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Macy’s, Inc. (NYSE:M)

Q3 2008 Earnings Call

November 12, 2008 10:30 am ET

Executives

Karen M. Hoguet – Chief Financial Officer

Analysts

Robert Drbul - Barclays Capital

Michelle Clark - Morgan Stanley

Jeffery Stein - Soleil-Stein Research

Lorraine Maikis - Merrill Lynch

Charles Grom - JP Morgan

Deborah Weinswig - Citigroup

Dana Cohen - Banc of America Securities

Adrianne Shapira - Goldman Sachs

Lance Vatansa – [Knight Head]

Todd Duvick - Banc of America Securities

Uta Werner - Sanford Bernstein

Sam Poser – Sterne Agee

Matt [Witterheit] – Bond Street Capital

Dana Telsey - Telsey Advisory Group

Michael Exstein - Credit Suisse

David Glick - Buckingham Research Group

Alessandra Rosenfeld - Green Murray

Lizabeth Dunn - Thomas Weisel Partners

Howard Bryerman – Evergreen Investments

Eric Miller – Barclays Capital

Bernard Sosnick – Gilford Securities

Operator

Good morning and welcome to the Macy’s third quarter earnings release conference call. Please be aware that today’s conference is being recorded. I would now like to turn the conference over to your host, Karen Hoguet.

Karen M. Hoguet

Good morning and welcome to the Macy’s Inc. conference call scheduled to discuss our third quarter earnings. I’m Karen Hoguet, CFO of the company. Any transcription or other reproduction of the statements made in this call without our consent is prohibited. A replay of the call will be available on our website, www.macysinc.com, beginning approximately two hours after the call concludes. Please refer to the investor relations section of our website for a discussion and reconciliations of any non-GAAP financial measures discussed this morning.

Keep in mind that all forward-looking statements are subject to risks and uncertainties that could cause the company’s actual results to differ materially from the expectations and assumptions mentioned today due to a variety of factors that affect the company, including the risks specified in the company’s most recently filed Form 10-K and Form 10-Q.

In the third quarter as a result of the worsening climate we experienced an unexpected weakening of sales trend as compared to the first half of the year. We were pleased, however, that we were still able to outperform our key competitors throughout the quarter, as we have done all year.

But we did have to lower our guidance for the fall season on October 10, 2008. Our third quarter performance fits within that revised guidance.

Sales in the third quarter were $5.493 billion. On a comparable store basis sales were down 6% in the quarter. The slowdown in trend, relative to the first half of the year, was experienced broadly across categories of business and also across geographies.

The most significant negative trend change in the quarter happened in the furniture and mattress businesses and at ‘. However, while the sales trend weakened, Bloomingdale’s still continued to outperform the more upscale competition in the third quarter.

We also saw in the quarter a resurgence in sales of moderate goods led by strength in private brands like Karen Scott, Style&Co, American Rag, and Green Dog. The cold weather categories also did relatively well between cold weather accessories, cold weather home textiles, outerwear, and boots.

We believe that those areas were boosted both by fashion trends and also due to the fact that they are practical purchases. Our everyday value-priced items also did very well in the third quarter. And in the month of October our average unit retail decreased for the first time that I can remember. And another concerning trend in October was a slip in our regular-price business. Earlier in the year the weakness in sales was more in our clearance than regular-price businesses.

All of these factors point to the fact that consumers are pulling back in reaction to the economic weakness. This should not surprise any of you.

Geographically, our business was strongest in the Northeast and in Texas during the quarter. New York City was still our strongest market but it did soften some in the second half of the quarter. The weakest geographies continued to be the West Coast and Florida.

On a positive note, we did begin to see improved performance in many of the My Macy's districts, including Chicago, Pittsburgh, and Columbus in the third quarter.

Over the past few months, the corporate management team has made formal two-day visits to four of the My Macy's markets and numerous other unannounced visits to stores involved in the My Macy's pilot. All I can say is that the passion and energy in those markets has to count for something.

It is really still too early to judge the potential lift from the My Macy's localization strategy. In most families of business we haven’t been able to impact our assortments in a significant way yet, due to lead times and ordering but we are cautiously optimistic that the My Macy's regional structure will significantly improve our sales trends over time.

Gross margin in the quarter was 39.5%, up 20 basis points versus last year. Remember that last year in the third quarter our gross margin dropped a full point. Needless to say, we are taking more markdowns than we had planned to keep our inventory current.

