A Penney Saved

A deft turnaround buys time, but what's in store long-term for the venerable retailer?

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.

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