Red ink forces Blue Light to run up white flag as Kmart slides into bankruptcy

By Paul Deckelman and Paul Harris

New York, Jan. 22 - The suspense - if there ever was any - is over.

Attention Kmart shoppers and investors: the company is now officially bankrupt.

News that the embattled Troy, Mich.-based discount retailing giant had sought protection from the holders of more than $2.7 billion of junk bonds and other creditors via a Chapter 11 filing with the U.S. Bankruptcy Court for the Northern District of Illinois in Chicago was the dominant story Tuesday, as high yield marketeers returned to work following the three-day Martin Luther King holiday break.

When they sat down in front of their screens Tuesday morning, they were greeted by the somber news that Fleming Cos. Inc. - one of Kmart's most important suppliers of merchandise - had announced Monday that it had suspended shipments of food items and other consumable products to Kmart after the struggling store chain failed to make its regular weekly payment, totaling $78 million.

With Dallas-based grocery wholesaler Fleming keeping Kmart on a very short leash, requiring payment within seven days of delivery, the slip was enough to stop the big trucks that bring bags of potato chips, bottles of soda, boxes of cookies, cans of tuna fish, packages of paper towels and hundreds of other fresh and packaged food and consumable items to Kmart's 2,114 stores nationwide. A second supplier, Scott's Co., which furnishes lawn and gardening products to Kmart, also suspended shipments.

With supplier confidence eroding, liquidity declining rapidly from weak fourth quarter sales and earnings, and difficulties in the surety bond market, among other factors, Kmart's board authorized the filing, after having lined up $2 billion in debtor-in possession financing from Credit Suisse First Boston, Fleet Retail Finance, Inc., General Electric Capital Corp. and JPMorgan Chase Bank.

Kmart's bonds swung dramatically Tuesday, with its benchmark 9 3/8% notes due 2006 swooning as low as 41 bid and as high as 53 and change before settling in somewhere in the mid-to-upper 40s. Volume of $104.8 million made it the most active issue on the Nasdaq FIPS 50 market index.

Kmart finished "not with a bang, but with a whimper," a trader observed, pegging all of its different issues of senior unsecured bonds - from paper scheduled to mature this year to issues coming due 20 years from now - "all pari passu with the bankruptcy and all trading within the same context, around 45-47."

On Friday, the company's had bonds had seemed to stabilize, with traders quoting them generally bid in the 47-52 zone, depending upon the maturity, with the shorter-dated notes higher than the long paper.

When the trading day began, he noted, the bad news from Fleming "had been out there for at least 24 hours," and so the notes, which had initially fallen back into the mid-40s, bounced off the lows and recovered into the lower 50s, particularly after the bankruptcy announcement, which also contained news of the DIP financing and company assurances that vendors, such as Fleming and Kmart's other big-name merchandise supplier, Martha Stewart Living Omnimedia Inc., would be paid "under normal terms for goods and services provided during the reorganization." Fleming indicated that it intends to resume delivery of food and other consumables to Kmart upon receiving satisfactory assurances from Kmart via the bankruptcy court.

But after peaking in the lower 50s, the trader said, "as the day progressed, and there was negative press" about whether the battered company could successfully restructure and emerge from bankruptcy next year while continuing to battle its giant rival, Wal-Mart Stores Inc., "people got wigged out, particularly retail (i.e., non-institutional) investors, and most of the notes traded back down to around 46 to 47 cents on the dollar."

Another trader, while pegging the bonds a touch higher, in the 47.5-to-48.5 bid range, noted that they were now trading flat, or without accrued interest, amounting to an effective drop of several additional points beyond the nominal change in the price levels from the previous session.

He meanwhile saw Kmart's structured paper - those secured by tangible assets such as store lease payments as a result of a complicated transaction the company undertook with off-balance-sheet entities in the mid-1990s - trading anywhere from the lower 50s to levels above 70. "You have to go lease by lease and see what kind of collateral is there," good or bad, he explained.

The structured lease paper, the first trader said, "was definitely a different situation" than the unsecured notes, where everything converged around the same level around the upper 40s no matter what the maturity, since in a bankruptcy proceeding, the maturity is essentially irrelevant. The structured paper was "all over the place," he said, but was trading "with no decent size."

