Blue light, red ink.

That's the continuing story at beleaguered discount retailer

Kmart

(KM)

, which Thursday morning issued an earnings warning that only fed Wall Street's fears that the company is sinking into oblivion. The stock dropped 63 cents to $4.17, putting it 68% below its August peak.

Ski Slope

Kmart said fourth-quarter earnings would fall short of analysts' already meager expectations and that the company would "review its current and prospective liquidity position and business plan for the 2002 and 2003 fiscal years."

That comment marks the company's first concession to the now widely held view that Kmart can't survive without making major changes. The question now on Wall Street is what form the changes will take, and whether even strong medicine can revive the Troy, Mich., company.

Under the Hood

Kmart's negative comments seemed to vindicate Prudential Securities analyst Wayne Hood, who last week issued a scathing report on the company and cut his rating to sell. Hood warned of cash-flow problems, saying, "We don't believe a Chapter 11 filing is imminent, but we wouldn't rule it out if the first half of 2002 is disappointing." Hood's firm doesn't do investment banking. At the time, Kmart maintained it didn't have a liquidity problem.

Kmart says it has about $900 million remaining on $1.5 billion in revolving credit lines. But it also has $4 billion in debt, and investors are worrying about how it will service that load. Both Standard & Poor's and Moody's have junk ratings on Kmart's bonds; Moody's downgraded the company last month. Investors now wait to see just how costly the latest poor holiday season will be for Kmart, particularly considering that many discount retailers showed surprising strength around Christmas.

"It would be my belief that they are looking to expand the revolving credit facility," says Jeff Stinson, an analyst at Midwest Research who has a neutral rating on Kmart stock. He says that vendors are likely to pull back financing to Kmart, forcing the company to turn to the banks for more money. Midwest doesn't have an investment banking business.

"I think their revolver is under review, and they will probably have something to say about that when they release fourth-quarter earnings," says Dan Binder, an analyst who covers the company for Buckingham Research. Kmart, which is due to report earnings on March 5 for its fourth quarter that ends Jan. 31, now expects a full-year loss, reversing the year-ago 47-cent profit and falling short of the penny-profit analyst consensus. Binder has a neutral rating on the stock, and his firm doesn't do investment banking.

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The Time Is Now

Even analysts who think bankruptcy is unlikely agree the company must take action. Kmart shares more than doubled last year as investors bet new CEO Chuck Conaway would right the foundering ship. But efforts to cut prices to compete with giant

Wal-Mart

(WMT) - Get Report

failed dismally, provoking a price war that punished earnings and sent investors fleeing. Meanwhile, upscale discounter

Target

(TGT) - Get Report

swooped in to take coveted affluent customers, shrinking Kmart's market even further.

"I think there is cash there; there is liquidity there," says Daniel Schwarzwalder, managing director of Buckingham Capital. "But if the business doesn't turn around

Kmart will have to close stores." Schwarzwalder owned more than 400,000 shares in the company in late September but has since sold them.

Emme Kozloff, who covers the company for Sanford Bernstein, says Kmart should close 250 money-losing stores, a move she says would generate significant cash flow and boost earnings. Kmart has more than 2,100 stores. Kozloff has a market perform rating on the stock, and her firm doesn't have an investment banking business.

Indeed, Kmart's earnings weakness makes its shares look expensive even now. Despite their steep fall, shares still trade at more than 16 times next year's earnings estimates, a premium to Kmart's projected annual growth rate of just 9%, according to Thomson Financial/First Call.

"It's like trying to turn around a submarine in a bathtub," Schwarzwalder says.