Inventory at the end of October was down approximately 2.5% on a comp store basis.

SG&A in the quarter was $2.085 billion, or 38% of sales. This is down $36.0 million, or 1.7%, versus last year. However, due to the sales drop, SG&A as a percent of sales increased 210 basis points.

We were able to reduce our expense dollars versus last year in spite of higher expenses for the infrastructure driving our multi-channel strategy through the Internet and lower credit income.

On the positive side, in addition to the savings from the division consolidations completed earlier in the year, we benefited from lower retirement expense, due to reduced headcount from earlier consolidation, the impact of the lower stock price on stock-based compensation expense, and from lower marketing expense in the third quarter. We consciously shifted marketing dollars from Q3 to Q4.

Operating income, excluding one-time costs in the quarter, was $84.0 million, or 1.5%. Division consolidation costs in the quarter were $16.0 million for a total of $129.0 million year-to-date. We are still expecting a total of $150.0 million this year in division consolidation costs.

Interest expense was $143.0 million and we had a tax benefit of $31.0 million.

The net loss, excluding division consolidation costs, was $0.08 per share with average share count in the quarter 421.3 million shares.

Cash flow year-to-date continues to be strong. Net cash provided by continuing operating activities was $317.0 million, up from $285.0 million last year. And cash used by investing activities was $606.0 million versus last year’s $618.0 million. And remember, last year the cash from invested activities benefitted from proceeds from both the disposition of After Hours and the duplicate May Company locations.

Between these two categories of asset disposition we generated $137.0 million less cash this than last year.

Capital spending in the year-to-date was $131.0 million lower than last year.

For the first time this year, we borrowed $120.0 million under our bank credit facility on October 31. We currently have $150.0 million outstanding and expect to need more than this for just a few days over the next month. These borrowings will all be repaid in early December.

Now comes the harder part of this call, trying to give you insights into what we are expecting for the fourth quarter and how we are approaching planning 2009.

This has to be the most challenging business environment that I have experienced. We do feel very prepared for the next 60 days. Our assortments are looking great and full of great values and newness. Our price points are sharper than ever, our promotions are powerful, and marketing strong. And our stores and sales associates are providing better service than ever before, based on our consumer surveys.

But, we can only control so much. We will have to see how it plays out but we still hope to improve on our third quarter sales trend.

And don’t forget the calendar shift this year and last year’s very strong November. As a result, we are expecting the month of November to be down low double-digits, even though we expect the quarter to be down 1% to down 6%. And like all holiday seasons that I can remember, it will be a nail-biter.

We won’t be able to predict the season accurately until we’re through it at the end of December. We are expecting continued gross margin pressure in the fourth quarter given the sales environment. And please do also remember that last year our gross margin in the fourth quarter was 70 basis points above a year before, 2006, so we have a tougher comparison this quarter, unlike the third quarter.

SG&A in dollars is expected to be above last year in spite of what we accomplished in the third quarter due to higher Internet-related costs, lower credit income, and higher marketing expense.

All of this, though, has been factored into the guidance we have given.

We are expecting the fourth quarter earnings per share to be between $1.10 and $1.30 and annual earnings per share to be between $1.30 and $1.50 before division consolidation costs.

Having said that, if our sales performance does not improve from the October and third quarter trend, we would be at the lower end of both sales and earnings. But as I said, we do remain hopeful that we can do better.

But while we are hopeful for the fourth quarter, I have to caution that we are less confident about spring 2009. We will be year-rounding weakness but we are increasingly concerned that we won’t see the improvement that we had anticipated as recently as a month ago.

Now that doesn’t mean we are expecting further deterioration, but we may not get as much improvement as we had hoped. But until we are through the next 60 days we won’t know how to guide you about 2009. But I will tell you that we are taking a conservative approach and planning those longer lead times items.

For example, as you saw in our release this morning, we have reduced our 2009 capital. We have taken the capital budget from $1.0 billion to approximately $550.0 million to $600.0 million. This compares to approximately $950.0 million expected to be spent in 2008.

The reduction was helped by the delay in new stores, which saved us approximately $160.0 million but we are delaying and cancelling other projects as well in an effort to conserve cash in this challenging and uncertain environment.

We are also reducing our plans relating to merchandise receipts and our expense budgets for both spring and for fall of 2009, given this uncertainty. If trends improve, we will be able to add back some of these capital projects and order more merchandise, but at this point we don’t see any upside in being optimistic.

