The journey from adolescence to middle age takes about 15 steps for shoppers at the Stonebriar Mall’s J.C. Penney — the distance between the pile of Beavis and Butthead T-shirts and a luxurious, overplumped bed decked out in matching shades of sage.

As in life, though, the gulf seems much wider. Plasma TVs surround the neon-lit “tween” clothing section, pumping out music videos from dance-hall DJ Beenie Man and teen pop vocalist Katy Rose. It’s brighter — and much quieter — at the nearby bedding display, where Bruce Hornsby’s “Mandolin Rain” wafts from hidden speakers. It would be easy for a customer visiting either section to completely ignore the other.

This bit of display magic is just one example of Penney’s effective effort to revamp its stores and store brands (such as designer Chris Madden’s bedding collection) and bring customers, including younger ones, back after years of company decline. Yet the Stonebriar Mall store, a five-minute drive from Penney’s Plano, Texas, headquarters, also illustrates the challenges the company faces. The mall boasts a Sears, a Nordstrom, and a Macy’s, as well as numerous specialty stores. Just down the road sits a stand-alone Kohl’s store.

“It is very difficult to command loyalty,” says newly hired Penney CEO Myron Ullman. “Right now I would argue that in the core department-store business in the mall, [customers choose] whichever store has better parking.”

Ullman officially assumes the CEO role this month — four years into a five-year effort to make Penney more than a convenient entrance to the mall. Led to date by retail veteran Allen Questrom, Penney’s turnaround is widely regarded as an industry success story. But Ullman’s accession was greeted by a 7 percent drop in stock price and questions about the company’s future plans. Investors, it seems, know how hard it is to hold customers’ attention in an industry that’s as crowded as a jewelry counter on December 24 — and dominated by the behemoth that is Wal-Mart Stores.

Finance Follows Fashion

Penney’s ongoing “turnaround” is not driven by a dire liquidity crisis. Although the company lost its investment-grade rating in 2000, it has plenty of cash. At the end of 2003, its coffers boasted a $3 billion hoard that equaled 55 percent of Penney’s long-term debt at the end of 2003. Even CFO Robert Cavanaugh describes the turnaround first in nonfinancial terms. “It was the fashion content that needed to improve dramatically,” he says. “We weren’t listening to the customer.”

Penney’s private-label brands were languishing, he says, and both house- and national-brand fashions were stale by the time they hit the sales floor. Worse, the company’s antiquated merchandising operations were delivering far too much of both. “We were what a merchant would call ‘overassorted,’ ” says Cavanaugh. “Too many products in each space — too many men’s dress shirts. We needed to edit.”

Ultimately, of course, Cavanaugh is still talking about money, not shirts. Private-label brands deliver higher profit margins (300 to 500 basis points, experts say) if they sell. The private-label brands also distinguish a store from competitors carrying identical national brands. “When J.C. Penney was offering the same assortment as everyone else, it could compete only on price,” says Jason Asaeda, retail analyst at Standard & Poor’s. Penney’s moderate-income customers, he says, “became accustomed to a discount.”

In retail, finance follows fashion. In what other business would a Goldman Sachs analyst ask a CFO (in this case, Federated Department Stores CFO Karen Hoguet) whether the “acceptance of the early fall color palettes — lavenders and berry and green and so on” — constitutes an earnings risk?

But the gloss of fashion belies the vicious shelf-to-shelf combat among Federated, Penney, Kohl’s, Dillard’s, and Sears. Midrange department stores are fighting for a shrinking pie. “Retail is a zero-sum game,” explains Asaeda. “Each gain in sales for one store equals a loss for another.”

“Middle-to-upper-middle-income consumers are trading up to higher-end retailers,” observes PiperJaffray analyst Jeffrey Klinefelter. At the same time, discounters like Target and Wal-Mart are eating away at sales of fashion “basics.” (As Wal-Mart CEO Lee Scott recently remarked to the Wall Street Journal, “even CEOs” buy their underwear at his stores.) And as in fashion, strategies in retail are constantly changing and easily copied.