Kmart's slide into Chapter 11 came less than three weeks after Prudential Securities analyst Wayne Hood had warned that a bankruptcy filing was quite possible if the retailer was unable to improve its cash flow generation. In that time, Kmart, whose bonds had been trading in the 80s and whose share prices were above $5, slid precipitously - particularly after it reported that December sales were actually down a point while rivals Wal-Mart and Target Corp. and many other retailers posted gains for the all-important holiday shopping month. Kmart's bonds swooned into the 40s, while the stock eroded down to less than $1 per share, ending Tuesday down $1.05 or 60.34%, at 69 cents; NYSE volume of 148 million shares was over 13 times the usual daily turnover.

Veteran bankruptcy attorney John Hansen said there was nothing surprising about the speed with which Kmart fell out of favor with investors, credit ratings agencies and suppliers, calling the company's nosedive "a fairly typical downward spiral. Once it starts, it's very hard to reverse, because the financial community and the supplier community loses confidence and credit dries up. They just can't keep their shelves stocked if they don't do something. I've seen it happen in rapid succession before."

Hansen, chairman of the bankruptcy practice at Nossaman, Gunther, Knox & Elliott, LLP in San Francisco, told Prospect News that having now declared bankruptcy, Kmart had ensured that its restive suppliers would continue to stock its shelves, although he said it was almost certain that "they'll be paying cash on delivery. That's what the DIP line is likely to be used for."

Prior to the filing, there had been some worrisome press speculation, from the point of view of Kmart investors that Martha Stewart, perhaps the highest profile of Kmart's flagship merchandise lines, might have grounds to back out of its supplier contract in the event of bankruptcy and take its collection of bedding and linens, housewares, kitchenware and decorative items (total worth to Kmart last year: $1.5 billion) elsewhere. But Hansen doesn't believe the first lady of fine living is going anywhere, since "the bankruptcy escape clause, frankly, is probably not enforceable once you're in bankruptcy. People put those clauses in contracts, but the bankruptcy code specifically says you can't enforce those kind of provisions, to back out of an agreement merely because the other party files for bankruptcy. So they probably are locked into the supply agreement, in the short term, at least," as long as Kmart continues to pay its bills.

Kmart, on the other hand, will have the ability to back out of certain contracts - namely leases on its stores, since "store closings are one of the things that Chapter 11 helps with. They have an option, under the bankruptcy code, to reject leases, which then transforms the lease obligation into a past due debt that gets line with all of the other creditors, instead of an ongoing obligation. That will be one strategy for trying to improve their cash flow." Analysts have said that the company would have to close anywhere from 200 to 400 underperforming if it is to have any hopes of righting its capsizing ship.

Kmart said in its bankruptcy announcement that it would immediately seek Bankruptcy Court approval to terminate the leases of approximately 350 stores that were closed previously by Kmart or which are currently being leased by other tenants at rents below Kmart's obligation; such a step would result in an immediate annual savings of approximately $250 million, the company said. Furthermore, Kmart said it would be "evaluating the performance of every store and terms of every lease in the Kmart portfolio by the end of the first quarter of 2002 with the objective of closing unprofitable or underperforming stores this year to increase cash flow and return on invested capital."

Kmart on Tuesday further announced the appointment of Ronald B. Hutchison to the new post of Restructuring Officer. Hutchison most recently was chief financial officer of Advantica Restaurant Group Inc., where he worked with then-Chairman/Chief Executive Officer James B. Adamson in turning around the troubled restaurateur and bringing it out of bankruptcy several years ago. Adamson last week was appointed chairman of Kmart, replacing Charles C. Conway, who was retained as CEO.

Hansen says that while the company is keeping Conway in the executive troika because of his retailing experience, (although Adamson also has some retailing background from his days as a senior executive at Kmart competitor Target), the two former Advantica executives probably will be the main players "at least for the short term."

Hutchison, in addition to having helped guide Advantica (formerly known as Flagstone Cos. Inc.) out of Chapter 11, performed a similar role for Leaseway Transportation, a troubled transportation holding company which emerged from bankruptcy earlier in the 1990s.

Hansen declared that "often people like that will come in, stay a year or two and go on to another opportunity, rather than planning on staying and being the managers for the long term. But for the short term (at Kmart), I'm sure they will be calling most of the shots."

Elsewhere, market activity was generally muted, with most secondary players focused on the latest developments in the Kmart soap opera. Fleming, whose fortunes are tied to Kmart's (at least in the public mind, although the grocery wholesaler has taken pains to try to minimize its exposure to Kmart), was seen little changed in Tuesday's dealings, its 10 1/8% notes quoted at 96 bid, its 10½% paper at 91 and its 10 5/8% notes at 89.

