Note to Readers: This report contains substantially new material. Subsequent reports will have changes highlighted.
Reason for Report:1Q07 Earnings Update Previous Edition:March12, 2007
Recent Events
On May16, 2007, FD reported its earnings for 1Q07 ended on May 5, 2007. Highlights are as follows:
Total revenue in 1Q07 was $5.921 billion, a decrease of 0.2% y/y.
Gross margin in 1Q07 was 39.8% versus 38.8% in 1Q06.
Operating income from continuing operations in 1Q07 was $244 million versus $149 million in 1Q06.
Diluted earnings per share from continuing operation in 1Q07 was $0.16 versus $0.01 in 1Q06.
Overview
Analysts have identified the following factors for evaluating the investment merits of FD:
Key Positive Arguments / Key Negative Arguments- FD continues to generate significant cash flow, and maintains a strong balance sheet.
- It continues to exhibit strong cost containment, despite incremental expenses incurred to undertake the Macy’s re-branding initiative.
- FD’s gross margin could improve due to the integration of best practices of both May and Federated stores.
- Combination of operating margin expansion, asset sales and merger synergies could drive the FD stock price higher.
- Management is focused on several strategic initiatives, which will drive solid long-term opportunities for the company.
- The merger with May will create value over the long term, but merger integration challenges could prove tougher than current market expectations.
- The challenging retail environment and discretionary consumer spending remain challenges for the company.
- Near-term results could be impacted by operational consolidation, the completing of clearance activity, and the continued store divestment.
- Operational changes at May stores – staffing cuts, conversions to Macy's and potentially dark stores for a brief time period are likely to depress FD’s results in the coming quarters.
Federated Department Stores (FD), with corporate offices in Cincinnati and New York, is one of the leading department store retailers in the United States. The company operates more than 850 retail stores in 45 states, the District of Columbia, Guam, and Puerto Rico under the names of Macy's, Bloomingdale's, Famous-Barr, Filene's, Foley's, Hecht's, Kaufmann's, L.S. Ayres, Marshall Field's, Meier & Frank, Robinsons-May, Strawbridge's, and The Jones Store. It also conducts direct-to-customer mail catalog and electronic commerce businesses under the names Bloomingdale’s By Mail, macys.com; and bloomingdales.com. The company’s website address is Its fiscal year ends on January 31.
Contingent upon shareholder approval, Federated's name will change to Macy's, Inc. and trade on the New York Stock Exchange under ticker symbol "M", effective June 1, 2007.
Revenue
FY ends Jan. 31 ($ in m) / 2005A / 1Q06A / 2006A / 1Q07A / 2Q07E / 3Q07E / 4Q07E / 2007E / 2008E / 2009EDigest High / $22,390 / $5,930 / $26,970 / $5,921 / $6,089 / $6,061 / $9,301 / $27,280↓ / $28,475↑ / $30,041↑
Digest Low / $22,390 / $5,930 / $26,970 / $5,921 / $6,015 / $5,945 / $9,056 / $26,987↓ / $27,527↓ / $28,077↓
Digest Average / $22,390 / $5,930 / $26,970 / $5,921 / $6,054 / $6,015 / $9,119 / $27,123↓ / $27,894↓ / $28,824↓
Y/Y Growth / 0.0% / 0.0% / 20.5% / -0.2% / 1.0% / 2.2% / -0.4% / 0.6%↓ / 2.8%↑ / 3.3%↓
Q/Q Growth / 0.0% / -35.4% / 2.2% / -0.6% / 51.6%
Sales in 1Q07totaled $5.921 billion, a decrease of 0.2% fromtotal sales of $5.930 billion in1Q06. This is below the 1Q07 sales guidance range of $6-$6.1 billion. However, on a same-store basis, Federated's sales in1Q07increased0.6%.
