The holiday season's off to an unhappy start for perennial turnaround hopeful

Kmart

(KM)

.

Though Tuesday's third-quarter earnings report topped analysts' expectations, the ugly bottom-line loss served as a grim reminder of just how far Kmart must go to revive its business. And with the economy suffering a sharp slowdown and competition in the low-margin discount business expanding practically by the moment, that task is getting taller all the time.

For the quarter ended last month, Kmart lost 25 cents a share, 2 cents better than sharply reduced expectations (as recently as seven weeks ago, analysts expected the loss to be only 10 cents a share, according to I/B/E/S). Sales fell 2% to $8 billion, from $8.2 billion a year earlier.

Kmart Chief Financial Officer Jon McDonald backed Wall Street's fourth-quarter consensus earnings estimate of 48 cents, flat with last year's fourth quarter. But the stock slipped 37 cents, to $6.48, leaving Kmart more than 50% below its 52-week high.

Kmart's turnaround plan, which calls for sprucing up shops, slashing prices to better compete with the likes of

Wal-Mart

(WMT) - Get Report

, and overhauling its supply chain operations, has clearly been hindered by the recession. The company is currently below November's plan for a modest same-store sales rise.

Kmart has also clearly failed in its supposed

price war with Wal-Mart, notes Robert Buchanan, an analyst at A.G. Edwards, who has pinned a rare sell rating on Kmart. "Over at least the next few quarters this high-cost provider will continue to lose market share, and its margins will remain under pressure amid what we believe will remain an at-best subdued environment for general merchandise sales," he wrote in a report published Tuesday.

Despite aggressive price cuts from its much-publicized

Bluelight Always campaign, the company has lost market share to Wal-Mart, the world's largest retailer, which is famous with consumers for cutting prices and notorious with suppliers for demanding generous terms. In the third quarter, for example, Kmart saw its same-store sales decline 1.5%, while Wal-Mart enjoyed a 6.7% gain.

Now the risk is that Kmart could be left behind during a holiday shopping season that appears likely to benefit discounters at the expense of higher-end retailers. A recent holiday survey conducted by Sanford Bernstein found that only 7% of shoppers polled chose Kmart as their favorite bargain chain, against 44% for Wal-Mart. "This lack of popularity suggests no upside for Kmart during the holiday season," says Emme Kozloff, who covers Kmart for Sanford Bernstein. (Kozloff has a market perform rating on Kmart, and her firm doesn't do investment banking.)

Some analysts say the company could regain its form next year.

"People do not have the patience for turnarounds right now," says Eric Beder, who covers the company for Ladenburg Thalman. Beder, one of the more bullish analysts following Kmart, has a buy rating on the stock. "The company is making progress on its turnaround but it won't be reflected in the numbers until 2002." (His firm has not had a banking relationship with Kmart.)

But if investors don't see some good news soon, they may give up on Kmart altogether.