By and  on February 21, 2006

HAYWARD, Calif. — When Mervyns changed hands in September 2004, one of the first things the new owners did was remove the apostrophe from the store's corporate name.

That was just the tip of the iceberg.

A whole new management team, a slew of store closures, a nifty real estate transaction and a revamped merchandising structure soon followed. The changes — which have resulted in eight consecutive months of comp-store sales increases — are designed to position the $3 billion, midtier department store retailer based here to compete more effectively with Kohl's, J.C. Penney, Wal-Mart and Target.

"We want to stay in the game," said Rick Leto in his first full-fledged interview since taking over as Mervyns' president and chief merchandising officer in December 2004.

When Target Corp. sold Mervyns to an investment consortium led by Sun Capital Partners Inc., Cerberus Capital Management LP and Lubert-Adler/Klaff and Partners LP for $1.2 billion in cash — about eight times Mervyns' pretax profits of $160 million — "everybody said it was a real estate play," Leto recalled. "The operating company was not valued and the three owners knew they'd get their money back from the real estate. But they asked me to come out here and see what I could do."

Leto, a 31-year retail veteran, had been executive vice president and general merchandise manager of apparel and accessories at Kohl's for eight years, and a key player in that company's explosive growth in the Nineties. Earlier in his career he was with Macy's and he had spent a short time at Galyan's before joining Mervyns.

The first thing Leto realized when he walked through the door was that the chain had been neglected for quite some time. "There had not been a lot of capital investment for many years," he said. Step one was to "assess the real-estate portfolio and divest ourselves of the drains on our profitability."

When the investment group bought the chain, Mervyns operated 257 stores in 13 states, mostly in the West and South. In September, it revealed plans to close nearly a quarter of those stores and lay off 4,800 people in an attempt to cut its losses. The 62 underperforming units slated to be shut were mainly in Michigan, Oklahoma, Colorado, Louisiana and Texas, and represented only 17 percent of sales. Two distribution centers were to be closed.In January, Mervyns revealed a second round of closings, of 20 stores in Oregon and Washington, affecting another 1,400 people. These decisions allow Mervyns to concentrate on the Western and Southwestern U.S., where its business is strongest.

"We'll have 170 stores by the end of 2006," Leto said. "We need to be on a level playing field in the markets in which we choose to operate."

After all the stores are closed, Mervyns will operate 125 units in California, versus 66 for Kohl's and 85 for J.C. Penney, according to Leto. "But we're the neighborhood store — smaller, and more convenient," he said. "We can satisfy a lot of communities."

With the store-closing decisions behind them, Leto and his team turned to the company's infrastructure. Because Mervyns had been part of Target Corp., all services had been taken care of by its former parent. As part of the terms of the sale, Target agreed to continue to operate Mervyns' back-office structure for two years.

"It will be a two-year process of taking control of our own fate," Leto said. "We have to become self-sufficient. We didn't even buy our own paper." The plan, he said, is to "de-couple our systems from Target by the end of July and be independent by Aug. 1."

Leto said Mervyns is spending $100 million on the project. "It's very critical — we're changing every system at the same time, not just one." He said the company has hired JDA Software Group to handle its merchandising system, Lawson Financial Services for its financials and Manhattan Associates for its supply-chain technology.

Once the infrastructure changes were set, Leto said Mervyns turned to the most critical component of the puzzle — "how to become relevant and survive in today's business environment when you're the smallest player in the midtier."

Not only is Mervyns the smallest in volume — sales in 2003 (the last year the chain was public) were $3.6 billion; that year, Penney's had sales of more than $18 billion, and Kohl's, more than $10 billion — its stores are the most compact. "Our stores generally have around 50,000 square feet of selling space," Leto said, "while Kohl's has around 87,000 square feet." Penney's stores are even larger, averaging 100,000 square feet. "We're undersized," he admitted. "We have one-third to 40 percent less fixtures."But instead of looking at this as a disadvantage, Leto views it as an opportunity. "We have to ensure that our stores are laser-sharp. There are no unimportant fixtures in our buildings."

By improving the displays and merchandising techniques in the stores, Leto said, Mervyns has been able to increase productivity by one-third. "We have to be over $200 a foot in sales, and we just weren't there," he said. "The nationals have the size and leverage, so we have to maximize our advantage of being local and understanding the lifestyle needs of our customers."

