(FORTUNE Magazine) –

EVEN IN THE WORLD of J. Crew and Target, Terry Lundgren believes there's a place for the good old department store. It's hard not to believe. Earlier this year the Federated Department Stores CEO purchased May Department Stores for about $17 billion; as he points out, the combined companies produced sales of more than $30 billion in 2004. That's a lot of customers who don't yet know they're supposed to be shopping someplace else. But growing is another thing. Lundgren's plan is to focus on a few brands. That way he can efficiently market to consumers nationwide. The strategy hasn't been without pain. When Lundgren said he was replacing the Marshall Field's nameplate in Chicago with Macy's, movie critic Roger Ebert and the Chicago Tribune recoiled in horror. Over Bloomingdale's frozen yogurt, Lundgren explained to FORTUNE's Julia Boorstin and Eugenia Levenson why he's not worried about getting a thumbs-down in Chicagoland. Excerpts:

Any second thoughts about replacing the Marshall Field's name?

I am not surprised that there was a very strong emotional reaction. Marshall Field's captured the hearts of Chicagoans but over the past few years has been unable to catch their pocketbooks. The reality is that the division's sales declined in four out of the past five years. Two-thirds of the customers we surveyed said that if you have the same merchandise, the same service or better, the same store environment or a better one, and your pricing is the same or better, and if my salesperson behind the Frango Mint counter is the same person--if all that is the same and you're going to change the name--the answer is, Yes, I would still shop with you.

But why risk offending that third of customers who remain loyal to regional brands?

I couldn't expand Marshall Field's. When we tested the name, it did not register on the East or West Coast. This is not unique to Marshall Field's. The regional department store sector has been under attack for a long time. People remember how great things were 20 years ago, but 20 years ago the retail landscape was substantially different.... Thousands of new stores have opened from the lower end and even at the higher end, and so customers have many more choices. The idea behind Macy's is that it can market on a national basis but can respond regionally to consumer fashion, choices, and taste. That's a new model for growth.

Will the rest of the country embrace a New York brand?

We do more business in the state of California than we do in the state of New York. Macy's is a national brand, and it's an international brand. I was in Beijing in March because they were recruiting me to open a Macy's store there. They said, "We've done our market research, and the Chinese consumer knows the Macy's brand more than they know brands from Japan and France." So we've got this great, untapped asset in the Macy's brand. On March 1, 2005, we had 240 Macy's stores in America. On Sept. 1, 2006, we'll have 850 Macy's stores.

What's one of the biggest benefits of a national platform?

We have never been able to advertise on our Macy's Thanksgiving Day Parade because it's a national program, and we didn't have national coverage. This year we've gone to 425 stores, which is enough coverage to get us onto national TV. When we go to more than 800 stores next September we'll be in 63 of the 65 largest cities in America. And while advertising is national, merchandising and local marketing, like newspaper advertising, will stay local.

The market seems to be splitting to discount stores and specialty retailers. What's your niche?

We're not like a strip mall self-service operation, and we're not like a specialty boutique that is so high-end that it turns off the large majority of customers. We sell affordable luxury. A large segment of the population can afford to shop at Macy's. It crosses numerous income brackets, and it addresses the lifestyles of a large population of America. We're able to offer a much broader assortment of different products at different price ranges, focused on the four lifestyles of our core customers.

Four lifestyles?

We call them Katherine, Julie, Erin, and Alex. There's a male version too. Katherine is traditional, a classic dresser, doesn't take a lot of risks, likes quality. Julie is neo-traditional, slightly more edgy but still classic. Erin is the contemporary customer who loves newness and shops by brand. Then there's Alex, the fashion customer, and she wants only the latest and greatest. She worries about what everybody was wearing at the event she went to last night.

Erin and Alex sound pretty hip. Haven't they deserted the department store?