Also in the retailing sphere, Rite Aid Corp. bonds were quoted down about eight points, with its 7 1/8% notes down to around 60 bid and its 6 7/8% notes at 52. The Camp Hill, Pa.-based drugstore chain operator recently reported reported a wider-than-expected fiscal third-quarter loss and cut its cash flow outlook for the rest of fiscal 2002,. That helped spark investor fears that it may be unable to boost sales and earnings and cut its debt significantly in a retail environment featuring intense competition from larger rival Walgreen and discounters like Wal-Mart poaching on traditional pharmacy turf.

Conseco Inc. bonds continued the firming trend seen late last week, its notes quoted up three points across the board. The Carmel, Ind.-based insurer's 6.80% notes closed at 49 bid, while its 6½% paper ended at 77.

Late in the session, the company issued an announcement confirming Friday's market speculation that it was shaking up its core insurance division - including several changes of key personnel - in hopes of revitalizing its performance. Thomas Killian, up till now in change of Conseco's life insurance and annuity operations, will leave the company; those units will meanwhile be consolidated with Conseco's supplemental health insurance operation under the leadership of Liz Georgakopoulos, who up till now has overseen the supplemental health business.

Almost-junker Georgia Pacific Corp.'s weak 6-B rated debt widened out sharply Tuesday on news that Willamette Industries Inc. walked away from the proposed purchase of Georgia Pacific's building products unit and will instead be acquired by paper products rival Weyerhaeuser Co. Georgia Pacific had hoped to be able to use the proceeds of that asset sale to pay down much of the $11 billion of debt it took on to finance the 2000 purchase of tissue maker Fort James Corp. Analysts say Atlanta-based forest products producer GP had no backup plan and now has to try to cut its debt other ways, perhaps by spinning the building products maker off - by no means an easy task.

Georgia Pacific's Baa3/BBB- 6½% notes due 2002, which previously traded at bid levels equivalent to 385 basis points over the six-month LIBOR rate, widened out to 512 basis points over. Its 6.70% notes due 2003, which had been bid 514 basis points over Treasuries, gapped to 619 basis points over. On the long end of the maturity curve, the bid spread on its 7 3/8% notes due 2025 widened to 550 basis points from 465 previously.

In the primary market, news of a new euro deal, and an add-on slated for late February or March surfaced. However sources who spoke to Prospect News were generally seeing the market "quiet," at the conclusion of the three-day weekend.

"I don't know if it's because of the solid beatings that the equities are taking, or just a hangover from the long weekend," one syndicate official commented after the close of Tuesday's session.

"Around here we seemed to be having trouble shaking the cobwebs out."

Information was heard about a new offering for approximately €300 millionfrom Kamps AG; a syndicate source said it will likely hit the US and European roads on Monday. J.P. Morgan will run the books on the deal, which is expected to price the week of Feb. 4.

Also on Tuesday, the market heard information regarding a Yell Holdings NV approximately $250 million add-on to its notes due Aug. 1, 2011, via joint bookrunners CIBC World Markets and Credit Suisse First Boston. The structure of the Yell add-on depends upon on McLeodUSA's reorganization . It was announced Monday that Yell will pay $600 million for McLeod's telephone directory business.

Price talk of 11%-11¼% was heard Tuesday on Compton Petroleum's $150 million senior subordinated notes due 2012 (B3/B-) via Lehman Brothers. The deal is expected to price shortly after noon Wednesday.

Noting that Januarys have been tone-setters in recent years for the high yield primary market, the above-quoted syndicate official commented that the present volume seems to be falling somewhat short of December's expectations, and certainly short of December's hopes.

"It's going to be interesting to see where the next couple of weeks take us," the official said.

"Right now we've done a little less than $5 billion, this month. And there's another $1.8 billion, approximately, on the road. Not all of that's going to price in January, of course.

"So we're looking at a $6 billion or $7 billion month. And I was hopeful that we were going to be a little bit better."

This official conceded that based upon the activity in the December primary market, January volume of $10 billion to $12 billion of new issuance had seemed conceivable.

"A lot of deals that normally would have been held off until January got priced in December because the market was hot," the official said. "And some of the deals that bankers were working on for January maybe got pushed onto the back burner so that they could do another deal in December.

"And I guess $7 billion would not be a bad month, if it weren't for the fact that this month is January, and January has been a tone-setter."

End

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