Where Penney Fell Short

Today’s retail reality took the venerable Penney by surprise.

Company founder James Cash Penney was famously frugal. A replica of his first store counter — built from the packing crates in which his merchandise arrived — is on display at the company’s headquarters. But elsewhere in the sprawling office park, built in 1992, is evidence of a more recent period of management complacency.

“That’s the Penney of the 1990s,” explains longtime investor-relations executive Eli Akresh, after this reporter returned from a trip to an expansive private bathroom in a darkened, empty executive suite.

Even more emblematic of that era is a state-of-the-art television studio. Penney was one of the last retail chains to leave control of merchandising decisions in the hands of local store managers. From the studio, buyers would broadcast the selection of wares to store managers, who decided whether and how much to buy. “The centralized merchants did not have authority over how much to buy or how to promote it,” recalls Cavanaugh. Many stores also made independent purchases. “Anyone with a van could sell to our stores,” he says.

That setup was the legacy of the “Penney Partnership,” an expansion model used until 1929 in which managers of new stores put up one-third of the equity capital. “In the old culture,” recalls Cavanaugh, “everyone was told, ‘You are working for the stores.’ The stores knew what was right because they served the customers. Today, everyone is working for the company.”

What worked beautifully for 90 years became a disaster in the mid-1990s, as competitors began perfecting centralized merchandising and inventory systems, which permitted daily updates on sales of individual items in each store. (Ironically, the man who pioneered the new supply chain — Sam Walton — got his start at Penney.) By contrast, says Cavanaugh, “we didn’t know what any store had.”

Worse, the decentralized system stretched out lead times. “Fashionability was changing much more rapidly,” says Cavanaugh. While competitors filled shelves with a single hot-selling item, Penney’s store managers hedged their bets with variety. Unwanted items swelled inventory, while popular items quickly ran out.

From 1965 to 1995, the company averaged a 16 percent return on equity. Such comfortable numbers initially blinded the company and investors to its merchandising failures, and Penney’s presence in 90 percent of U.S. malls masked many deficiencies. In 1998, buoyed by the economy, Penney’s stock hit a high of $78. By then, however, sales were languishing. “Our management team really didn’t know what to do,” recalls Cavanaugh (then assistant treasurer).

By 2000 the stock had plunged below $10. In July of that year, the company cleaned house and appointed Questrom — known for turnarounds at Barney’s, Federated, and Neiman-Marcus — as the first externally recruited CEO in company history. Cavanaugh, then CFO of the company’s struggling Eckerd drugstore chain, was elevated to CFO of Penney in January 2001.

The Turnaround

For Cavanaugh, who had risen through the ranks of Penney’s treasury department, it was a return to a diminished company. Once A-rated, Penney’s stock had dropped to junk status, which shut off the company’s access to commercial paper. “Before, we could access the commercial-paper market at any time,” recalls treasurer Michael Dastugue. Now Cavanaugh had to use cash to buy the $1.5 billion in peak inventory needed between the back-to-school season and Thanksgiving — not to mention maturing long-term debt obligations that averaged $265 million a year since 2000.

Cavanaugh’s task was to build a “financing bridge” that would not only meet the company’s obligations but also give Questrom and his new management team the resources and time needed to carry out a five-year plan to centralize Penney’s merchandising, as well as revamp its stores and private-label program. Those efforts demanded an increase in capital expenditures, not cutbacks. “Vibrant businesses are the ones that need the most capital resources,” notes Cavanaugh. “We want to ensure that the operating people don’t have to worry about liquidity.”

Fortunately, Cavanaugh started with some $2 billion in the bank, more than half of which came from the sale of a direct-marketing insurance business. Funding the centralization of merchandising proved something of a virtuous circle, producing working-capital improvements that threw off free-cash flow. Despite anemic profitability numbers, Penney generated a total of $1.6 billion in free cash flow from 2000 to 2003.

