Polyester Palace

Kmart Corp., once the No. 2 retailer in the country, lost its edge some 30 years before it entered into bankruptcy in early 2002. Here, for the first time, is the untold story of what contributed to Kmart’s bankruptcy, as told by former executives whose public nondisclosure agreements have recently expired.
48053

One summer day in Troy in the early 1980s, a tall, thin man with a syrupy Southern drawl ambled into Kmart International Headquarters (KIH) at Big Beaver and Coolidge and signed in at the security desk.

He was given a visitor’s badge that allowed him unfettered access to the inner sanctum of the then No. 2 retailer in America.
Few of the thousands of employees paid much attention to the silver-haired gentleman as he wandered through the maze of 23 interconnected modules that made up Kmart’s sprawling headquarters. He spent most of the day chatting with managers and executives, quizzing them about retail practices and procedures, and asking technical questions about everything from current store layouts to merchandising trends to new store designs.

The courtly and curious gentleman was none other than Sam Walton.

At the time, Walton and his fledgling Wal-Mart stores were shrugged off by Kmart’s brass as a rural, regional operation in the South. The upstart was hardly a threat to Kmart’s $18.6 billion in annual revenue (FY 1983). But what Kmart’s brass didn’t know, or chose to ignore, was that Walton was a force. Long before Kmart, Walton had developed his own well-oiled warehousing and distribution system, because none of his suppliers would directly service the small Southern towns where Wal-Mart dominated.

“The senior folks at KIH just smiled and said: ‘Shucks this, and shucks that,’ as Mr. Sam built his knowledge base,” recalls James Carlson, a Kmart systems analyst at the time. “Almost all of Kmart’s executives gave uncensored information to Mr. Sam. Wow!”

That Kmart’s management team, led by Chairman Ben Fauber, allowed Walton to examine their organization up close and personal showed how fatally insulated management had become. The state of denial that permeated Kmart’s executive ranks alarmed some like Carlson, who saw that Wal-Mart — along with up-and-coming Target Corp. — were taking dead aim at them.

The same was true for Dave Carlson (no relation to James), who joined Kmart in the summer of 1985 as vice president of electronic merchandise systems. Dave Carlson was the first outsider to be hired at the executive level since the retailer’s founding in 1899 as a five-and-dime operation called S.S. Kresge Co.

Shortly after settling into his new job, Dave Carlson witnessed the institutional denial firsthand. In a gathering of executives honoring an employee’s 25 years of service, a vice president of marketing told Carlson that he had just completed a market analysis of  Wal-Mart. The result: Wal-Mart had run out of primary sites in the rural South to locate future stores.

However, the truth of the matter was that Sam Walton had set his sights on being the largest retailer in the world. While Walton readily admits he made lots of mistakes in his early days, Wal-Mart’s problems were well-insulated from potential competitors because, at that point, no one had expanded into the South.

“That afternoon, I took a short position on Wal-Mart futures and put down $400. In about two weeks, my money was gone,” says Dave Carlson, chuckling at his mistake. “I may be the only person who was dumb enough to go short on Wal-Mart.”

David Marsico, another Kmart vice president who spent 30 years with the company, echoed Carlson’s experience. “I remember an executive meeting where they said, ‘Wal-Mart is a regional discounter, leave them alone,’” he says. “We had a lot of our managers from the South complaining about them, and about their prices, but we let them grow.”

The late Walton, who once said he spent more time in Kmart stores than Kmart executives did, was able to pick up on two fundamental weaknesses in his competitor’s operations during his visit. “Wal-Mart developed systems for ordering on-time merchandising (in the mid-1970s), and spent a lot of money on that,” Marsico says. “And their transportation systems were just unbelievable. They figured out how to get product to the stores a lot quicker.”

Marsico, once one of Kmart’s four highest-paid executives, resigned in 2005. Today, he is a regional vice president of Ann Arbor-based Borders Inc., which Kmart once owned.

The Carlsons, Marsico, and other former Kmart executives say the iconic discount retailer imploded over time because of its own internal dysfunction. While today Kmart operates under Sears Roebuck & Co., and is headquartered in the Chicago suburb of Hoffman Estates, the seed of the Kresge legacy was bursting at the seams with hubris when the 1980s rolled around. As far back as 1972, Harry Cunningham, the Kmart chairman who had pioneered the discount segment for Kresge in 1962, warned his fellow managers at his retirement party that Sam Walton was a threat. But no one listened.

 

Top management also failed to address chronic problems that were allowed to metastasize. During the chairmanship of Joseph Antonini, which began in 1987, he and his management team unexplicably abandoned several major turnaround initiatives that likely would have reversed Kmart’s decline. Antonini, who maintains an office in Bloomfield Hills, declined comment for this story.

