Troy, Michigan-based Kmart Corp. held a board meeting late yesterday [Monday] afternoon which, insiders say, was to decide whether to file for Chapter 11 bankruptcy-law protection today.

The meeting was aimed at securing a bailout sum of as much as US$2bn. Debtor-in-possession financing from lenders such as J.P. Morgan Chase & Co., FleetBoston Financial Corp. and General Electric Co. would save Kmart from negotiating further loans. However, to secure such funding and be able to continue operating, Kmart will need to file for bankruptcy protection.

Kmart, which operates 2,100 outlets, has seen its problems mount over the last three decades, and neared the courts during a cash-strapped period in the mid-1990s. It has so far dodged financial disaster, despite seeing several regional competitors seek court protection, but its market share has been gradually whittled away by market leader Wal-Mart, which is now nearly five times Kmart’s size. Retailer Target meanwhile has replaced Kmart as the second-largest discounter in the US.

Recent problems

The chain was crippled by a depressing holiday season sales. In December, the Kmart stores that had been open for more than 12 months saw sales fall 1% – while Wal-Mart equivalents recorded sales up 8%.

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Problems in the surety-bond market exacerbated Kmart’s difficulties. The company has, in the past, backed up self-insurance against certain liabilities, including those associated with employees’ compensation plans and its outlets’ gun sales, by buying surety bonds. These are essentially agreements by insurance companies to continue financing in case of a default, and the overall surety bond market has seen crippling losses in the current national economic downturn and the collapse of Enron.

Enron also relied on such bonds and after it crashed, becoming the largest corporate bankruptcy ever, insurance companies were left to cover its liabilities. Insurers raised surety bond prices drastically and Kmart found it increasingly difficult to get such coverage.

The necessary switch to buying more expensive insurance placed a large, unanticipated drain on Kmart’s cash flow – exacerbating its problems.

The company’s sole grocery supplier, Texas-based Fleming, dealt the deathblow yesterday by withholding grocery shipments, a self-preserving move, it explained, after Kmart failed to make a regular weekly payment. Fleming said that Kmart owes around US$78m for the goods covered by last week’s invoice and the perishable groceries that it received over the weekend.

“They’re now starved for food, so to speak,” retail consultant Walter F. Loeb told the New York Times: “and that can’t go on for more than two or three days.”
Market watchers are now waiting to see if Martha Stewart, Kmart’s most important supplier of house-wares, will continue to supply the stores.

Nevertheless, the speed of its demise has taken sector watchers and the company by surprise – leaving the likelihood of a quick fix slim, and the turnaround strategy unclear. Kmart has so far refused to comment on its plans, but investors fears have been growing since the board’s marathon 36-hour meeting through 7 to 8 January. It took two days to hear public statements on the meeting, which then merely announced several high-level executive changes and an intention to review Kmart’s liquidity and financing options.

Chapter 11 protection

The Chapter 11 process will provide the retailer with temporary protection from creditors while it restructures its operations, to ease the pressure of debt worth US$4.7bn and close down underperforming outlets.

The bankruptcy law carries a provision that sets a ceiling on debtor companies’ liability for rejecting real-estate leases. This will be useful to Kmart, as currently it must continue to make lease payments on stores it has closed down. Any Chapter 11 filing will mean Kmart has to close other under-performing stores, a figure analysts have put at as many as 500, in which case it may extricate itself from these outlets with liabilities of either only one year’s rent or 15% of the remaining rent for up to three years, whichever is greater.

Another major advantage of the filing would be the incentives it provides Kmart’s suppliers to keep the shipments coming. Among these is a guarantee that the vendors who continue to provide goods after the filing will receive priority-payment status in the event of bankruptcy.

If Kmart reveals that it has filed for Chapter 11 protection, it will become the largest retailer ever to seek bankruptcy-court protection [a dubious record currently held by Federated Department Stores and sister company, Allied Stores, which filed in 1990].