By August of this year, it was beginning to look like the turnaround had succeeded. As other retailers stumbled in the back-to-school season, Penney posted good results. Operating profits represented 4 percent of sales, not far from the turnaround EBIT goal of 6 to 8 percent (and a far cry from 1.7 percent in 2000). Its newly centralized merchandising system — built by executives spirited away from Wal-Mart and other competitors — was kicking into high gear. Best of all, the store’s revitalized lines of private-label brands were delivering 40 percent of sales, providing both higher margins and unique customer draw.

Then, in July, Penney announced the sale of its Eckerd drugstore chain, a 1997 acquisition that had been the centerpiece of Penney’s fast-growth initiative. That sale relieved Penney of annual capital expenditures of more than $400 million, as well as $3.4 billion in off-balance-sheet lease obligations.

At that point, the company immediately committed all of the $3.5 billion proceeds to share-buybacks, plus $1.1 billion of its cash to debt reduction. “I think the degree of debt reduction is sufficient to produce pro forma credit measures that are comparable to or better than some of the other BBB- rated retailers,” says Gimme Credit’s Evan Mann. Fitch now rates Penney BB+, a notch below investment grade, and both Moody’s and Standard & Poor’s have improved their outlook for the company. But despite the huge deleveraging — debt-to-capital ratio dropped from 51 percent to 34.6 percent — Penney is not out of the woods. “The agencies are going to wait and make sure the company’s operating performance stays solid,” says Mann.

On the Rack

Therein lies the challenge. On October 5, analyst Klinefelter downgraded the stock from Buy to Neutral, predicting that “JCP market-share gains will likely slow as other moderate retailers catch up.” Two days later, the company announced that September department-store sales had grown just 2 percent, citing record-high energy prices as a contributing factor. October sales also grew 2 percent.

On October 27, the company selected Ullman as the new CEO. Although an official search for Questrom’s replacement had been under way for some time, he was not expected to step down until September 2005. (Ironically, Ullman was CEO of Macy’s in 1994, when Federated took it over in a hostile bid led by Questrom.)

Analysts were surprised that Wal-Mart veteran and merchandising expert Vanessa Castagna, who had served under Questrom as CEO of Penney stores, as well as of its catalog and Internet operations, was not selected for her boss’s job. The choice of retail veteran Ullman, whose last position was CEO of luxury-goods purveyor LVMH Moet Hennessy Louis Vuitton, suggests a continuing emphasis on building exclusive brands.

Questrom called Ullman’s experience with brands critical. “[Brands] are a bigger and bigger issue in retail because of the clutter we have out there,” he said. Ullman’s brief remarks to analysts focused on taking Penney’s revitalized and new house brands “to the next level.”

Indeed, it’s not clear what comes next. Just before Questrom announced his early retirement, CFO asked him where Penney’s future growth would come from. He said his sights still were set on taking market share from competitors, noting that the improvements Cavanaugh funded are only just taking hold. “We are one of the few [retailers] that has had top-line growth without adding a lot of stores,” he said. “We can continue to do that for the foreseeable future.”

Indeed, Penney’s expansion plans are relatively modest. It opened 10 off-mall stores this year, and officially plans about 75 over the next several years. Kohl’s, with no base of mall stores, is planning to add 500. From a big-picture perspective, Questrom conceded that “the retail business is limited in its ability to come up with new ideas and to create new products.”

He’s right. In both his interview with CFO and in his subsequent retirement announcement, Questrom cited the Internet and off-mall stores as the two “new strategies in place that were not so visible when this [turnaround] program started.”

Yet neither strategy is particularly new.