That said, and amid all of the bad news, we do have some things to feel good about and I would like to conclude with those.

First, as poor as business is, we did outperform our key competitors again in the third quarter on a comp store sales basis.

Secondly, we are extremely well prepared for the holiday season. Our stores are looking great. There’s a lot of newness in the assortment and we have great value on deck. And the marketing campaigns at both Macy’s and Bloomingdale’s are strong.

Third, our cash position is strong. In fact, stronger than last year at this time. And we have more than enough cash and borrowing capacity to handle debt maturities in 2009 should we decide not to refinance.

And last, and certainly not least, our organization is enthusiastic and motivated to perform as well as the economy will allow through the holiday season and beyond.

Thank you all for your interest and now, what questions do you have?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Robert Drbul - Barclays Capital.

Robert Drbul - Barclays Capital

The first question I have is when you look to the debt that you have coming, from your perspective today, would you expect to use the credit line? Is there a time limit you think we should think about as you look, given the situation in the credit market today?

Karen M. Hoguet

It’s a question of cash and the credit markets. So, again, we will look to refinance some of that debt, or all of it, again, depending on how we’re looking at 2009, but I can’t really help you in terms of the time frame.

As we come from November into December, that’s when our cash flow is highest. So it’s really not until the back half of next year where we need to tap into the credit facility.

Robert Drbul - Barclays Capital

A bigger picture question, as you look to the end of this year and into next year, could you address any more potential store closings? There has been a lot of discussion in the industry around that and I just wanted to see if you had any updated thoughts on the current store base that you have and how you are thinking about it.

Karen M. Hoguet

We have always been aggressive at looking at our store base and closing any that are not contributing on a cash basis. And we have a comprehensive analysis we do many times during the year, especially in a year like this.

As in all other years, we do expect to close some stores. I do not expect it to be a number any bigger than a typical year’s closings. I have heard rumors of 50, I heard a rumor of 90, I don’t know where they are coming from.

So I would expect closings, but nothing unusual.

Robert Drbul - Barclays Capital

On the marketing spend, the shift from Q3 into Q4, can you quantify how much of that you shifted?

Karen M. Hoguet

No, I can’t.

Operator

Your next question comes from Michelle Clark - Morgan Stanley.

Michelle Clark - Morgan Stanley

First question is on the vendors. Are you noticing any change in willingness from vendors to provide markdown support?

Karen M. Hoguet

We have not yet.

Michelle Clark - Morgan Stanley

I was wondering if you have had any recent updated discussions with the rating agencies?

Karen M. Hoguet

Have not yet, either.

Michelle Clark - Morgan Stanley

But your commitment there is to continue to remain to be investment grade?

Karen M. Hoguet

It is our objective to be investment grade. Over the longer term we would like to go back to being BBB flat or maybe even BBB+. But we recognize in this environment that’s going to take some time.

Operator

Your next question comes from Jeffery Stein - Soleil-Stein Research.

Jeffery Stein - Soleil-Stein Research

I was wondering if you could talk about seasonal hiring and if you had made any changes with regard to the fourth quarter plan there or are you just going to tough it out and make sure you can serve the customer?

And secondly, given that you are making some adjustments to your spring of 2009 receipt plan, that has got to based on some type of sales forecast or outlook that you have at this point. Are you willing, and do you think it’s prudent, to plan the spring down to last year?

Karen M. Hoguet

In terms of seasonal hiring, we are refining our plans depending on the needs of individual stores but are still doing a significant amount of seasonal hiring. And one of the positives, if there is a positive from this environment, is we do think we will be able to hire a higher quality person. So that could be helpful to us as we hit the fourth quarter.

In terms of the sales forecast, yes we are obviously dealing with numbers as we are refining our merchandise receipt orders. And I do think it is likely that the spring will be planned down. I just can’t be more precise than that right now.

Operator

Your next question comes from Lorraine Maikis - Merrill Lynch.

Lorraine Maikis - Merrill Lynch

I was hoping to hear a little more about the capex cuts. What types of projects will be cut above and beyond the new store growth? Is it renovations or systems? Can you give us a little more clarity on that?

Karen M. Hoguet

Frankly, it is a little bit of everything. We are obviously cutting back maintenance that doesn’t have to be done this year. We are cutting back some remodels that aren’t strategically critical. We are cutting back some technology, although I confess we are continuing to fund systems and our Internet business fairly aggressively.

