About the About

By Edward Cone  |  Posted 2003-06-01 Email Print this article Print

Retailing is getting cutthroat. In major metropolitan areas, direct rivals are opening up shop across the street, daring the other to blink and pull up stakes. Among neighborhood pharmacy chains, Eckerd is now in a fight for its life, as Walgreens threate

About the About-Face

It's possible no company has attempted such a complete about-face on a comprehensive outsourcing deal, says analyst Richard Matlus of Gartner Inc. After all, Eckerd had contracted with IBM to take over all its information systems and staff.

But Eckerd wanted to reclaim control of its technological destiny. A desire to conserve cash and reduce operating expenses drove Eckerd's decision to buy out the remainder of its contract with IBM, a 10-year deal originally valued at $440 million.

The two companies expanded the contract for an undisclosed amount in 1998 when Eckerd was acquired by Penney, so that IBM's services also would cover more than 1,000 additional drugstores Penney already owned, including those in the Thrift Drug chain.

Even with those stores, Eckerd had to compete with a company, Walgreens, which had grown to twice Eckerd's size. Eckerd's revenue last year was $14.6 billion; Walgreens had $28.7 billion in revenue and generated 3.6 cents of profit on every dollar of sales, compared with the industry average of 1.5 cents. Eckerd had to find every possible dollar to compete nationally and even regionally against the only drugstore chain earning $1 billion a year.

"We had a business need to control SG&A [selling, general and administrative] costs," says Eckerd chief financial officer Dennis Miller. By managing its own technology, he says, Eckerd could save on fixed costs and have more flexibility to pursue business objectives or projects such as Quantum Leap.

Miller says he told Wayne Harris, the former grocery executive who was named chairman and chief executive of Eckerd in 2000, that he could get a return on the move in six months, without compromising service.

Since the IBM deal called for fees to ramp up 17% every 12 months in the final years of the agreement, Eckerd thought it could buy out the remainder of the contract, pay an early-termination penalty and still save money. "After we sat down with Wayne and showed him what this thing could do, he just said, 'Go, I'm all for this,'" Petersen says.

Eckerd will not disclose how much it was paying IBM per year nor how much the contract had grown over the original, reported 10-year value of $440 million. But the company does say it avoided $70 million in scheduled fee increases by exiting the contract three years early.

When Eckerd notified IBM that it would buy out the remainder of its contract, Petersen was betting he could deliver better service at less cost. "He put his job on the line," says David Evans, a long-time Penney CIO.

Since termination of the outsourcing contract, Eckerd claims to have cut operating expenses for technology in half. "It is working from a financial point of view, and our service level has been better than expected. We hit our number in the second half of the year we canceled, and we have done it consistently since then," Miller says.

While Eckerd will not release precise details of its calculations, the savings on information technology show up in sales and administrative expenses that have dropped by $22 million since 2000, the year before Eckerd brought technology in-house. Sales grew to $14.7 billion from $13 billion over the same period, and the relevant SG&A expenses have been cut to 21% of sales from 22.4%.

Eckerd says maintaining duplicate operations while IBM was being phased out cost $5 million, and the termination fees paid to IBM contributed to a $72 million charge that appeared in Penney's 2001 financial report. However, the $72 million figure also includes some accounting charges Petersen says he did not include in his internal return on investment calculation, such as "asset impairments" for computer equipment that would have to be valued differently now that Eckerd was taking control of it. Eckerd won't say what fraction represents the contract termination penalty, but Petersen says the figure was considerably lower.

IBM Global Services declined to comment for this story. But Eckerd continues to do business with IBM—which still manages mainframe computers for Eckerd at its Lexington, Ky., data center—and Petersen says his decision to cancel the contract was not because of any performance problems. In fact, he gave credit to IBM for allowing Eckerd to recruit from among its employees.

"IBM did one classy job of exiting this," Petersen says, noting Eckerd ultimately recruited nearly 40% of the technical staff assigned to its contract—or about 200 people—easing the task of rebuilding a large technology department.

The two companies also struck a deal for developing Quantum Leap, a big part of Eckerd's business improvement plans and a crucial piece of its strategy to catch up to Walgreens. Eckerd and IBM negotiated a side agreement that allowed IBM personnel assigned to the Quantum Leap project to continue on for six months past the termination of the general outsourcing contract.

Quantum Leap is an inventory turnover system that's designed to keep the right amounts of drugs in its pharmacies and diapers on its shelves so customer demand is met without Eckerd's having to keep large stocks of items—some of which may never be sold—in its back rooms.

"Inventory turns are all about cash," says Eckerd CFO Miller. "The faster you turn your inventory, the more cash you can generate out of business, the more you can reinvest." For example, last year Eckerd turned its inventory into sales 4.8 times. Improving that ratio by one-tenth would improve net cash flow by about $35 million.

Eckerd is aiming for an inventory-turn rate of five turns this year. The trend is positive: that final score for 2002 was up from 4.0 in 1999. But Walgreens' inventory turn rate reached 5.8 in the same period, and Eckerd's top three competitors averaged 5.2.

The Quantum Leap for Eckerd would be a move toward parity with the industry and, someday, Walgreens.

"I wouldn't be selling a leapfrog strategy," says former CIO Evans. "Eckerd has a lot of room to run before it approaches Walgreens" in managing technology.

Beyond inventory turns, Eckerd needs to catch up in areas such as making prescriptions ordered at one store available at branches nationwide—one of the innovations Walgreens pioneered.

Eckerd has chosen packaged software for such a system from pharmacy technology vendor TechRx. But because the software has been used only by smaller chains, Eckerd is requiring the vendor to beef up the system's architecture and demonstrate it's ready for large-scale use before the drugstore starts active development.

Meanwhile, improvements from Petersen's strategy are already evident. For example, the reborn internal technology department discovered inefficiencies in the process for extracting sales data gathered from cash registers and loading it into an Oracle data warehouse. Merchandising managers were working with data that was two or three days old, which made them unnecessarily slow to react to sales trends. But by whittling away at errors in the way a system schedules the processing of sales data, Eckerd managers now have up-to-date information when they arrive at work each morning.

Undoing big computer services contracts remains extremely rare, although customers are asserting more control over performance (see sidebar at www.baseline.mag/jun03). But Eckerd's experience shows that it is possible to rebuild an internal information technology organization pretty much from scratch.

Senior Writer and author of the Know It All blog

Ed Cone has worked as a contributing editor at Wired, a staff writer at Forbes, a senior writer for Ziff Davis with Baseline and Interactive Week, and as a freelancer based in Paris and then North Carolina for a wide variety of magazines and papers including the International Herald Tribune, Texas Monthly, and Playboy. He writes an opinion column in his hometown paper, the Greensboro News & Record, and publishes the semi-popular EdCone.com weblog. He lives in North Carolina with his wife, Lisa, two kids, and a dog.

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