James Carlson, meanwhile, left Kmart in 1998 after working his way up to a senior position in human resources. As part of his severance agreement, he wasn’t allowed to discuss the company’s business publicly for 10 years. He now runs an executive search firm down the street from Kmart’s former headquarters.

“The wound was self-inflicted — not by a lone gunman but, rather, by a combination of steps resulting in giving away the store and the store contents, and wrecking a major retail force that changed the way the public was sold goods,” James Carlson says of Kmart’s demise.

The same viewpoint is shared by Dave Carlson, who holds a doctorate in industrial and operations engineering from the University of Michigan, as well as bachelor’s and master’s degrees in finance and industrial administration. During his time at Kmart, and in the years since he left, he has been recognized as one of the foremost technology experts in the world. He is currently based in Denver, and is senior vice president and chief technology officer at IHS Inc., a worldwide information company.

Dave Carlson was recruited in 1985 by Kmart’s then-chairman Fauber to rescue a failing companywide effort to install electronic cash registers that would allow sales tags to be scanned as customers went through the checkout line — a rather routine practice today, yet state-of-the-art technology back then.

Carlson’s route to Kmart was a curious one. He was Fauber’s neighbor. The two had met at a neighborhood gathering several years earlier. At the time, Carlson mentioned he was working as a consultant for Wal-Mart, installing the exact type of electronic cash registers and scanning system that Fauber needed.

Despite a seven-year installation timetable, Kmart technicians in 1985 were 18 months behind schedule and millions of dollars over budget. For the $1 billion system, half of the costs were devoted to equipment, with the remainder to be used for software, labor, and programming.

In frustration, Fauber hired Carlson to take over the project. But Carlson soon realized that the effort was for naught — splicing a new scanning system into Kmart’s existing computer network wouldn’t work. He suggested that Fauber swallow the loss, throw out the cobbled system, and start all over. It would be 1990 before the new system was hooked up in Kmart’s 2,400 stores.

Despite the massive investment, managers were reluctant to embrace computer-driven data to make merchandising decisions. The cult of Kmart during that period was that the store managers ruled, and if they thought they were smarter than the computers, so be it.

To understand how that failure contributed to the implosion of a company that filed for bankruptcy in 2002 under then-chairman Charles Conaway, who was recently found liable in federal court for failing to tell investors that the retailer was delaying payments to suppliers prior to filing for Chapter 11, one simply has to look at the culture that had been in place since the early days of founder Sebastian Kresge. Promotion into top leadership positions started and ended with store managers.

“To be selected for advancement as a merchandiser at Kmart, the typical career path evolved around a successful store career. Store managers were kings,” James Carlson says. “If you could run a Kmart store, (it was assumed) you knew the company, the processes, merchandising, human resources, budgeting — you knew it all.”

 The store-manager-knows-best mentality that helped contribute to Kmart ‘s bankruptcy was fostered in the way store managers were compensated, to the detriment of the company. “A store manager was paid and incentivized on the profitability of the store, and the culture was the store manager had a right to understand his store’s profitability,” Dave Carlson says. “What that meant was there were between six and 10 individuals on the payroll in every store who basically ran a second set of books for the manager, to keep track of profits. Wal-Mart never did that, so every Wal-Mart store had a lower fixed overhead of hundreds of thousands of dollars per year.”

Merchandise managers who supplied the stores with goods were also compensated using an arcane system that turned out to be counterproductive. Their incentives were based on a formula called “theoretical gross,” Dave Carlson says.

“For example, the candy buyer decides to add a Hershey bar into the assortment of candies for 40 cents, and marks it up to sell for 50 cents,” he explains. “Theoretically, every time one of those bars is sold, it means an increase of 20 percent gross margin. So the buyer ships trainloads of these bars into the distribution centers and every one that goes in there has a theoretical gross of 10 cents, or 20 percent. Now multiply that Hershey bar by, say, 50 other chocolate bars sold the same way, and the buyer is credited with generating a huge amount of gross profit.”

As the scanning system began to come online, Carlson looked closely at the vast amount of candy going through Kmart. “The first controversial report I did using scanning data was on what prices were actually being charged [for candy] at the register,” he says.

“What that report showed was that there were several lines of candy that were selling below cost. So instead of getting 50 cents, we were getting 39 cents because of competitive pressures that made stores lower their prices,” Carlson says. “Instead of tens of millions of (dollars in) gross profit generated by candy, it was actually costing the company to move candy. The divisional manager said to me, ‘You cannot issue that report.’ She said it was obviously flawed. It was the first time Kmart had a statement of what was actually happening in the stores.”

Surprisingly, it would be two years before Carlson had enough statistical evidence to convince Kmart’s brass to make a change in its candy distribution. “Nothing happened to the candy manager, however, or any other managers found to be similarly deficient,” he says.