Most brokerage firms believe that 1Q07 sales were disappointing primary due to problems in the former May stores and the Home store. Sales were belowmanagement’s expectation in February 2007 and March 2007 and became worse in April 2007. However, management was pleased with sales at legacy Macy’s, Bloomingdale’s, and online business units. The strong categories were dresses, juniors, handbags, shoes, young men’s, luggage, and mattresses. In addition, more contemporary looks in ready to wear and men’s sold well during 1Q07. Categories with weak sales trends were furniture, all seasonal businesses as well as the traditional moderate businesses like structured career looks.
One firm (Bear Stearns) believes that sales at the former May stores continued to lag the legacy Macy’s doors during 1Q07, as customers have taken longer than anticipated to adjust to the merchandising and marketing changes since the September 2006 conversion of the May nameplates. It also believes that in order to drive traffic, FD's marketing strategy in 2Q07 will be more promotional, rather than brand-oriented.
For 2Q07 the company provided total sales guidance of $6.0-$6.1 billion,which is below the previous guidance of $6.1-$6.2 billion, and for FY07, the sales guidance is $26.9-$27.3 billion. On a same-store basis, the company expects 2Q07 sales to be flat to up 2% versus the prior guidance of up 1.5%-2.5%. Management indicated that the revised 2Q07 guidance reflects its concern about uncertainty in the economic environment and consumer spending.
Management highlighted four factors supporting its optimistic sales outlook for 2Q07, and these are:
1)warmer weather, as evidenced by the positive results in apparel in the early weeks of May 2007;
2)a shift in the marketing strategy;
3)easier comparisons at former May doors given the inventory transitions occurring in June2006 and July 2006; and
4)additional time for former May doors under the Macy’s nameplate, enabling the company to get a better understanding of its customers, and giving both customers and store associates more time to get comfortable with the Macy’s brand.
One firm (KeyBanc) believes the company has the opportunity to improve its sales momentum in the second half of FY07, and the launch of the exclusive Martha Stewart home products line could provide an added boost to the lagging home area.
Another firm (B. of America) believes that management’s plan to add some incremental expense and shift dollars for moving to more event marketing from brand marketing will help the company to boost its traffic as well as same-store sales in FY07.
Please refer to the separately published spreadsheet of FD for additional detail and updated forecasts.
Margins
Margins / 2005A / 1Q06A / 2006A / 1Q07A / 2Q07E / 3Q07E / 4Q07E / 2007E / 2008E / 2009EGross / 40.7% / 38.8% / 40.6% / 39.8% / 42.2% / 40.6% / 41.1% / 40.9%↓ / 41.1%↓ / 41.1%↓
Operating / 10.8% / 2.5% / 8.4% / 4.1% / 7.1% / 5.0% / 15.6% / 8.9%↓ / 9.6%↓ / 9.8%
Net / 6.1% / 0.1% / 4.5% / 1.3% / 3.1% / 1.7% / 8.8% / 4.4%↓ / 4.8%↓ / 5.0%↓
In 1Q07,gross margin grew modestly by 100 basis points to 39.8% from 38.8%in 1Q06, reflecting a good performance at both legacy Macy’s and May stores.
In 1Q07, SG&A expensedecreased 60basis points as a percent of sales to 35.7% from 36.3% in 1Q06 due to thecost savings in merchandising, logistics, advertising and general management. However, these savings were partially offset by higher-than-planed selling expense, increased D&A expense, start-up costs for the new direct-to-consumer (DTC) facility, store pre-opening expenses and the impact of the sale of the former May credit card portfolio.
In term of SG&A expense, one firm (Bear Stearns) believes FD will be more likely to scale back on selling expenses in the future. It also believes that as the year progresses, the SG&A ratio comparison will become more challenging as FD cycles increased benefits from cost-cutting efforts and merger-related synergies last year.
