Kmart: Out of the Box?

Even if the company's accounting scandal was a one-off occurrence, Kmart must still overcome the legacy of what many see as major strategic misstep. One in a series of ''corporate cleanup'' profiles.

Compared with its weightier business woes, Kmart’s accounting scandal seems more of a nagging problem than a looming catastrophe.

Much more troubling is the question of whether or not the discount retailer, which emerged from bankruptcy in May, can resurrect its brand and explain to consumers why they should shop at its stores, Kmart watchers say.

To be sure, they credit the chain with bounding out of Chapter 11 two months ahead of schedule and with an impressive $2 billion in exit financing. They also praise its renovated management, merchandising logistics, and financial reporting. But they question whether it can put the brakes on its market-share slide and gain any ground at all on its vaunted competitors, Wal-Mart Stores and Target Corp.

To do that, Kmart Holding Co., as the parent organization is now called, must overcome the legacy of what many see as a major strategic misstep: Trying to compete with Wal-Mart on price.

The struggle to vie head-to-head with the formidable competitor put tremendous pressure on Kmart to maintain its profit margins in the years running up to bankruptcy, according to Gary Ruffing, a former Kmart vice president of sales and marketing. During that time, the company slashed both its everyday prices and the cost of goods featured in advertised sales, notes Ruffing, who says he left in February 2001 after thirty years the company because he disagreed with that policy. “You’ve taken two hits in the same year,” he says. “That’s very hard to manage.”

The strategy of slashing prices also meant that the company had to move many more products through its pipeline to maintain its gross-profit margins.

Besides increasing the need for cash to pay suppliers, the surge in inventory placed a crushing burden on out-of-date systems. “When goods moved from distribution centers to stores, it was not an optimal process,” says Richard Hastings, chief retail analyst at Bernard Sands, a credit advisory firm.

The supply-chain breakdowns threatened the credibility of the company’s financial reporting. “If you don’t know where the boxes are, you don’t know what they’re worth,” says Hastings, who noted that such problems created “a lot of questions about the validity of Kmart’s accounts-payable numbers.”

Apparently, the problems were longstanding. A software programming flaw in Kmart’s accounts-payable system involving one of the company’s vendors led to an understatement of the company’s cost of sales from 1999 through 2001. The error was one reason given by the company for a December 2002 restatement that boosted its net loss for that period by not quite $100 million. (At the time, the company also restated its results for the first two quarters of 2002, lowering its net loss for that period by roughly the same amount.)

Another reason Kmart gave for that restatement was the premature recording of vendor allowances, also called slotting fees, paid to Kmart (and many other retailers) by suppliers to keep their products on store shelves. Indeed, alleged improper reporting of vendor allowances have been the source of an accounting scandal at the company.

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