Kmart is one of America's most well-known retailing names, yet in the past ten years the company has fallen on hard times. Competition has come in multiple forms, from discounts like Wal-Mart and Costco, to category killers like Home Depot to online retailers like Amazon.com. Struggling with declining sales and mounting debt, Kmart was purchased by equally struggling Sears Holdings in the latter's attempt to reshape its business and improve buying power for both firms. Today, Kmart is a profitable operating unit for Sears Holdings, earning $333 million in net income on revenues of $15.593 billion from 1307 stores (Sears Holdings 2010 Annual Report). This paper will analyze Kmart's financials, its business environment and its competitive strategies in the years leading up to its purchase by Sears. It is clear that the company's external environment changed significantly in that time, and Kmart struggled to adapt to those changes. The struggles were eventually reflected in negative outcomes -- declining sales and market share in particular. By the conclusion of this paper, an assessment will be made about the problems that plagued Kmart, what the company's response was and whether or not that response was appropriate or sufficient.

History

Kmart was founded by Sebastian Kresge in Detroit in 1899 as a five-and-dime store, the forerunner to the modern department store. The store was an immediate success, and by 1912 Kresge owned 85 stores and had annual sales of more than $10 million (SHC, 2011). From the beginning, the company operated using what today would be termed as a cost leadership strategy (QuickMBA, 2010). This involved selling ordinary goods to the mass market at low prices. Executing this strategy effectively requires that the firm have efficient operations and strong buying power so that the merchandise can be purchased at lower prices than the prices competitors receive. In addition, most successful retailers in the cost leadership sector are experts at merchandising, a skill that helps to maximize the average ticket and improve customer throughput.

Kmart was an industry leader for several decades but by the 1950s was already facing its first major challenge. The external environment had become much more competitive and Kmart was in tough to defend its market position. Its response evolved into the Kmart discount department store concept. This concept reinvigorated the company and became the model that Kmart still follows today. Sales increased rapidly and the company opened stores at a rapid pace for several years. By 1990, the store was beginning to lose its prestige and the company began an expensive revitalization process that involved modernizing the look of the stores and introducing the Kmart Superstore concept to counter an emerging Wal-Mart. The company entered e-commerce in 1999, late by Internet retailing standards but the site still signed up large numbers of customers.

Despite this, the company was struggling. Kmart entered into Chapter 11 bankruptcy in January 2002. At the time, the company had $37 billion in revenue and $17 billion in assets, but had severe cash flow problems that prevented it from making payments to suppliers (CNN, 2002). The company re-emerged from Chapter 11 as the smaller, leaner operation that analysts had predicted. It turned a profit for the 39 weeks ended January 26, 2005 (2005 Kmart Holdings Annual Report). Kmart purchased Sears, Roebuck & Co. In November 2004 in an $11 billion deal and merged the two companies (Bhatnagar, 2004). The deal was orchestrated by Edward Lampert, and at the time there were skeptics who felt that the cash Kmart was generating after its Chapter 11 would be put to better use, as the deal now resulted in one company trying to turn two giant retail names around (Berner & Weber, 2004). As of 2011, the deal has yet to pay off. While Kmart is profitable, it is still shrinking and Sears continues to struggle. Neither company has been able to revitalize itself and the real estate crash destroyed much of the combined entity's stock value, which reflected the value of Sears real estate as much as anything else (Heller, 2011).

Financial Analysis of Kmart Prior to Chapter 11

In was evident by the early 2000s that Kmart's revitalization strategy of the 1990s had not truly revitalized the company. Worse, it was facing intense competition from Wal-Mart and Target, two companies that operated in its category, but that had competitive advantages over Kmart. The superficiality of Kmart's remodeling and modernizing efforts became apparent -- the success factors in the industry were in...

Compounding the problems for Kmart was that the company waited too long to get into online retailing, ceding market share to more adept retailers in that space. There was nowhere for Kmart to grow, and its existing business was being eroded.
The company's revenues were increasing in the late 1990s, to $37 billion in fiscal 2000 (Kmart Corp 2001 Annual Report). However, the net income was declining. There were a number of culprits. The gross margin declined from 21.8% in 1998 to 19.9% in 2000. Selling, general and administrative expenses rose from 18.5% of gross revenues in 1988 to 20% in 2000. These two factors took the company from a net income of $518 million in 1998 and $403 million in 1999 to a net loss of $244 million in 2000. The situation did not improve. The company started to see its revenues fall. They were $36.1 billion in 2002 but in fiscal 2003 were just $30.76 billion. The net loss widened: it was $2.6 billion in 2002 and $3.26 billion in 2003. The gross margin in 2002 had decreased to 17.4% and in 2003 the gross margin was just 14.6%. The company was having trouble reigning in its SG&A expense as well. In 2002, it was 20.9% of revenues. Despite cuts, it was 21.2% of revenues in 2003 as the company's sales declined faster than it could cut costs.

The trend analysis points to a consistent downward trend in the company's finances in the years prior to the Chapter 11 filing, and especially the year after the filing (FY 2003). Kmart was faced with declining sales, escalating losses and seemed to lack the ability to control its COGS or its overhead expenses. Not only did these struggles show through on the bottom line, but they took their toll on the balance sheet as well. The company's assets declined 3.1% from fiscal 1999 to fiscal 2000. The assets fell further, to just $11.2 billion in 2003 after the Chapter 11 filing. The losses gutted Kmart's equity. The company's total shareholder equity in 1999 was $7.774 billion. It was at just $4.119 billion in 2002 and by January, 2003 the book value of the shareholders' equity in Kmart was just $345 million.

Until the late 1990s, Kmart was performing reasonably well. The company was profitable and it had growing revenues. However the signs of impending trouble were already evident. Either Kmart's buying power or its pricing power were being eroded and as a result the cost of goods sold was increasing faster than the revenues. Overhead expenses were also growing more quickly than revenues. These issues alone would have been a significant challenge for the company to address. When revenue began to fall and the company began to have short-term cash flow issues, the problems escalated rapidly.

The company attempted to change its tactics in order to address the problem. In 2000, the company brought in a new CEO, Charles Conway, to turn its ship around. Conway launched around 100 restructuring initiatives, many focused on increasing the level of accountability at the company. Performance-based analysis principles were introduced to remedy the company's myriad problems -- stockouts, poor service levels and poor merchandise choices among them (Muller & Palmer, 2001). Initiatives focused on everything from marketing to technology investments, at this point just to catch up to where the market leaders were.

Financial Condition End of January 2001 and January 2002

Conaway's efforts, while strategically reasonable, did not have the desired impact on the company. As a result, Kmart's financial condition continued to deteriorate. The company was ultimately undone by a cash crunch, so this portion of the financial analysis will begin with the liquidity ratios. In 1999, Kmart was liquid. It had a current ratio of 2.0 and a quick ratio of 0.26. While these figures are consistent with the company's model, they point to a key problem relating to Kmart's cash flow: most of its current assets are inventories. If the inventories do not move, the company's liquidity will decrease significantly and quickly. By the end of January 2001, the company's liquidity ratios appear to have improved significantly. There were, however, $8.06 billion in liquidities that were now classed as "subject to compromise." The company already knew that its financial condition was untenable.

For a company where inventories make up the bulk of current assets, the key to maintaining solvency is to have high rates of inventory turnover and accounts receivable turnover. As a baseline reference, the inventory turnover rate in 2000 was 4.38 times, or 83.3 days. The company did not…