In 1Q07, operating income totaled $208 million or 3.5% of sales versus operating income of $20 million or 0.3% of sales in 1Q06. The 1Q07 operating income includes $36 million in May company integration costs, compared with $129 million in integration costs and related inventory valuation adjustments in 1Q06. Excluding these items, operating income was $244 million or 4.1% of sales in 1Q07, and $149 million or 2.5% of sales in 1Q06. Interest expense decreased 9.4% to $125 million in 1Q07 from $138 million in 1Q06.
One firm (Merrill) believes that improvement in private label penetration and markdowndrove the operating income, partly offset by softness at former May doors. Another firm (B. of America) believes that there are some expense pressures in the business driving more underlying SG&A expense growth than previously.
During the 1Q07 earnings call, management provided 2Q07 guidance as follows: gross margin –flat to up slightly, SG&A expenses as a percentage of sales –relatively flat, interest expense – $530 million due in part toborrowings to fund the share buyback program, and tax rate – 37.2%.
Please refer to the separately published spreadsheet of FD for additional detail and updated forecasts.
Earnings per Share
Excluding May company merger integration costs of $36 million ($22 million or $0.05 per diluted share after tax), 1Q07 earnings per share from continuing operations were $0.16,compared to diluted earnings per share from continuing operations of $0.01 in1Q06, excluding merger integration costs and related inventory valuation adjustments of $129 million ($81 million or $0.14 per diluted share after tax).
FY ends Jan 31 ($ in m) / 2005A / 1Q06A / 2006A / 1Q07A / 2Q07E / 3Q07E / 4Q07E / 2007E / 2008E / 2009EDigest High / $2.56 / $0.01 / $2.30 / $0.16 / $0.47 / $0.30 / $1.94 / $2.75↓ / $3.55↓ / $3.86↑
Digest Low / $2.56 / $0.01 / $2.07 / $0.16 / $0.38 / $0.20 / $1.74 / $2.46↓ / $2.86↓ / $3.07↓
Digest Avg. / $2.56 / $0.01 / $2.24 / $0.16 / $0.41 / $0.23 / $1.85 / $2.58↓ / $3.14↓ / $3.43↓
Digest YoY growth / -12.5% / 1500.0% / -8.5% / 17.2% / 12.7% / 15.2%↓ / 21.8%↑ / 9.4%↑
Q/Q Growth / -90.3% / 155.8% / -42.8% / 689.6%
EPS estimates by analysts are as follows:
2007 forecasts (total 15) range from $2.46 to $2.75; the average is $2.58.
2008 forecasts (total 15) range from $2.86 to $3.55; the average is $3.14.
2009 forecasts (total 7) range from $3.07 to $3.86; the average is $3.43.
For 2Q07, management expects earnings per diluted share, excluding merger integration costs to be in a range of $0.35 to $0.45, compared with the previous guidance of $0.40 to $0.45. For FY07, management reiterated its guidance for earnings per diluted share from continuing operations, excluding merger integration costs, of $2.45 to $2.60.
One firm (Buckingham) believes the lowered guidance for 2Q07 reflects management’s uncertainty about consumer spending in the near term.
Please refer to the separately published spreadsheet of FD for additional detail and updated forecasts.
Target Price/Valuation
Rating DistributionPositive / 40%↓
Neutral / 60%↑
Negative / 0%
Avg. Target Price / $49.20↓
Of the 15analysts covering this stock, 6provided positiveand 9provided neutral ratings. The average target price assigned by analysts is $49.20(↓from previous report; 26.38% upside from the current price) ranging between $43 (10.45% upside from the current price) and $56 (43.84% upside from the current price). The analyst (Deutsche Bank) with the highest target price has given a Buy rating and based the valuation on 17.0x FY09 EPS estimate. The analyst (B. of America) with the lowest target price has given a Neutral rating and based the valuation on 13-14x FY08 EPS estimate. Most analysts have used the estimated EPS method to arrive at their respective target prices.
Risks to the price target include general consumer spending trends, fashion trends, and successful execution of the integration of former May doors. It also includes high interest rates and merger integration issues.
