a $900 million valuation on a business that lost more than $140 million last year. Of course, retailers set up their dot-com arms with multimillion-dollar public offerings in mind; now that the Internet stocks have crashed, there's little reason to maintain these businesses separately.

Howard Hansen, a portfolio manager at Lord Abbett, which owns around $40 million in Kmart stock, acknowledges that Kmart's terms look reasonable alongside Staples'. But he says Bluelight is still expensive for a money-losing business with no immediate profit prospects. "No one is ever really happy about that," he says.

Still, "from our standpoint, the Internet in retail is seen as a necessary expenditure," he says. "Something like a broker having a telephone."

You Have to Be There

Despite the losses, Bluelight.com is still considered a valuable asset to Kmart. While stand-alone Internet retailers have had their troubles, the online offshoots of brick-and-mortar retailers are winning out in the grab for market share.

For example, figures released Wednesday by Nielsen//NetRatings showed that Bluelight.com was the third most-visited site in June among online divisions of brick-and-mortar retailers, after Walmart.com and JCPenney.com, with 1.7 million visitors. In addition, traffic growth for so-called bricks-and-clicks operations is outpacing that of Internet-only retailers like Amazon.com (AMZN). (Wal-Mart recently announced it, too, was pulling its online division back in house, buying out venture capital firm Accel Partners. Terms of that deal haven't been disclosed.)

"The top five brick-and-mortar mass retailers are enjoying success in converting their regular offline customers to online shoppers," says Sean Kaldor, vice president of analytical services at NetRatings.

Staples recently settled a shareholder lawsuit over its planned buyback, and company insiders who had invested in Staples.com will no longer stand to reap a windfall, although outside investors such as venture capitalists will. The fiasco became a test case for how to value a failed dot-com that was no longer headed to the public markets, and how it played out clearly influenced what Kmart did.

Detailed in a recent Securities and Exchange Commission filing, and discussed at length in a column by TheStreet.com's Adam Lashinsky, Staples.com and its bankers used dubious methods to come up with its valuation, including comparing it, on a price-to-sales ratio, with a host of unprofitable dot-com retailers that included the now-defunct Webvan.

Kmart did a better job, but clearly the art of valuing an Internet company is still that: just an art.

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