Kmart Rising

With Kmart Holdings (Nasdaq: KMRT  ) announcing its first profit since filing for bankruptcy in early 2002, investors need to ask themselves if this former third-rate discounter has indeed turned the corner and can compete against the likes of Wal-Mart (NYSE: WMT  ) and Target (NYSE: TGT  ) .

Let's start with the bad news first.

Same-store sales and total sales declined 13.5% and 25.8%, respectively, for the fourth quarter. For the 39 weeks since the Big K reorganized, sales were off 23%. The company shuttered 600 locations and fired 57,000 employees during the bankruptcy, giving it less workers per store than any of its competitors. None of this has helped the perception that Kmart has shabby stores, shabby customer service, and too numerous out-of-stocks. University of Michigan's annual American Customer Satisfaction Index rated Kmart dead last with a 70 rating in its most recent mid-February report. Leading the way was Kohl's (NYSE: KSS  ) with a 79, while Wal-Mart had a 75.

Most prognostications of Kmart's future suggest that it will ultimately go the way of Woolworth's, Montgomery Ward, and Bradlees: into the dustbin of retail history.

But I disagree. What's to like? A lot, actually.

First is a $276 million fourth-quarter profit. Even with falling sales from 600 fewer stores and a 20% reduction in inventory, Kmart is focusing on faster-moving, more profitable lines. It's not discounting as much to generate sales, and it's not going head-to-head against the competition in all products lines.

Same-store sales aren't as important to a company in turnaround as reversing losses, increasing margins, and strengthening the balance sheet. CEO Julian Day is doing just that. Gross margins are steadily marching higher each quarter: 22%, 23%, and 25% in the second, third, and fourth quarters, respectively.

The 42-year-old retailer jettisoned the low prices everyday structure that led it into bankruptcy in favor of a high/low strategy, promoting frequent but limited sales and higher-than-average prices. It's focused now on generating profitable sales, not top-line revenue growth. Add to this the fact that it's managed to put $2.1 billion in cash and equivalents in the bank, and Kmart now has a war chest to fund basic operations.

To compete against Sears (NYSE: S  ) or Kohl's, let alone Target and Wal-Mart, it needs to focus on soft lines and fashion and take an ax to superfluous lines like hardware, automotive, sporting goods, and consumer electronics.

Management is scrapping 10 new store openings in favor of targeting what Kmart calls the "New American consumer": urban and ethnic shoppers. The deal with Latina pop star Thalia is also key to updating its image of has-been celebrity endorsements. She anchors a broad array of new items from music to apparel to her own branded line of home goods and brings instant cross-cultural appeal.

A new Joe Boxer line extension last fall complements the Disney (NYSE: DIS  ) and Sesame Street mainstays, and despite the notable turmoil with Martha Stewart Living Omnimedia (NYSE: MSO  ) , her Everyday line remains one of the retailer's most profitable brands.

It won't be a smooth transition, and the competition is fierce. Yet with a new focus on the hip, urban market, a core line of profitable products, and a ton of cash in the bank, Kmart is one of the more liquid retailers around, enough to keep the bluelight blinking for a long time to come.

Will Kmart make the cut? Talk about it on the Retail discussion board.

Fool contributor Rich Duprey doesn't own any of the companies mentioned in the story.


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