Back to School

Innovation in retail may start with the customer, but finance offers some new lessons.
Randy MyersSeptember 1, 2007

Teens chattering their way into Abercrombie & Fitch stores for back-to-school clothes this year were greeted by two things: the iconic retailer’s heavily stylized decor — dark lighting, wood-shuttered windows, pulsing music — and, with few exceptions, the exact size and color of fleece pullover or polo they wanted to buy. That’s because the $3.3 billion retailer recently equipped associates with handheld scanners that show at a glance exactly which floor items need to be replenished from the stockroom. By eliminating the need to print out and scan written sales reports throughout the day, the new system is yielding not just better stocked stores, says Abercrombie & Fitch CFO Michael Kramer, but more time for associates to spend with customers.

Using technology to keep a close eye on supply levels may be old hat in many industries — think automakers and anybody else practicing just-in-time inventory — but it is revolutionary in retailing. Although $348.7 billion Wal-Mart Stores Inc. began tracking inventory electronically in the 1980s — an in-house innovation that helped it leapfrog its discount-store competitors — most retailers have continued to rely on a fuzzy amalgam of gut instinct and institutional memory to decide how to best stock shelves. “Because our industry’s success is perceived to be all about merchandise,” says Paul Carbone, CFO of $884 million apparel retailer Tween Brands Inc., “we haven’t been big innovators in terms of leveraging technology or thinking about how we run the business.”

Today, though, that paradigm is being turned on its head. Retail CFOs are weighing in on operating decisions, pushing business units to focus on metrics that drive sales, and funding technology initiatives that are bringing new science to the black magic of merchandising. Good thing, too. Consolidation has weeded out many of the weaker retailers, such as May Department Stores Co. and Albertson’s Inc., notes Citigroup analyst Deborah Weinswig, leaving a more competitive marketplace. At the same time, higher food, energy, and debt-service costs are prompting consumers to push not just for quality products but also great prices. More dramatically, fast-changing consumer expectations are leading to shorter product life cycles, forcing retailers to constantly rejigger their merchandising strategies. Abercrombie & Fitch, Kramer notes, now puts new product at the front of its stores not on a seasonal or monthly basis, but weekly. And, of course, industry leader Wal-Mart is hardly standing still. Having conquered the traditional discount-store space, it made giant inroads into the grocery business over the past decade, and, more recently, put the squeeze on electronics retailers by beefing up its own selection of flat-screen TVs and other high-tech goodies.

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In such a fluid environment, waiting for the end of the season to figure out whether this year’s line of women’s tops is selling won’t cut it. Fortunately, the timing is right for finance to step into the breach. Having wrestled their companies into compliance with the Sarbanes-Oxley Act, CFOs are focusing on greater value to operations. The typical CFO’s job may not be “to come up with new product ideas,” says John Mahoney, vice chairman and CFO of $18.2 billion office-products retailer Staples Inc. “But it is their job to make sure the business understands the value of innovation in order to get the top line growing.” And in retail, he adds, “if you’re not constantly thinking about new things, you’ll ultimately suffer declining productivity in your stores.”

Valuing Color, Size, and Style

Technology is one solution. Over the past several years, powerful off-the-shelf merchandising software has become available from vendors such as Oracle Corp., SAS, and others. The software can process sales data on a real-time basis, helping merchants decide more quickly and accurately what sizes and colors to stock, when to replenish inventory, and when and how much to mark down goods. While merchants are the principal users, says Oracle senior vice president David Boyce, it is often the CFO who pushes for the systems. “Merchants don’t go out of their way to ask for software,” he notes. “For them, it’s all instinct and feel. But the CFO sees the impact these systems can have on performance.”

And what an impact it can have. Boyce says prices for individual components of his firm’s merchandising software start “north of $1 million” and go from there, depending on the size and scope, but typically pay for themselves in less than a year, sometimes as much as five times over. In fact, apparel retailer American Eagle Outfitters Inc., an Oracle customer, has publicly attributed some of its success to the systems. Commenting on the $2.8 billion company’s second-quarter earnings last year, for example, CFO Joan Hilson attributed a 10 percent increase in comparable-store sales, following a 21 percent increase the prior year, in part to its use of Oracle’s markdown-optimization software.

One of the biggest benefits is that the technology allows CFOs and merchandisers to assess inventory risk — the risk that goods will decline in value before they sell — at a far more granular level. They can gauge the strength of their inventory on a store-by-store or item-by-item basis, and do it early in the selling season, while there’s still time to do something about it. If an item isn’t moving in one location, for example, the company can halt future shipments or, if it is selling well in another location, send surplus inventory there. In effect, the technology allows retailers to track critical performance metrics down to the individual garment.