So it’s really across the board.

Operator

Your next question comes from Charles Grom - JP Morgan.

Charles Grom - JP Morgan

How many stores are you planning to open next year?

Karen M. Hoguet

I think the number is four, of which one is a replacement store.

Charles Grom - JP Morgan

Just a question on the balance sheet, composition of your good will. I know your auditors looked at it the second quarter, but if you could give us a little bit of clarification on how much of the good will is allocated for any private label trademarks that you have, as well as the May acquisition.

Karen M. Hoguet

That’s not part of good will. I mean, the good will is allocated across our various operating entities, but there is a separate category of intangibles for things like the private brand.

Charles Grom - JP Morgan

And you auditors are not planning to do another review any time soon?

Karen M. Hoguet

We are constantly looking, and remember, without trying to get into too much detail on the accounting, but there is sort of two-step process with looking at good will. One is evaluating the discounted cash flows going forward relative to the entities, and we have passed that, consistently.

Charles Grom - JP Morgan

And the last question is sort of a hypothetical question, if we were to fast-forward to the fourth quarter of next year and trends continued to stay weak, and let’s say hypothetically you do trip one of your two debt covenants, could you just clear the air on what the ramifications are is that scenario were to present itself?

Karen M. Hoguet

Let me start by being really clear, I don’t know that I agree with your assumptions that that will happen in the fourth quarter of next year. But let me assume that you are right, for a minute, even though I would disagree. If that is the case, you go back to the table with the banks and you try to renegotiate the banking facility. My guess is if that would happen, we would be able to renegotiate, possibly a smaller facility than $2.0 billion, and for sure more expensive than what we’re paying today, but I don’t think it would be likely that the bank group would walk away from it.

Charles Grom - JP Morgan

That was my point. I was just trying to say hypothetically, if it were to happen.

Karen M. Hoguet

I just wanted to be clear I’m not getting to the same conclusion that there will be a break, but should that happen that’s what we would do, we would work with our banks.

And obviously all the banks in our credit facility we have close relationships with, which theoretically should help in that situation.

Operator

Your next question comes from Deborah Weinswig – Citigroup.

Deborah Weinswig - Citigroup

With regards to SG&A, I think you said for the fourth quarter we should expect dollars to be up year-over-year. How should we look out to 2009?

Karen M. Hoguet

That’s a good question. Obviously we are trying to reduce expense as much as we can but I don’t think it’s likely to be below 2008. So there will be some increase but I can’t tell you today what that will be.

Deborah Weinswig - Citigroup

And with regards to the Internet, obviously there has been some investment there. I think we have heard that trends there have exceeded same store sales. Can you help us understand where you are with regards to the Internet and what your plans are longer term?

Karen M. Hoguet

The truth is the dot-com business continues to grow faster than the comp store sales and do well. We are also, though, moving towards more of a multi-channel strategy. Remember, when you buy on the Internet you can return to our stores. So that negative gets deducted from stores sales, not from the Internet sales. So it’s getting very murky between the two definitions.

Also we are testing now, in Florida, the ability of being in the store and having the sales associate say, “We don’t have that in stock. Let me get it for on macys.com,” which so far seems to be working very well.

So we are encouraged by not only what dot-com can do on its own, but more importantly how it is being integrated into the marketing and merchandising for the stores as well.

Deborah Weinswig - Citigroup

Last quarter you provided some very helpful insights into My Macy's with regards to some specific examples. Can you talk about some wins in the third quarter?

Karen M. Hoguet

You know something, I don’t have that in my head today. There are lots of them and I apologize to any of the My Macy's people. There are lots and lots of good things happening, merchandising success where we have put goods in. And interestingly we were in Chicago a couple of weeks ago and part of that was premium denim, and at the same time Levi’s. So again, trying to tailor assortments, both up and down to get what that Chicago customer wanted. And that denim business is now doing significantly better. That’s one example, but I confess I don’t have a long list sitting here today.

Operator

Your next question comes from Dana Cohen - Banc of America Securities.

Dana Cohen - Banc of America Securities

On credit, can you give us an update? No surprise given what’s going on with all the card companies, but can you give any quantification as to what you are seeing in your numbers.

And then when you said that the My Macy's business was getting better, are those areas that you highlighted, is that absolute improvement or relative to the rest of the business.