Internet sales generated more than $600 million for Penney in fiscal 2003, and are expected to top $1 billion in fiscal 2006. Although to some degree these sales simply compensate for the decline of the company’s paper-catalog business, Penney executives argue that tight integration with its stores provides a competitive edge. “Customers who order online can pick up and return goods to the store if they choose,” says spokeswoman Carolyn Covey Morris. They can also place orders online at a store, she says, noting that the Website might have 50 available sizes to the stores’ 10. S&P’s Asaeda says Penney’s multichannel approach gives the company more ways to reach customers than its rivals enjoy — at least for the time being.

The off-mall concept, epitomized by rival Kohl’s, falls into the category of “everything old is new again.” In theory, some customers find such stores more convenient than malls. In practice, the market for new malls is stagnant, so adopting an off-mall strategy allows Penney to open new stores when and where it likes — just as it did in the days before malls.

Questrom has chided analysts for not taking the strategy more seriously, saying, “This is a better deal than we thought it was.” He suggests that the company might add as many as 200 off-mall stores, depending on customer demand. But Penney is hardly alone in adopting this idea: Sears recently purchased 50 stores from Kmart and leased 6 more from Wal-Mart as sites for its new, off-mall Sears Grand concept. “It’s ironic that Sears, among others, seems to be imitating Kohl’s with its off-mall format just when Kohl’s sales are languishing,” notes Gimme Credit’s Carol Levenson. (By selling food in addition to other goods in these locations, Sears appears to be copying Wal-Mart, too.)

When pressed about the future, Cavanaugh is quick to note that Penney’s turnaround isn’t finished, and won’t be until the company consistently generates sales and operating profits of 6 to 8 percent or better. He and other executives, including Ullman, emphasize that newly introduced brand lines have a long life cycle, and the company is devoting substantial advertising dollars to promoting them. Beyond that, he says, “our focus will remain on refining and capitalizing on the things we know — the mall and off-mall stores and the catalog and Internet businesses.”

Cavanaugh would not speculate on what a new CEO means for his own future, although he notes that “our financial situation was significantly different, in a negative way,” when Questrom appointed him. Indeed, in his first call with analysts, Ullman cited the company’s financial strength as “a huge asset.” Ullman, adds Cavanaugh, “indicated that generally his style is not to make broad, sweeping changes.”

The same could be said of the department-store business in general, where the focus remains on getting the selection of products just right. “Conceptually, retailing is an easy business,” says Cavanaugh, quoting his departing boss. “The challenge is in the execution.” With more than 200,000 items and 1,020 stores, he says, “we’ve got huge permutations and combinations.” Getting the right products in the right amounts and right styles takes tremendous work, says Cavanaugh. “But customers don’t care about all that,” he says. “They just want the right product in the right place in the right style.” And if both the teen T-shirt buyer and the bedding customer see that when they walk in, says Cavanaugh, “then the balance sheet, the capital structure, and free cash flow will take care of themselves.”

Tim Reason is a senior writer at CFO.

Or Your Money Back

J.C. Penney’s post-Eckerd share buyback is another fashion in the slow-growth department-store segment. Sears, with more cash on hand than it knows what to do with, still has $500 million left over from the sale of its private-label credit card, money it plans to return to shareholders. Even Target, which effectively exited the slow-growth segment by shedding its Mervyn’s and Marshall Field’s department stores, followed up with a $3 billion buyback program. Federated, which passed on the chance to buy those stores from Target, has spent $687 million on buybacks, with $880 million still authorized. “We continue to view our stock-buyback program as a good way of returning value to our shareholders,” Federated CFO Karen Hoguet told analysts in August. (May Department Stores, which bought Fields and nine of the Mervyn’s, is the exception — it paid $3.24 billion in cash.)

Even without cash on hand from an asset sale, specialty clothier Limited Brands announced a $2 billion buyback in October — a move Gimme Credit’s Carol Levenson criticizes for being partly funded by borrowing. “Limited’s headstrong plunge into shareholder enhancement [comes] at the same time that its results have become increasingly unpredictable,” she says. And, she later pointed out in a tartly worded research note, the move “hasn’t exactly set the stock on fire.” — T.R.