If halting shipments or shifting goods aren’t options, markdown-optimization software can help determine how the item might be repriced. As Oracle’s Boyce explains, the software can monitor sales through the selling season, compare them to nonlinear forecasts generated from sales of like items in prior years, look back to historical sales data, and predict how that item will sell for the remainder of the season. If it looks like the product won’t sell out, the software can look at how similar items responded to past markdowns, then test a variety of pricing strategies to identify the one that will result in selling all of the merchandise.

Fewer Shirts, Higher Sales

Tween Brands is a convert to this thinking. It began modifying and upgrading its merchandising systems, including markdown-optimization software and merchandise-planning and
-allocation systems, in 2005. Early results are encouraging. Last year, for example, after introducing half-sizes at its more than 560 Limited Too stores, it was able to establish that in approximately 40 percent of its stores, sales weren’t sufficient to justify the cost of carrying the additional inventory. It promptly removed half-sizes from those locations.

Tween Brands has yet to realize the full benefits of its technology push — its five-year sales and net-income growth rates still trail those of its apparel-industry peers — but many early adopters are already outdistancing their competitors. At $8.6 billion apparel retailer Nordstrom Inc., for example, where CFO Michael Koppel helped drive the implementation of a real-time inventory system six years ago, net income has grown at an average annual rate of 40.3 percent over the past five years, versus 17.1 percent for the average apparel retailer. The inventory system, says A.G. Edwards retail analyst Robert Buchanan, gives the company instant information on how much merchandise it holds in each store by color, size, and style. “Prior to that, they literally had 500 people on the payroll whose job it was to hand count the merchandise so they knew what they owned,” he says.

Such granular thinking isn’t only happening at specialty stores. Venerable department-store operator JCPenney Corp., which had revenues of $19.9 billion in the fiscal year ended January 2007, has become an aggressive user of technology since Robert Cavanaugh took the top finance job there in 2001. The company has invested about $110 million annually in, among other things, new planning-and-allocation software, point-of-sale terminals, and infrastructure to support the business. The company’s systems categorize each of JCPenney’s more than 1,000 stores into volume groups for each major product category, helping it determine how much of any one product it will stock and how frequently it should bring in new items. Last year, for example, JCPenney used the technology in deciding to stock a particular style of knit shirt at a lower initial level than the previous year, but to replenish that stock on a more frequent basis. The approach doubled unit turnover for the season while allowing the company to hold fewer shirts in inventory. Today, says Cavanaugh, JCPenney managers operate on a single set of facts and can spot variances in performance on a timely basis. “This not only permits management to take action on merchandise,” he says, “but also on operating expenses, cash forecasting, and balance-sheet management.”

Retraining Wall Street

To be sure, technology is not a panacea. The best retail CFOs are also trying to keep business managers, particularly merchandisers, focused on the right metrics. “Merchants and finance people want the same thing for the business, but define success against different metrics,” says Staples’s Mahoney.

What they should be focused on, say retail CFOs, are general business measures such as operating margins and return on capital, and also retail-specific metrics such as same-store sales and gross margin return on inventory investment (GMROII), which shows whether companies are earning a sufficient gross margin on their inventory in relation to its cost. At Staples, executives also closely track gross margin per square foot. “That’s one we ask our merchants to take a hard look at,” Mahoney says. “It recognizes that there are resources needed to generate sales, including space in the store as well as all the costs that go along with the product, whether it’s advertising or price promotions.”

Sometimes, though, the most important thing finance can do is keep merchandisers focused on top-line growth. Walking recently through the model store his company maintains, Mahoney stopped to examine an $800 fixture for displaying bulk office products. Worried about costs, Staples’s merchandisers were proposing to test it in just a small number of the chain’s nearly 1,900 stores. Mahoney thought they were focusing on the wrong issue, and told them so. “I challenged them to think about what the sales from those fixtures could mean to our stores’ sales growth and the probability of success, rather than getting bogged down in the relatively small cost of the fixture,” Mahoney recalls.