Karen M. Hoguet

Let me start with the second question, which is on the My Macy's districts, it’s absolute performance versus what they had been doing earlier in the year. So I can’t tell you it’s great performance necessarily, in some of these markets, but it is a significant improvement from where they were.

That’s been the good news. And we are feeling very encouraged by that even though we had said to ourselves, and to you, don’t expect to see much until spring. We are beginning to see some traction there.

In terms of credit, that continues to be a challenge. Interestingly, penetration or usage on the card continues to rise. That probably means our best customers are sticking with us most, in this environment. It may also have to do with credit availability and tapping other lines.

But the penetration is up versus what we had expected and versus last year. However, things like bad debt, bankruptcy, write-offs, all of those continue to trend down. And in fact, the payment rate also came down in the third quarter. So like others in this business, we are concerned. Fortunately we have Citi as a partner, which both benefits us in times like this in terms of the P&L, and also they have an expertise in this business and are making decisions based on a broader portfolio than just ours.

Dana Cohen - Banc of America Securities

But where do they stand in terms of credit availability?

Karen M. Hoguet

So far I would say we have made minor tweaks. But given the pressures of the profitability, I suspect we will be looking to make other changes as we head into 2009.

Operator

Your next question comes from Adrianne Shapira - Goldman Sachs.

Adrianne Shapira - Goldman Sachs

Your comments about the fact that moderate price points, you have seen a resurgence and AUR coming down. Can you share with us thoughts in terms of how you’re thinking about positioning merchandise heading into the spring 2009? Perhaps the everyday value of percentage, of sales that represents today and what it can grow to if that’s where the customer’s appetite is?

Karen M. Hoguet

We are still looking at that. It also impacts our marketing plan because customers are saying to us they want value. By the way, value doesn’t mean lowest price. It really does mean value and quality, all at the same time. But we are reviewing our spring plan, having watched this.

And by the way, those changes really happened in the second half of the quarter so that’s relatively new information.

Adrianne Shapira - Goldman Sachs

Any sense in terms of the everyday value offering, what that accounts for as a percentage of sales?

Karen M. Hoguet

It’s still relatively small. It’s about 6%.

Adrianne Shapira - Goldman Sachs

And no target?

Karen M. Hoguet

No target, no.

Adrianne Shapira - Goldman Sachs

And following up on the credit questions, assuming you are having these ongoing conversations with the rating agencies, could you share with us what perhaps could expedite ratings upgrades, what would they find more constructive? Is that pay-down or perhaps building cash on the balance sheet?

Karen M. Hoguet

I can’t speak for them. You will have to talk to them directly.

Operator

Your next question comes from Lance Vatansa – [Knight Head]

Lance Vatansa – [Knight Head]

Regarding your comp guidance, down 1% to 6% in Q4. Comps were down 6% in Q3 and it seems to me that the world looks worse this quarter than last, so what are the drivers that would lead to your outperformance, just relative to the deterioration that we are seeing in the rest of the consumer spending environment?

Karen M. Hoguet

I think there’s three parts to that. One is last year the business softened in the fourth quarter so on a two-year basis the comparison looks different. The second I would point to is the fact that our marketing shift from the third quarter to the fourth quarter, we hope will drive business incrementally in the fourth quarter. And the third is the softer factor, which is we tend to do well in holiday periods. And we are very prepared for the holiday season, but customers tend to like to come shop at Macy’s over the holiday period. They often prefer to give a Macy’s box or bag rather than some of our competitor’s. And we have typically done well. So that’s the reason for the greater optimism about the fourth quarter.

But also as I mentioned, once we head into the first quarter, that shifts.

Lance Vatansa – [Knight Head]

With respect to the gross margin improvement in Q3, I really found that to be a terrific performance with 7% top line decline and yet you improved gross margin. I did hear your comments about the favorable comp but still, that seems very impressive. Can you talk more about what other drivers there may have been with respect to that outperformance.

Karen M. Hoguet

This is a very experienced management that has been forecasting sales and reacting with inventory and our inventory aging has been in good shape, we’ve been taking our mark-downs on a timely basis all year. So the reason we were able to increase the margin this year, in the third quarter, I think relates as much to last year as anything.

But nonetheless, I would put our merchant team up against any, in terms of managing inventories, mark-downs, and margin.

Lance Vatansa – [Knight Head]

Is there anything drawn currently, under the revolver?

Karen M. Hoguet

Yes, it’s $150.0 million.

