Kmart: Retail or Real Estate?

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It's time for mass merchandiser Kmart Holdings (Nasdaq: KMRT) to reveal its real identity. Is it the $150-a-share real estate-rich company fellow contributor Rich Duprey wrote about in July? Or is it the third largest discount retailer behind Wal-Mart (NYSE: WMT) and Target (NYSE: TGT) that has a lot to prove?

The latest quarterly results are decidedly mixed. A net loss of $5 million last year has given way to a $155 million profit this quarter (although $72 million pre-tax is from the sale of assets). That sounds great until you realize that same-store sales (a key measure for all retailers) were down 15%. So, as a retail operation, Kmart is not growing in sales like its competitors.

Wall Street is abuzz about the company's real estate value. Retailers such as Lowe's (NYSE: LOW), Home Depot (NYSE: HD), and Sears (NYSE: S) have all bid on Kmart locations and, so far, the company has realized premium prices for the assets sold. That raises two questions. Were those first sales low-hanging fruit? And if these sites are so valuable that other retailers are willing to pay premiums, why can't Kmart make money with them?

Kmart's balance sheet carries a small $103 million in long-term debt (an outcome of going through bankruptcy). What should catch investors' attention is the increase in diluted weighted average shares from 89.7 million to 101.5 million. Those added shares, and maybe many more to come, are a weight that will limit income per share growth.

Wall Street is having trouble computing what Kmart is worth. Today's earnings announcement sent the stock up 15% to $74 and change -- but the stock is still 12% below its 52-week high of $84.50. Current year earnings are estimated at $3.35, so the stock's trading at about 22 times earnings. That is approximately what profitably growing Wal-Mart and warehouse giant Costco (Nasdaq: COST) fetch on Wall Street.

So, will the real long-term Kmart please stand?

Kmart is not selling itself as a liquidation story, so making real estate the focus is inappropriate -- although it will have a very positive impact on this cash-rich company. The question is whether declining same-store sales are masking a retailer with great long-term margins. The stock, as currently priced, is expecting margin growth. But, given its No. 3 position behind two strong competitors, investors would be wise to consider just how high Kmart can raise margins.

Fool contributor W.D. Crotty owns stock in Home Depot but none of the other companies mentioned.