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.

The same profit squeeze that damaged Kmart’s logistics seems to have played a big role in its accounting problems. In February, the Securities and Exchange Commission sued two former Kmart executives, Enio Montini and Joseph Hofmeister, charging them with improperly booking the entirety of a $42 million slotting fee paid by American Greetings in the fourth quarter of 2001, rather than over the five-year life of the deal. Their alleged motivation: to hit quarterly gross-margin performance targets on which their incentive pay was based.

Besides the SEC action, Montini and Hofmeister face criminal charges of securities fraud, lying to the commission, and conspiring to commit those offenses. The SEC and the U.S. Attorney’s office for the Eastern District of Michigan are also conducting broader investigations into how Kmart has accounted for vendor allowances.

Sprucing Up

Despite the investigations, however, the company has done an excellent job of pulling itself out of its operational and accounting quagmire, some observers say. Last month management signaled a willingness to repair its logistics, according to Ruffing, by naming Bruce Johnson senior vice president of supply chain and operations. Previously Johnson served as director of organizations and systems at grocery giant Carrefour, which has more than 9,500 stores in 30 countries.

Further, since filing for Chapter 11 protection, Kmart’s financial reporting has gone “from somewhat unreliable to highly credible and reliable today,” says Hastings, the credit analyst. Part of the reason for Kmart’s new transparency, he thinks, is that the bankruptcy occurred during a particularly robust period of regulatory reform that included the Sarbanes-Oxley Act. But he also credits Albert Koch, who served as Kmart’s temporary CFO during the bankruptcy, with sprucing up the company’s books.

The installation of Koch and temporary Kmart treasurer Ted Stenger, members of turnaround management firm Jay Alix & Associates, were part of a considerable housecleaning. Nearly all of the top executives who ran Kmart before its January 2002 Chapter 11 filing have left the company. Among the departed were a group executives granted retention loans by former chairman and CEO Charles Conaway as the company headed down the tubes. Conaway and Mark Schwartz, the former president and chief operating officer — and a Wal-Mart veteran — were the architects of the price-cutting strategy.

The new top executives, led by president and CEO Julian Day and chairman Edward Lampert, are given high marks for their roles in the company’s quick escape from the ranks of the bankrupt. The hands-on approach of Lampert — a hedge-fund manager whose firm, ESL Investments, owns more than 50 percent of the company’s shares — reportedly played a big part in the company’s swift emergence.

But was the fast track too fast? “There’s speculation that they could have benefited from a longer period in bankruptcy” to have more time to plot strategy, thinks Nancy Aversa, a research analyst with Victory Capital Management in Cleveland. She also questions whether Kmart’s closing of about 600 stores during the bankruptcy was enough to “rationalize its base.” If Kmart were to undertake a second round of closings, even of fewer stores, the public perception might be even more damaging.

Another potential problem is the vacancy where the CFO should be. In its complaint against Montini and Hofmeister, the SEC noted that the men were able to freeze out a key finance official — Montini’s direct report — from the vendor-allowance negotiations with American Greetings. If the company doesn’t come up with a strong replacement for Koch, whose role as interim CFO concluded when Kmart emerged from Chapter 11 in May, questions could arise about the company’s ability to enforce its internal controls.

To be sure, a fair number of Kmart watchers now see the accounting scandal as a one-off occurrence with no lasting impact on the company’s core business. But if the government investigations become prolonged, and “Kmart’s name keeps coming up in a negative way,” that would hurt its ability to attract loyal customers, thinks Ruffing. The former Kmart vice president, by the way, is now a now a senior director at BBK Ltd., a Southfield, Michigan-based firm specializing in turnaround advice.

Shopping — especially bargain-hunting — may be a favorite American pastime. But fail to restore a company’s good name, says Ruffing, and customers might well come to ask, “Why should I shop somewhere where people are taking advantage?”

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