Financially speaking, road to recovery is still fairly rocky

Discount Store News, June 23, 1997 by Richard Halverson

By many financial measures, 1996 was a good year for Kmart, but the company must clear several major hurdles before it can fully regain its standing on Wall Street.

Besides the major success in laying to rest fears of Chapter 11 bankruptcy, Kmart has seen its stock price recover to about $13.25 from a low of $5.75 as of Jan. 26, 1996.

Kmart's borrowing costs declined by 1.25 percentage points over the past year, despite the stigma of having its debt issues rated as junk bonds. It paid off more than two years early a $1.2 billion term loan that was part of its financial restructuring last year; it whacked $620 million out of its expense structure, lowering its SG&A expense ratio to 19.9%--the first time in several years it has dipped below 20%, it ended the year owing nothing on its $2.5 billion bank line of credit; and it sold for $74 million its 50% stake in its money-losing Mexico operations.

More good financial news last month: Kmart's bankers extended the term of its $2.5 billion bank credit line by another year, and Kmart persuaded its bankers to cut interest rates and the commitment and letter of credit fees. Moreover, the banks eased limits on how much Kmart can invest in new stores and how much inventory it can carry.

Now its main challenge remains one that has been obvious for the past two years: drive the top line of sales, especially in women's apparel, its most problem-prone category.

Other financial obstacles to be cleared are regaining the investment grade rating for its bonds and restoring the stock dividend suspended almost two years ago as Kmart wrestled with its cash crunch.

Perhaps the biggest problem remaining is to unload its money-losing Builders Square chain and sell its losing Kmart Canadian chain as a viable business.

Complicating the Builders Square sale are some $2 billion worth of leases Kmart has guaranteed. Including operations already sold, such as Furr's Cafeterias sold in 1986, Kmart is obligated for $3.1 billion of leases besides those on its own discount and Super K stores.

Kmart, of course, had a deal pending this past spring to merge Builders Square with HomeBase, the home center chain of Waban, also the parent of BJ's Wholesale Club. But Waban pulled out of the deal, sending Kmart back to the drawing board.

Because of the guaranteed leases for Builders Square, Kmart is limited in its selling options, said Bob Burton, vp for investor relations.

"Leases are an important discussion point," Burton said. Kmart can't consider a thinly financed investment buyer because if it failed Kmart would be stuck with a chain in a worsened condition.

"The best solution is either a strategic partner or a well-financed financial buyer that would restore the chain."

Kmart has completely written off Builders Square, Burton said, and now is treating it as a discontinued operation. "We think we're fully reserved."

Kmart is going to have serious discussions about selling the chain but has nothing material to announce now, Burton said.

Regarding the sale of Kmart Canada, "some conversations continue," Burton said. Several buyers have approached Kmart.

Kmart Canada is No. 4 in a two- or three-player market, chairman Floyd Hall told a recent analysts' meeting.

As a viable business with sales of $1 billion per year, "Kmart Canada is a valuable asset," Burton said. It has a positive cash flow but fails to cover the interest costs of intercompany borrowing, he said.

The Hudson's Bay Company has offered to buy 36 of the 123 Kmart Canada stores for conversion to either department stores or Zellers discount stores. But selling the chain piecemeal is the opposite of Kmart's position that the chain is a viable business with an established position, Burton said.

Meanwhile, Wal-Mart Canada continues to widen its market share, now estimated at 50% of discount store sales in that country, up from 40% two years ago.

With the recent sale of its 50% stake in four Super Kmarts in Mexico, which fetched $74 million, Kmart has joined Sears in abandoning that country to the rapid growth of Wal-Mart.

A below-investment grade rating of Kmart debt issues means the company has to pay extra interest that lops several cents per share off its net earnings Burton said. Kmart also cannot participate in the commercial paper market. One analyst puts the earnings penalty at 11 cents per share.

The worst aspect of not having an investment grade rating is that it limits the cash Kmart can raise by mortgaging its stores, Burton said.

Kmart recently had to put up almost $1 billion worth of stores (81 stores worth $964 million) in order to borrow $335 million through mortgages, money that went to help pay off early its $1.2 billion term loan for operations.

If Kmart had an investment grade rating, it wouldn't have to over-collateralize such mortgages "and be a lot more effective. We would be able to borrow $1 billion worth of stores," Burton said.

Although rating agencies such as Standard & Poor's and Moody's decline to give any estimate when they might restore investment grades to Kmart debt, the soonest would be 1998, Burton said, provided Kmart can show two years of solid improvement in performance.