Lance Vatansa – [Knight Head]

Does that include LCs?

Karen M. Hoguet

No, that’s separate, but that’s separate from the lines. And it’s a tiny number.

Operator

Your next question comes from Todd Duvick - Banc of America Securities.

Todd Duvick - Banc of America Securities

I wanted to follow up on some of the questions that have already been asked and some of your comments. So far this year you have put share buybacks on pause. You are now cutting capital spending targets for next year. Can you provide us any guidance for how much cash you expect to generate in terms of total cash flow this year and it sounds like you would consider paying down debt if that’s what it would take next year to preserve your credit rating. Can you comment on that?

Karen M. Hoguet

Let me do the second part first, which is yes, we would consider paying down debt, and no we don’t forecast what the cash will be like at the end of the year.

But we are going to do what we need to do to maintain the investment-grade rating.

Todd Duvick - Banc of America Securities

And do you currently have any plans to visit with the rating agencies in the near term?

Karen M. Hoguet

We don’t comment on the rating agencies in that specificity. We talk to them all the time.

Operator

Your next question comes from Uta Werner - Sanford Bernstein.

Uta Werner - Sanford Bernstein

Can you tell me a little bit more about inventory? You mentioned earlier that comp store inventory is down 2.5% but comps are down minus. Can you comment about the difference?

Karen M. Hoguet

We did bring some inventory early so that we would be ready for the holiday season. We wanted to make sure that in the replenishment business we were in stock and ready to go and have the stores set up for the beginning of November.

Uta Werner - Sanford Bernstein

So it’s seasonal build-up more than it is any issue that you’ve run into.

Karen M. Hoguet

Correct.

Uta Werner - Sanford Bernstein

My next question would be related to tourism. I remember that Macy’s in Herald Square is one of the favorite tourist sites. And I wondered to what extent the comps that we have seen recently indicate that maybe there is less tourism coming through the flagship stores and that maybe as it is anniversarying big numbers from last year.

Karen M. Hoguet

This is anecdotal as opposed to anything statistical, but New York did slow down in the second half of the third quarter so I suspect it has to do with tourism but I can’t tell you that definitively.

Operator

Your next question comes from Sam Poser – Sterne Agee.

Sam Poser – Sterne Agee

Just a quick follow-up on the inventory levels. When you said that you are expecting negative low teen’s comps in November and then you’re bringing in inventory to set up for the holiday, if the customer is not going to be there why do you need the inventory early?

Karen M. Hoguet

You want to be ready for the November December period all together. And when we look at our inventory on a two-year basis, we feel perfectly comfortable with it.

Sam Poser – Sterne Agee

Can we expect that that would correct itself at the end of November?

Karen M. Hoguet

End of December.

Sam Poser – Sterne Agee

And so you basically cover seats out of the middle and left up front.

Karen M. Hoguet

We accelerated them. Again.

Operator

Your next question comes from Matt [Witterheit] – Bond Street Capital.

Matt [Witterheit] – Bond Street Capital

On the Citigroup support of your credit card program, they haven’t changed any of the requirements that they have for potential borrowers, have they?

Karen M. Hoguet

Do you mean for credit card holders?

Matt [Witterheit] – Bond Street Capital

Correct.

Karen M. Hoguet

We have tweaked a little bit the approval rates, and remember we have the proprietary card and the Visa card. We tweaked it a little more on the Visa side than the proprietary card. But not in any significant way.

By the way, we would have done also had we still owned the business.

Matt [Witterheit] – Bond Street Capital

What about credit limits?

Karen M. Hoguet

That’s been tweaked a little bit. But again, I put in the category of tweaks.

Operator

Your next question comes from Dana Telsey - Telsey Advisory Group.

Dana Telsey - Telsey Advisory Group

Can you talk a little about the private brand? What drove the improvement in the moderate private brand and how do you look at the tax rate going forward?

And lastly, level of clearance inventory versus last year or versus previous quarters, how is that doing?

Karen M. Hoguet

In terms of clearance inventory, we are down versus a year ago. Again, because of managing the inventory so well this year. That’s the case.

In terms of private brand, some of it has to do with the economy and some of it has to do with some restrategizing and product design that we have improved. I mean for example, Karen Scott has recently been redesigned as a line and just looks fabulous. Style&Co. denim is [break in audio] again a function of great value, meaning a terrific fit, which is obviously important in denim, high quality product, and also at a fabulous value.

