Cool-Down Continues at Kmart

The retailer's stock has fallen a lot in 2005, enlivening its long-suffering skeptics.
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Updated from 9:04 a.m. EST

Snowstorms and freezing temperatures have ravaged the Northeast in January, but the resilient bears following

Kmart

(KMRT)

have enjoyed their first rays of sunshine after a long hibernation.

The retailer's stock has been sliding faster than the broader markets all month, down 14% in 2005 after a frantic selloff Monday that sent the longtime Wall Street darling tumbling $5.27, or 5.7%, to $86.40. Amid a

solid rally Tuesday, the stock rose $1.87, or 2.2%, to $88.27. The

Nasdaq Composite

, meanwhile, has lost 7.1% since the year began, and the S&P Retail Index is down 8%.

The stock fell another $1.32, or 1.5%, to $86.95 Wednesday morning.

"This is a massive revision in the whole perspective on Kmart, and it's happening within the context of what is unfolding to be a market correction," said Richard Hastings, retail economist with Variant Research. "It's clear that the macroeconomic concerns that have been pushed aside for about two years now are finally gathering steam. There's a bearish attitude starting to step on people's toes, and I think the Kmart story has gotten caught in the middle of this." (Hastings does not own shares, and Variant has no business relationship with Kmart.)

On the other hand, with the market approaching levels seen before the rally that followed the reelection of President Bush last November, traders are looking for signs of volatility that often presage a bottom in a market correction. Monday's selloff in Kmart could be just such a sign, and while investors caught up in Wall Street's negativity may be taking a second look at the company's prospects, long-term bulls could view the decline as a good opportunity.

To be sure, Kmart is not alone in this downdraft. The

Dow Jones Industrial Average

, the

S&P 500

and the Nasdaq have all fallen for three straight weeks in January for the first time since 1982. In retail, some of the outperformers from the holiday season have hit the rocks. Luxury retailers took a hit, with

Neiman Marcus

(NMG.A)

down 3%,

Guess

(GES) - Get Report

down 10.6% and

Coach

(COH)

down 1.7%.

First Shall Be Last

But Kmart, leading the declines, evinces the degree to which attitudes are changing -- and how many of last year's winners are suffering the most since the calendar flipped to 2005. The stock was one of the biggest gainers of 2004, up 326% for the year. In November, Wall Street's adoration for the stock was palpable as Ed Lampert, of ESL Invesments and the hedge fund guru that saved the company from bankruptcy less than two years before, announced that Kmart was acquiring

Sears

(S) - Get Report

, one of America's oldest and most beloved retailers, to form the third-largest discount chain in the U.S.

While the conventional view was that discount leaders like

Wal-Mart

(WMT) - Get Report

and

Target

(TGT) - Get Report

would suddenly have a new force to reckon with, many Kmart followers suspected that other forces were at work.

Lampert quickly restored Kmart to profitability in 2004 through cost-cutting measures, but its sales gauges continued to languish. Much of the company's steep valuation has long been attributed to the estimated value of its real estate portfolio, which was proven to be considerably richer than the bankruptcy process had given it credit for. Meanwhile, real estate speculation also inflated Sears' stock price, particularly after a real estate investment trust,

Vornado Realty

(VNO) - Get Report

, disclosed a stake in the retailer.

Wall Street cheered the news of the merger immediately. Sears closed up $7.79, or 17.2%, to $52.99 the day of the announcement, while Kmart added $7.78, or 7.6%, to $109. Many believed that Lampert had a series of asset sales planned that could grow his already-sizeable cash pile at Kmart. Valuations for Sears' real estate reached $8 billion to $10 billion, suggesting the stock had inherent value regardless of whether the retailing operation could ultimately compete with the big guys.

In the end, the most optimistic of bulls speculated that Lampert would turn the company into his publicly traded investment vehicle, modeled after Warren Buffett's

Berkshire Hathaway

(BRK.A) - Get Report

. Meanwhile, the bears, doubting the long-term viability of Kmart's real estate operations, persisted.

The skeptics have been rewarded this month, as investors' second thoughts about the market's outlook for 2005 bled into the exuberant valuations of Kmart's shares. With its same-store sales declines and analysts' lack of visibility due to management's refusal to provide sales and earnings guidance, uncertainty about Kmart's future and the success of its proposed acquisition suddenly gained more prominence.

"I'm just not sure how this merger is going to go, and how it's going to work," said Jim Rice, analyst with Bernard Sands LLC. "Kmart made a lot of improvements on margins and expenses, but they still haven't proven they can get the customer back in the store yet. Also, Sears has its own set of issues." (Rice does not own shares in Kmart and his firm has no banking relationship with the company.)

UBS analyst Gary Balter said the reported talks between

Federated

(FD)

and

May Department Stores

(MAY)

may have cast doubts about the value of real estate in the retail sector where continued consolidation seems likely.

"There is a 20% overlap between May and Federated locations, which represents about 90 to 100 locations," Balter wrote in a recent research note. "If they were to sell these locations, that may drive down the value of the properties that Sears would be looking to sell."

Still, he noted that Kmart's lack of communication with Wall Street is likely playing on people's fears, and any news event about its progress, such as the closing of the Sears acquisition or an asset sale, could bring another frenzy of buying interest to the stock. (Balter does not own shares of Kmart or Sears, and his firm has no banking relationship with the companies.)

Hastings, meanwhile, remembers when people had serious doubts about Kmart when it was trading at $30 a share in 2003. The real estate speculation in the stock's valuation has long made him uncomfortable, since asset sales are inherently sporadic and unpredictable, and there are usually extenuating circumstances involved when the deals actually materialize, particularly in real estate.

"The variables that go into property agreements are unbelievably complex," Hastings said. "This is not a pure asset play. People should be paying attention to the core, recurring underlying business. I think that's what's happening now. People are turning back and taking a look at this in a more conventional way, and in the process of doing that, there's a revision regarding the risks involved."

Hastings said that recent valuations of Kmart could be way off base.

"A lot of people don't understand the retailing business, especially in the case of Kmart," he said. "The management is very quiet. They don't issue estimates. If that's the case, then what do you have to go by? You have no idea what it's worth."