Although it's no secret Mervyns struggled for many years under Target's ownership, Leto said there were three businesses that always managed to do well: shoes, children's wear and women's ready-to-wear. The goal, then, is to "make sure the space and adjacencies are right and get the other businesses back on track."

Through the first half of 2005, he said, overall comps at Mervyns were still running in the negative numbers, but the chain managed to end the year with comp increases in the midsingle digits, thanks in large part to a mid-double-digit gain in the fourth quarter. "That gives us tremendous momentum," Leto said. "We dramatically exceeded our corporate goals for the year on an EBITDA basis and that gives us the confidence to move the bar up significantly." Projections for the first half of 2006, he said, are high-single-digit comp increases.

"Everybody thought this was a straight-to-liquidation play," he said, "but Mervyns is a 56-year-old company with a strong emotional connection to the customer, and it definitely still has a place."

Over the years, Mervyns had allowed its merchandise mix to become "broad and shallow," Leto said, but the new team quickly "returned to carrying inventory in depth and focusing on basics."

Marketing to the Hispanic customer is a primary initiative, he added. "Our stores attract a disproportionate number of Hispanic customers," Leto said. He attributes this to the neighborhoods in which the stores are located, and the fact that a Mervyns credit card is easier to obtain than many competitors', allowing many first- and second-generation Hispanic families to buy on credit.Mervyns works to create a merchandising strategy that "is legitimate" for the Hispanic customer, "not lip service. We're not just hiring some celebrity with an Hispanic name to endorse product in our stores. Our signs are appropriate, our associates are bilingual and we make sure the taste, size and color are appropriate."

The only way for this — and all the other significant changes that have occurred at Mervyns over the past year — to work is if the executives calling the shots are truly committed to revamping the business.

"There's been a staggering change in the company over the last year," Leto said. "We've changed our systems, our buying, our merchandising, our in-store presentation. Changes like this have to be driven from the top."

Sitting at the top of the Mervyns heap is Vanessa Castagna, executive chairwoman; she is also a senior member of the management team of Cerberus. Castagna is a "conduit" between Mervyns and its owners. She also has been a critical player in effectively managing the company's real estate portfolio.

The investment consortium managed to get some money out of the business by inking a deal with Diversified Realty and Macquarie DDR Trust, which formed a joint venture to purchase real estate under 36 Mervyns stores for $396.2 million. Mervyns agreed to lease back the assets for 15 years at an annual rent of $30.5 million.

And, sources said, if Mervyns is successful in its turnaround, its owners undoubtedly will sell the business or take it public. "They'd be quite happy if they did an IPO for seven to eight times EBITDA," one observer said.

The executive team also is working to renew relationships with the vendor community, he continued. "Target was moving Mervyns to a private label business," he said. "We are creating an appropriate balance." Under Target, the private label penetration was in the 40 percent range, but Leto is striving for 30 to 35 percent. "We want the right merchandise, regardless of the name on the label. There are a lot of great moderate brands out there."

Overall, he said, Mervyns eliminated about 50 percent of its resources since the purchase, both private label and brands. "We had to take the gloves off," he said. The biggest change came in women's wear, since in men's and children's, "a lot of the key players continued to be important."Today, the focus is on brands that can grow along with the company and have not shied away from selling a retailer that is in the midst of a "downsizing," as Leto described it. In apparel, Levi's is the largest label, along with Nike, Van Heusen, Arrow, the labels from Jones Apparel Group, Sara Lee and Perry Ellis International, Adidas, Carter's and Maidenform.

Looking to the future, Leto said Mervyns will announce soon that it will open its first new stores by the end of this year. "Our goal in five years is to have 200 high-volume, profitable stores," he said. "But we can't wait for new developments." Instead, the company is looking at supermarkets that are closing or industrial areas being converted to retail.

He also hinted that by back-to-school, two "important" fashion brands in young men's and juniors would make their debuts at Mervyns. "[Vendors] stopped coming here to introduce lines, so we're working with them now to change that. Kohl's and Penney's are definitely ahead of us in joint ventures and proprietary labels, but we'll be entering that arena soon."

The first priority, he said, was to be in stock; with that accomplished, Mervyns can turn to offering trend-right merchandise and exclusive labels.

"You can't do everything in one year," he said, "or you can't do anything well. The game's not over and we're certainly not ready to declare victory, but we really stretched ourselves and now we're ready to move to a higher level. To compete in this game, you have to be on top of your game and never get complacent."

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