Another unsettling inefficiency Carlson discovered was the company’s use of color advertising inserts, which were distributed twice weekly to households across the country. “On Saturday nights, they had crews that went into the stores and changed all the prices that were going to be in the Sunday advertising supplement, and on Tuesday night they would go back and change the prices for new sales in the Wednesday or Thursday supplements,” he says.

Carlson calculated that among 1,500 stores, by way of example, and 3,000 items being marked up and down twice each week, stock crews were physically handling 6,000 items in each store every week.

“So a conservative estimate for 1,500 stores is that 200 million items would be handled by store people every week and re-priced. The cost was massive. Even at a penny apiece, that would be $1.8 million,” he says. “Every week, Kmart would distribute more than a billion pages, a billion with a B, of color advertising — that’s 10 to 16 pages going to 70 million households twice a week. So in addition to handling 200 million items, there was the cost of a billion pages of advertising that went out.”

Wal-Mart, on the other hand, never expended the manpower or cash to change its prices up and down. The retailer merely advertised low prices, always.“I remember doing an analysis that showed that if we eliminated the twice-weekly price changes, it would double our profit,” Carlson says.
Up until Carlson brought in computer technology, most Kmart sales — everything from candy to detergent to coffeemakers, some 60 percent of all items sold in the stores — were rung up on a single key on the cash register.

“The culture of Kmart was a massive department culture,” Carlson says. “In general, with a couple of exceptions, the merchants were not interested in, or capable of, fully understanding what the scanning data was telling them. And this plagued me, drove me a little crazy, for the 10 years I was there.”

Although Kmart’s disastrous venture into diversification with a buying spree that saw the company aquire at premium values, then later sell for a loss, retail operations like Borders, Sports Authority, Builders Square, and PayLess drug stores, James and Dave Carlson, David Marsico, and other former executives say Kmart’s eventual downfall was management’s failure to adopt the fundamental principles of discount retailing — rate of sales per square foot and gross return on investment.

“From the very beginning, Wal-Mart focused on sales per square foot. Sales per square foot for Wal-Mart were 40 or 50 percent higher than Kmart,” Dave Carlson says. “The ideal discount model is that you sell things timely, at relatively low percentage margins, but for enough dollars that, through volume, you pay the fixed and variable costs of a store. Kmart’s culture emphasized percentages rather than sales per square foot.”

 

Kmart’s inventory of toasters, 10 brands in every store, was a case in point. The rule merchandisers generally follow in stocking items is “one to show and one to go,” which means allocating twice as much space for items on shelves than those in reserve.

Toaster sales from the scanning data showed the top two sellers among the toasters offered at a typical Kmart store accounted for 90 percent of the sales.

“I went to the merchant who was responsible for toasters and pointed out that the bottom three of the 10 toasters we offered contributed less than 1 percent of the sales, but were taking up 30 percent of the (shelf) space,” Carlson says. “His answer was that because they contribute 45 percent gross profit, we have to keep them. So the focus, again, was on gross profit percent as opposed to gross profit dollars.”

The scanners were equally unkind to the 80 to 100 different deodorants sold in packages of 12 or 24 units. The data showed most of the shelf space was taken up by the slowest-selling packages, while the best sellers were frequently out of stock.

“I said to the guy in charge of deodorants, ‘We don’t have enough shelf space allocated to the high-volume items,’” Carlson recalls. “He said, ‘Yes, but if I give those items more space, we won’t have space for the others.’”

Carlson says during his time at Kmart, he could guarantee that the top-five-selling deodorants would be out of stock by 8 p.m. on Sunday because there wasn’t enough shelf space allocated to cover the volume of their sales over the weekend.

Kmart’s reluctance to measure performance on the rate of sales per square foot also undermined a major turnaround effort, the “bigger is better” campaign that was kicked off by Antonini in mid-1990.

The company spent $3.5 billion building bigger stores, and expanding those that were 60,000 square feet to 90,000 square feet. Stores that were profitable but, because of their size, deemed not suitable for expansion, were closed.

Initial returns on sales in the bigger stores showed a 38 percent increase in sales. Wall Street analysts cheered. However, the scanning data rained on the parade, Carlson says. “No one ever said, Excuse me, but if you have 50 percent more square footage in a store, shouldn’t you be getting at least a 50-percent sales increase (in sales) just to stay even? It was just astounding that no one ever made that observation.”

A six-month data analysis using two stores from each Kmart district, one refurbished and one not refurbished, showed that the refurbished stores were still losing numerous customers — but at a slightly lower rate than the old stores. “You really can’t justify spending billions on new stores and you’re still losing customers, but you’ve slowed it down a little,” Carlson says. “Antonini told me to stop doing that analysis.”