Sometimes, it’s not merchandisers who need to be pushed to look at the right metrics, but Wall Street. Tween Brands, which specializes in selling apparel to girls ages 7 through 14, achieved its initial success with its mall-based Limited Too stores. In 2004, the company launched a second chain, Justice, aimed at girls in the same age group but stocked with lower-cost goods and located in so-called power-strip shopping centers. Some Wall Street analysts, Carbone says, have been leery of that lower-margin strategy. “But what we focus on here,” he says, “and what we try to get the Street to understand, is that we’re trying to drive absolute dollars.” Besides, he adds, virtually no new enclosed malls are being built anymore, and a significant portion of customers shop at power centers.

Today, Tween Brands operates more than 560 Limited Too stores and more than 200 Justice stores, and so far gross margins are holding up well — 37.7 percent last year versus 33.5 percent in 2003, the year before the Justice launch. Its confidence apparently running high, the company plans to launch a third chain of stores that will cater to both girls and boys. “We know the boy of 10 doesn’t shop like the girl of 10,” says Carbone. “But who’s doing the shopping for the boy? It’s the mom — and we already have the mom. Why wouldn’t we do a dual-gender concept, and maybe offer something for the boy to do besides shopping?”

Like Carbone, Mahoney cautions against giving any one metric too much weight. “If you focus solely on moving the operating margin rate, there are many things you might do in the short run that can get in the way of innovation,” he insists. “For the past several years we’ve seen nice improvement in our operating margin rate, but to do that, you have to set aside resources and encourage risk-taking and innovation, not just from the merchants but also from your business-development people.”

Also like Carbone, Mahoney knows what it’s like to sail against conventional Wall Street wisdom. In the late 1990s, Staples decided to trade off short-term financial performance for long-term potential by plowing millions of dollars into “We worked very hard to change the way Wall Street was expecting us to perform,” Mahoney says, “but we think it turned out to be one of our greatest accomplishments.” Last year, sales of Staples’s North American delivery business, which includes its online operations, grew 18.6 percent, versus 10 percent for its North American bricks-and-mortar stores and 12.6 percent for its international business. Today, Mahoney boasts, is the second largest online retailer in the world by sales, trailing only

Basics Still Count

For any of this innovation to work, of course, finance has to provide the basics. That means building balance sheets that give business units the wherewithal to pursue change. When Cavanaugh took over as JCPenney’s finance chief, for example, the company finished the year with several hundred million dollars in cash, but it also had $2 billion in debt coming due within two years — and, as he likes to put it, no E in its EBITDA (earnings before interest, taxes, depreciation, and amortization). “We’d lost all our financial flexibility,” he says. To right the ship, Cavanaugh and the rest of a new management team began shedding non-department-store businesses, closing individually weak stores, and paring back catalog operations. That allowed the company to reduce debt, buy back shares, and buttress its balance sheet, as well as undertake operational changes like centralizing the merchandising operation and revitalizing the company’s private-label brands.

“Creating the financial flexibility to do that was the key to our turnaround,” Cavanaugh says. Now, having met 70 percent of its five-year goals in the first two years of its turnaround, JCPenney has established ambitious new targets aimed at compounding annual earnings per share by 16 percent a year from 2008 to 2011. “A lot of analysts would have preferred much more moderate targets and higher levels of stock buybacks,” Cavanaugh says. “Our view is that we are in a unique moment where there is significant turmoil in our industry, and we’ve got a value proposition that we know works” (see “A Penney Saved,” December 2004).

That’s a refreshing approach for an industry where, for too long, CFOs weren’t making themselves part of the innovation equation. Today, the right combination of time, talent, and technology can ensure that greater success is in store.

Randy Myers is a contributing editor of CFO.

Failure Is an Option

What do mail shredders and coffee machines have in common?

Beyond pushing for technology that can bring new speed and discipline to merchandising decisions, retail CFOs are working to create environments that encourage creativity and experimentation. “My job is to facilitate innovation by giving our businesses the necessary resources,” says Staples Inc. vice chairman and CFO John Mahoney.

When Staples decided several years ago to create its own branded products, Mahoney and the rest of the management team made a commitment to compete on quality and packaging, not just price. Rather than try to sneak into the game on the cheap, the company budgeted resources to support a long-term investment and hired experts in consumer-products packaging and product development to assist. Since then, the company has enjoyed a string of hit Staples-brand products, including, most recently, a small but powerful mail shredder about the size of a coffee machine that can sit on a kitchen counter, where Staples’s research has shown most people sort through their mail.

Such success happens only in an environment in which people can risk failure, says Mahoney, who sees it is as part of his job to create that type of culture. “A fear of failure is the surest way to stifle new ideas,” he says. “Freedom to fail comes with the territory. If we’re able to get enough arrows in the air, some will land in the right place.” — R.M.