Please refer to the separately published spreadsheet of FD for additional detail and updated forecasts.
Capital Structure/Solvency/Cash Flow/Governance/Other
Net cash used for continuing operations was $370 million in 1Q07 versus $114 million in 1Q06. The difference reflects the fact that the company no longer owns proprietary credit receivables. In addition, inventory levels in 1Q06 were impacted by the liquidation of merchandise in the former May company stores. During 1Q07, the company issued $1.6 billion of debt, $1.1 billion of five-year debt at 5.35%, and $0.5 billion of thirty-year debt at 6.375%.
During 1Q07, the company opened six new stores – Macy's in Bolingbrook, IL; Boston and Hyannis, MA; Collierville, TN; and Austin, TX, as well as a Bloomingdale's in Costa Mesa, CA. A Macy's store in Salt Lake City, UT, was closed.
Total inventory level at 1Q07 end slightly increased 1.2% to $5.5 billion from $5.4 billion in 1Q06. One firm (Deutsche Bank) believes that inventory levels would continue to move at the same levels as sales through the rest of the year is cycled after the effect of inventory liquidation from 1Q06.
Capital expenditure in 1Q07 amounted to $125 million versus $86 million in 1Q06. This increase was due to the increase in the number of store openings. Management reiterated its capital expenditure budget of $1.2 billion for FY07.
The company repurchased 45 million of its outstanding shares of common stock on February 27, 2007 for an initial payment of approximately $2 billion through accelerated share repurchase agreements. Credit Suisse has completed the variable term accelerated share repurchase agreement, involving 22.5 million shares. The second part of the program, representing 22.5 million shares, is ongoing. At the end of 1Q07, the company had remaining authorization to repurchase up to approximately $2.2 billion of its common stock
May Stores Acquisition
Federated moved very quickly to convert the acquired May stores to the Federated format. May used to invest heavily on heavy promotional campaigns. Now Federated is going to refine that advertising/marketing strategy to be more value compelling. Federated will spend additional incremental advertising dollars, and spend a greater portion of the promotional spending in public media (such as broadcast TV) rather than in private media (such as with direct mail to existing credit card customer).
Key potential opportunities related to the merger include: 1) projected cost synergies of at least $450 million in FY07; 2) increased leverage with both vendors and mall operators; 3) marketing economies of scale (combined 2004 advertising and promotional costs were $1.4 billion); and 4) continued improvements in merchandise assortments to help drive more full price sales at new Macy’s locations, which could help drive margins. One firm (Lehman) believes Federated negotiated a good price, and that the acquisition is a strategic fit.
Name Change to Macy’s Inc.
A vote on the company’s name change to Macy’s Inc. will be taken during Federated's annual meeting on May 18, 2007. If approved, the company will be known as Macy's Inc., effective June 1, 2007. One firm (Bear Stearns) believes that the company is seeking the change in order to further leverage the Macy’s brand name. Another firm (Merrill) expects new Macy’s doors to improve on a sequential basis, and results Federated legacy stores to remain strong.
Change in Marketing Strategy
Federated announced that until it can build on its proprietary credit database on converted May customers, and gain a better understanding of their shopping habits, it will favor mass marketing over a more targeted approach. This means more national advertising and public sales versus direct mailings and private cardholder events. The shift will be most apparent in the Home area, which is a more promotion-driven business.
Potentially Severe Problems
There are none other than those discussed in other sections of this report.
Long-Term Growth
The average of long-term growth ratesprovided byanalysts is 11.7%, ranging between 8%(AG Edwards, Lehman) and16% (Buckingham).
One analyst(Lehman) holds a favorable view on FD’s acquisition of May, and believes the move puts FD in a strong competitive position as it should far outpace the next largest player. Key potential opportunities related to the merger include: (1) projected cost synergies of at least $450 million in 2007; (2) increased leverage with both vendors and mall operators; and (3) marketing economies of scale.