People have been saying that for decades. My friends in college asked, Why did I want to get into the department store business? Isn't it a dinosaur business? Shortly after that people said, Aren't you worried that the catalog business is going to make stores obsolescent? And then it was QVC. Next was the [Internet]. Every time I became less and less of a believer in all those things. We did $15.6 billion in sales last year, May Department Stores did $14.4 billion last year, and so people are still shopping at department stores. My job is to grow the business.

A lot of brands sold at Macy's are also available elsewhere. What's the draw?

One of our absolute secret weapons, a clear sustainable competitive advantage, is our private-brand prowess. Macy's private brand, INC, is a several-hundred-million-dollar brand today, the single fastest-growing brand in all our stores. The largest brand we have in our entire company--bigger than Estée Lauder and Ralph Lauren--is Charter Club. May's private brand was the worst-performing part of their business. We're going to replace that with the best-performing private brand in the industry, the Macy's private brand. That's a very key part of this whole merger--our very productive private brand replacing space that was not as productive in those stores.

So what's different about your brand?

We have great people working on the private brand. We were faced with the expense challenge: Should we move the Federated merchandising organization out of New York City? May moved it to St. Louis. J.C. Penney moved it to Texas. Target is in Minneapolis. Limited is in Columbus. We recognized that it would be a several-million-dollar decision to stay here. But here we can draw from the same pool of creative, talented people working on Seventh Avenue for all of the designers.

What else have you done to bring people into your stores?

We asked customers, What is it that you want from us? We found that our shoppers want us to speed the process of shopping. They said, Take merchandise off the aisles. Allow me to [go around] the fixtures with my stroller. Now every department manager at Macy's has a 32-inch ruler, and they have to have a 32-inch aisle between all their fixtures throughout their store. For accounting reasons, most retailers receive inventory between the 25th and 5th, but our customer is in the store more than once a month. So we changed the merchandise flow to have more frequent deliveries in smaller bites. Customers said, "I have to put my glasses on to see the menu signs," so now we've put up street sign--sized signs. Customers want to look beautiful with the product in fitting rooms, so we've made them bigger and added better lighting. Now we've got TVs outside, we've got a bench, we've got the sports channel, we've got the Cartoon Channel. You know what we're trying to do--we're trying to distract the distracters.

Your third-quarter profit more than quadrupled from last year. Besides the May acquisition and a one-time gain from selling some of your credit card assets, what caused the upside surprise?

It is a combination of things: sales, managing our expenses, managing our gross margins, taking timely markdowns. Six months ago we rolled out a program called 20-20 into all our Federated stores. Every buyer can call up the 20% best-performing items and the bottom 20% performers. So you have a natural forum for a conversation about what we're doing about both buckets. The bottom 20 is pretty easy: A lime-green product may not be selling, but it doesn't hit the manufacturer suppliers' markdown cycle for six more weeks. They would recommend that we hang on to it for a while, but when you've sold zero for two weeks, we know it's not going to get better.

And what store is the gold standard now? Nordstrom?

Bloomingdale's is doing as well as Nordstrom. Neiman Marcus is doing the best right now. But, again, I used to be the CEO of Neiman's. It's a great company, but they have 36 stores. We have 950.

What's your outlook for the holiday season? Analysts are predicting a slower year.

We have modest expectations for the fourth quarter, in the 1% to 2% comp-store-sales-growth range. This is a really critical period for us. Then in January we begin the full integration. We start remodeling the May stores, setting our inventory, training our service expectations. I can't tell you that oil prices won't be high, and I can't tell you that the housing won't be slow in terms of starts, but I can tell you that we will begin to take market share.

We hear that this Thanksgiving you're running ads with The Donald?

We had this idea to do a million-dollar giveaway for Thanksgiving. He was doing a personal appearance with us--his line of clothing is in our stores, selling off the charts. He comes to our store, and 2,000 people show up to see him. Our marketing people asked, "Do you think we could convince him to do this commercial?"

Do you have any other acquisitions in mind?

Not today.

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