Carlson credits Antonini for initiating two programs that might have dramatically changed how Kmart did business, if the chairman and the executive group had given them enough time to work.

The first was unveiled after Antonini and his inner circle of executives returned from a brainstorming session in Florida with a declaration of changes to be made in the assortment of goods Kmart carried. The 50,000 items in the retailer’s assortment would be cut by 10,000 units while, at the same time, another 10,000 items would be replaced by more trendy offerings.

“I was very excited about this, knowing that if you get rid of slow-movers you would do more volume per square foot and free up space for better sellers,” Carlson says.

The technology department began keeping track of items in various departments including sporting goods, which at the time offered hundreds of fishing rods, reels, and lures. After six months of tracking the inventory, the data showed that the number of lures for sale actually went up, not down.

“I served on the senior merchandising committee that met every Friday at noon. I took that information to them and there was just a firestorm of protest,” Carlson says. “I carried in a stack of 200 pages that had every rod and every reel listed, and sales by week, sorted in order by sales in cumulative percentage. The top 10 rods and reels accounted for only 25 percent of sales; the bottom group did 8 percent.”

The department merchandisers revolted, accusing Carlson of stepping on their turf, he says. “They absolutely did not want to see that kind of data.”

Carlson says he lost his temper — one of only three times he lost it in his 45-year career. “I remember grabbing my 200 pages, walking out, and slamming the 200 pages into the wastebasket,” he says. “The merchants didn’t want to see the hard data of what was going on. And that was on top of the fact that they didn’t meet the 20 percent reduction in assortment that Antonini had committed them to do.”

With the Kmart merchandisers up in arms, Antonini dropped the program.
The end for Carlson at Kmart came shortly after Antonini discarded a program he commissioned in 1993 that would have improved the company’s efficiencies and bolstered its merchandise assortment.

It was a multimillion-dollar project called the VCR program, short for Valued Chain Re-engineering. Several management committees, working with consultants from Accenture, were formed to look at business processes within Kmart and identify chains linking the best in retailing performance.

For example, carrying a collection of merchandise that meets the needs of targeted customers was one chain. Another was keeping merchandise in stock, and a third was providing customers with accurate price information.

“A company that does those three things well has a very good start at being a pretty good retailer,” Carlson says. “With Accenture’s help, we decided on five of these valued chains to implement to better serve customers. We began addressing some of these fundamental, essential ingredients to retailing — discarding stale merchandise, freshening products, and giving more shelf space to best-sellers.”

Unfortunately, the changes went into effect just in time for the company to record a bad 1993 Christmas quarter, which ended in January. As a result, the re-engineering effort was scaled back. “That was kind of, in my view, the beginning of the end,” Carlson says. “From that point on, there was nothing.”  The program was shut down a short time later, and Carlson saw the writing on the wall. He quit in 1995.

 

David Marsico suffered a similar disappointment with his last major assignment at Kmart, starting up the super center grocery and merchandise stores. He was sent to Europe to study hypermarkets but came back only to discover a Meijer store in the Detroit area that was the perfect model to copy.

Marsico says Kmart hired Gene Hoffman, a retired president of Kroger and Super Value, to serve as a consultant on the grocery side of the operations.

“Gene Hoffman was the biggest inspiration for me in the business,” Marsico recalls. “You couldn’t have had a better executive, the best I ever experienced in my retail career. He was a big help to me in building up food service, and a big help to everybody at Kmart.”

The first super center opened in Medina, Ohio, in 1991. Because of the difficulty in cracking into the wholesale supply chain for groceries, Hoffman and another Kmart executive worked out a plan to cluster nearly a dozen new super centers in each market to improve distribution and boost efficiency. Cleveland was to be the first regional market, followed by Detroit and Pittsburgh.

The day the Medina store opened, one noticeable observer walking through the aisles was Sam Walton. “I will never forget the day we opened that store,” Marsico says. “Sam Walton flew there, came in, and walked the store. And I swear it was the next day, he came back and bought land across the street.”

Marsico was opening the 20th super center store in Virginia Beach, Va., when Hoffman showed up for the ceremony.  “He said to me, ‘I don’t think I’m going to be working with you anymore. I don’t think they need me,’” Marsico recalls. “I said, ‘I do.’ And he said, ‘Yeah, but they don’t,’ and he left.”

Hoffman would later say he quit when Antonini and the management team decided to drop the plan to cluster the super centers in favor of stand-alone stores around the country. “The super center concept could have really taken off for Kmart,” Marisco says. “It’s a case of what could have been. But the support wasn’t there to do it, and it was a shame because, as mousetraps go, I think we had a better mousetrap.” db

Facebook Comments