J.C. Penney Opens the Door on Its Unused Warehouse Space

The catalog retailer follows Fingerhut into third-party fulfillment territory.
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The Internet has created some unlikely heroes.

Fingerhut

went from cataloguer to the poor and credit-unworthy to savior for the likes of

Wal-Mart

(WMT) - Get Report

and

eToys

(ETYS)

thanks to its ability to ship products directly to consumers.

Now

J.C. Penney

(JCP) - Get Report

has a chance to turn an albatross in the form of unused warehouse capacity into a windfall when it begins shipping products for other retailers early next year.

This so-called third-party fulfillment is in demand as the number of companies selling everything from toasters to

Tae-Bo videos on the Net explodes. Yet many lack the infrastructure necessary to ensure that an order placed online winds up at a customer's doorstep.

As an experienced catalog operator, J.C. Penney has an opportunity to wring extra profits from existing infrastructure. The plan also could provide a little spark to the Plano, Texas-based company, which has been struggling to revitalize its ailing department stores. Penney's stock is trading at about 46 a share, off the 52-week-high of 60 11/16.

Penney is wading into these new waters slowly. It plans to convert just a portion of a 2 million-square-foot facility (out of 12 million square feet of warehouse space all told) to handle third-party shipments early next year, says Stephanie Brown, a company spokeswoman.

"It's a nice, sweet deal," says Jeff Boudreau, a principal with market research firm

Kurt Salmon Associates

, which has acted as a consultant for Penney. "For J.C. Penney, this fell out of the sky. They have an opportunity to make some money here."

Boudreau estimates that typical third-party fulfillment facilities generate $70 per square foot in revenue. He adds that profits for this type of business run about 8% of sales. So if Penney were to convert all of that 2 million square foot space to third-party fulfillment, it could generate $6.7 million in after-tax profits, which translates into an additional 2 cents to earnings per share. For the most recent fiscal year, J.C. Penney earned $2.14 per share.

"J.C. Penney is looking to fill excess capacity, which gets them to a certain level," says Stacie McCullough, an analyst with

Forrester Research

, which has done consulting work for Penney. "They then must make a strategic decision to support this as a new business." Brown, the spokeswoman, says J.C. Penney has no plans to devote more capacity to this business at present.

The strategy sure worked for Fingerhut. It was acquired earlier this year by

Federated Department Stores

(FD)

in part because of its success in third-party fulfillment.

Federated declines to break out profits for

Fingerhut Business Services

, its direct-to-consumer arm. But Jeffrey Wiles, a senior vice president of sales and marketing for the division, expects "margins to increase, because demand will outpace supply."

And Wiles notes that the unit will generate nearly $100 million in revenue this year, or 6% of the $1.7 billion in sales Fingerhut rang up in last full year as an independent company. Plans call for the division to grow to $500 million in sales over the next five years. But that would mean it would have to add space since it'll fill its existing warehouses by 2001.

Fingerhut already has a sizeable piece of the fulfillment business. Salmon's Boudreau estimates that industrywide warehousing, operations and distribution functions totaled $2.6 billion in 1998. Of that number, he figures that $400 to $600 million was spent on direct-to-consumer shipping.

And customers are noticing. Product fulfillment has surpassed security as the No. 1 customer concern when it comes to online shopping, noted Richard Christner, vice president of

Mercer Management Consulting

, during the

Online Retail Forum

hosted by the

World Research Group

this week in New York.

Despite this growing demand, the skills required to fashion a seamless back-end operation are scarce, says Jim Daniell, chief executive of

OrderTrust

, a network of fulfillers that handled 100 million transactions last year. "On the Web, everything is clean and perfect," he says. The real world is messier. "Conveyor belts must run, boxes must be stacked onto the backs of trucks. If you don't have sufficient systems, a company's costs can skyrocket. People have yet to understand the impact of one mistake."

Daniell figures a company that mishandles an $80 order must sell $1,100 worth of merchandise to make up for that mistake.

Even if Penney attempts to follow in Fingerhut's footsteps, it will be faced with the additional task of trying to breath new life into its 1,150 department stores. To that end, it recently hired Vanessa Castagna, a former general merchandise manager of Wal-Mart Stores, as chief operating officer of

J.C. Penney Stores

. The company also plans to create a tracking stock for its

Eckerd Drugstore

division, of which it plans to sell 20% in an initial public offering later this year.

"If J.C. Penney doesn't fix its base business, it's irrelevant if they do fulfillment for others," says Wayne Hood, an analyst with

Prudential Securities

, who rates Penney accumulate. His firm hasn't performed underwriting.

Still, Fingerhut has become a jewel in Federated's crown for its ability to handle third-party fulfillment, not for its core business. Likewise, a brave new world is open to Penney.