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Searching for Growth in the Kmart Karma

Some observers aren't persuaded this turnaround story has turned the corner.

Lasting turnarounds in retailing are about as elusive as the next fashion trend.

Take the case of

Sears

(S) - Get SENTINELONE, INC. Report

, a retailer that was so out of touch before Chief Executive Arthur Martinez took charge that male shoppers often had to walk through the lingerie department to reach the bathroom. Martinez refurbished stores and tinkered with the merchandise mix. And for a time, the "softer side" of Sears melted the pocketbooks of Midwestern matrons. But ultimately, the department store chain was left struggling between upscale specialty retailers and downscale mass merchants.

Now

Kmart

(KM)

is saying its turnaround is nearly complete. At the company's annual meeting last month, Floyd Hall, president and chief executive, told investors that the company was switching into growth mode after five years of retrenchment. Kmart plans to open 17 stores this year. And an alliance with a major grocery chain also has been bandied about as a possibility.

"When is the end of a turnaround?" asks Robert Burton, Kmart's spokesman. "If I had to draw a line in the sand it would be this year. All of the things that we promised -- improving the merchandise mix and converting stores to the Big K format -- will reach closure this year."

But some analysts and investors say a happy ending is far from certain. Not only are they skeptical of Kmart's promises to grow again, but also one money manager calls the turnaround an outright failure.

To be sure, Hall has stacked up numerous accomplishments. Since taking charge in June 1995, he has set about remodeling most of Kmart's 2,161 stores to the Big K format, featuring stores with wider aisles, brighter lighting and an easier-to-shop layout -- a process that will be completed this year. He gave customers a reason to shop his stores by courting high-profile private-label brands that can only be found at Kmart, most notably

Martha Stewart

, which should ring up $1 billion in retail sales this year, up from $400 million in 1997, when it was launched.

That's a long haul from the company that would "stock golf equipment in January in Detroit and run out of hunting gear five days after hunting season opened," says a onetime consultant for the chain who asked to remain nameless.

These strategies are more than cosmetic. They have helped Kmart cut long its term debt-to-capitalization ratio nearly in half since 1995. And the company's ability to pay interest on that debt is three times what it was then.

In its most recent fiscal year, ended in January, earnings more than doubled to $518 million, or $1.01 a share, from $249 million, or 51 cents a share, a year earlier. Sales were $33.7 billion, up from $32.2 billion.

"They were on the brink of disaster," says Wayne Hood, an analyst with

Prudential Securities

who rates the company a buy. Hall has "done a good job of keeping the company from defaulting" on its debt. (Prudential hasn't performed underwriting for Kmart.)

But in an environment that has blessed almost every retailer with juicy sales and profits, simply avoiding bankruptcy isn't enough.

Store Wars
Stock prices of Kmart, Dayton Hudson and Wal-Mart from Jan. 1, 1996 to June 7, 1999

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"The turnaround hasn't been a success," says Bruce Olson, a portfolio manager with

Strong Capital Management

who tracks the retail industry but doesn't hold a position in Kmart. "In a great retail environment, Kmart is showing very mediocre same-store sales numbers."

For the past year, sales at Kmart stores open at least a year climbed a modest 4.8%, compared with 9% at

Wal-Mart

(WMT) - Get Walmart Inc. Report

and 6.1% at

Target

, a

Dayton Hudson

(DH)

unit.

"It's pretty clear, Kmart's run into a wall," says one money manager who's short the stock and asked to remain anonymous. "There's not much left for them to do with their current asset base."

Even among other turnaround plays, Kmart gets short shrift. "Sears had many of the same problems Kmart faced: A lousy store base with dicey locations," says the former consultant, who now manages money but doesn't hold a position in either retailer. "But Kmart didn't get the bang for the buck that Sears got."

Since Martinez took the reins at Sears, in August 1995, the stock is up about 54%. (Sears says its turnaround is a success on several levels, including in apparel, home services and hardware.) Kmart's stock, while tripling off its lows last seen in early '96, is nearly flat with where it stood when Hall joined the company. Monday shares closed at 15 13/16.

Kmart stock could come under pressure if the company elects to call an outstanding convertible preferred issue. Kmart will have the right to call the security, which can be turned into 3 1/3 shares of common stock at $15.81 each, after June 15. Burton, the spokesman, says the company has given no indication of its intent. If Kmart's stock at the time of the call is trading above $15.81, holders would more likely opt for conversion, which could create 66.7 million new shares in addition to the 494 million shares already outstanding. The theory is that since investors in convertibles don't typically retain common stock, some might sell, which could in turn weigh down the share price.

Holding Second Place
Total sales for most recent fiscal year

But Kmart is facing challenges greater than an overhang in its stock. Despite Hall's best efforts, the gap between Kmart and its competitors remains wide on important measures like sales per square foot and operating margins. And while Kmart may still hold the No. 2 spot behind Wal-Mart in terms of chain-wide sales, several analysts expect the No. 3 player, Target, which is expanding rapidly in the Northeast, to close the gap.

"The question isn't looking at others and asking whether Kmart can get there," Burton says. "The question is can Kmart provide a substantial return to investors. And the answer is absolutely we can."

Skeptics are less sure about Kmart's prospects. As one analyst who declined to be named says: "The gap between Kmart and its competitors gets wider and wider. If it's not bridged, Kmart's prognosis isn't good."

That leaves Kmart in the no-man's land occupied by other recent turnaround candidates like Sears -- still alive, but not necessarily kicking.

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