FD’s premier chains—Bloomingdale’s and Macy’s—are two of the most highly recognized names in the department store industry. However, these chains are not immune to the challenges facing the department store industry, and accordingly, the companyhas implemented strategic initiatives to improve its performance, including: (1) using only Macy’s nameplate with FD’s other regional chains, which should help the company leverage the strength of the brand, and (2) an effort to rebrand the Bloomingdale’s business as a bridge department store positioned between Neiman Marcus and Macy’s. In an effort to further bolster its nationwide Macy’s brand, the company will convert all May department stores that will be retained, with the exception of Lord & Taylor, to Macy’s nameplate.
Management’s long-term goal of EBITDA margin expanding to 14-15% by 2008–2009, remains in place, and implies about 200 basis points of expansion.
One analyst (Merrill) believes in the long term, a combination of an operating margin expansion, asset sales, and merger synergies would drive the stock. The company plans to continue to increase the private brand percentage in May doors over the next few years.
Upcoming Events
No details on upcoming events are available at present.
Individual Analyst Opinions
POSITIVE RATINGS
Bear Stearns– Outperform ($50) − (05/16/07): The firm maintained an Outperform rating and a target price of $50. INVESTMENT SUMMARY: The firm believes FD is one of the best operators within the department store group with high earnings growth potential in 2007. It also expects continued salesimprovement at the former May stores as FD fine tunes the assortments and as customers become used to the promotional strategy of FD.
Buckingham – Accumulate ($46) – (05/17/07): The firm maintained an Accumulate rating but decreased the target price from $48.00 to $46.00. INVESTMENT SUMMARY: The firm believes that FD can deliver solid second half earnings due to the easing comparisons as well as its more aggressive sales promotion strategy.
Deutsche Bank – Buy ($56) – (05/16/07). INVESTMENT SUMMARY:The firm reiterated a Buy rating as it believes merger synergieswould drive FD’s margins and cash flow. It also believes that FD shares are attractively valued and repurchases should support the shares, while comps improve over time.
Merrill – Buy ($47) – (05/16/07). INVESTMENT SUMMARY: The firm reiterated a Buy rating, as it believes that the long-term potential of the company remains intact. It also believes that investors need to be patient as the integration and re-branding ofacquired May doors unfolds.
UnionBankSwitz. – Buy ($55) – (05/16/07). INVESTMENT SUMMARY: The firm believes that thechanges in promotions, the launch of Martha and the lapping of the May conversion will drive better comps in the second half of FY07.
NEUTRAL RATINGS
B. of America– Neutral ($43) − (05/17/07). INVESTMENT SUMMARY: The firm continues to believe that issues facing Federated in the conversion of May doors are likely to take time to work through, though it also remains confident in management’s ability toturnaroundthe May stores.
Citigroup – Hold ($45) – (05/16/07): The firm maintained a Hold rating but decreased the target price from $50.00 to $45.00. INVESTMENT SUMMARY: The firm believes that FD's 2007 EPS guidance of $2.45 to $2.60 could prove to be conservative and itreflects management’s concern about the uncertainty of the current economic condition. The firm also states that it would remain on the sideline until there is further evidence of improved trends at former May doors.
Lehman – Equal weight ($48) – (05/16/07). INVESTMENT SUMMARY: The analyst looks favorably upon FD’s acquisition of May and believes this move puts FD in a strong competitive position, and it has the potential to outpace the next largest player in the future.
MorganStanley – Equal weight– (05/16/07). INVESTMENT SUMMARY: The firm believes that there will be continued pressure on the FD shares, as the converted May doors continue to under perform expectations over the near term.
Oppenheimer – Neutral – (05/16/07). INVESTMENT SUMMARY: The firm believes FD has initiated promotional advertising in an effort to draw the former May stores customers, to stimulate sales in the legacy Macy's stores, and to boost furniture sales.
Research Associate: Anupam Paitandi
Copy Editor: Joyoti D.
Content Editor: Sanjay Chowdhary