Dana Telsey - Telsey Advisory Group

And the tax rate?

Karen M. Hoguet

There’s no change from the guidance earlier in the year.

Operator

Your next question comes from Michael Exstein - Credit Suisse.

Michael Exstein - Credit Suisse

Can you talk to us about what the trends are in terms of the Internet business? Is it accelerating, decelerating? Is there anything to read in terms of it being a predictor for the in-store activities?

And what do you see from your competitors in terms of their inventory levels and promotional levels and how you are having to respond to them, if any?

Karen M. Hoguet

On the Internet it did slow in the third quarter as well, but at a higher level. So I think it’s just consistent with what we’re seeing with the consumer.

In terms of competitors, we think that, depending on the competitor, some are very heavy in inventory and all are being very promotion, but so are we. And so with every holiday period. So when you said what are we doing in reaction, honestly, we’re sticking to our strategy and we think that that will help. We are avoiding tit-for-tat because we don’t think that will necessarily increase sales and then will be permanently in our back-staff to do in future years. I do think they’re heavy in inventory in some cases.

Operator

Your next question comes from David Glick - Buckingham Research Group.

David Glick - Buckingham Research Group

Just a follow-up as it relates to cash flow. There are some lobbying efforts currently out there to delay contributions to underfunded pensions. Obviously the return this year is not helping the status of your pension. Just wondering if you can comment on the current plans for 2008 in terms of making a contribution? That was set forth as a possibility.

Karen M. Hoguet

Earlier in the year, as shown in the 10-K, had assumed that we would be making a $175.0 million contribution to the pension plan. I am going to try to do this simply and I apologize if I end up being overly complicated, but I think there is some misunderstanding out in the market place about pension funding.

There are actually two definitions of funding. One relates to expense, and that’s what you see in the 10-K. The other is what you use for actually calculating funding. And there are differences in the calculation.

At the end of 1/1/08 our actual funded status was 97%. Though at the time that we were estimating the $175.0 million contribution we were aiming to keep our funded status up in the 90%s. As a result of what has happened with the asset returns this year and continuing to happen, in order to stay in the 90%s we would have to contribute dramatically more than $175.0 million.

However, we don’t have to stay in the 90%s. Our sort of floor is an 80% floor because below that you would then have to notify the participants that the plan was underfunded to that degree. So we have sort of put that as a floor for ourselves at 80%. So in order to achieve the 80% funding, the $175.0 million may be adequate. And by the way, that $175.0 million would have to be contributed between now and September of next year. They give you nine months to achieve the funding, as of the beginning of 2009.

So the short answer is sometime between now and next September we would make a contribution. Estimate as of the beginning of the year was $175.0 million. I won’t know a real number until the liabilities are measured as of the end of this year, which won’t be until next summer.

So we will make a contribution at some point of that kind of magnitude. It can’t be more precise than that now. Sometime between now and next September.

The mistake that people are making is using the accounting numbers to drive what has to be done from a funding perspective.

David Glick - Buckingham Research Group

And the accounting numbers obviously would have some negative impact on EPS in 2009 but those would be non-cash?

Karen M. Hoguet

Yes. But again, remember that the impact of the market return this year gets smoothed over years. So it doesn’t impact us as greatly in 2009.

Operator

Your next question comes from Alessandra Rosenfeld - Green Murray.

Alessandra Rosenfeld - Green Murray.

I have a question on premium denim. Have you seen any weakness in that area?

Karen M. Hoguet

I don’t know the specifics to that.

Alessandra Rosenfeld - Green Murray.

What about denim in general?

Karen M. Hoguet

We don’t comment in that level of specificity.

Alessandra Rosenfeld - Green Murray.

For the moderate brands, basically you are saying those brands are doing the best right now, in your opinion?

Karen M. Hoguet

We were talking about the moderate private brand. But some of the private brands that aren’t moderate are doing well, also. It’s just what changed in the third quarter was an increase in strength of those private brands.

Alessandra Rosenfeld - Green Murray.

Do you see this trend going on into the spring of next year?

Karen M. Hoguet

I don’t know that but at this point it would feel that way.

Operator

Your next question comes from Lizabeth Dunn - Thomas Weisel Partners.

Lizabeth Dunn - Thomas Weisel Partners

On the bank borrowing, you said that you have $150.0 million and you will borrow a little bit more. Can you discuss that relative to last year’s peak borrowing need, which I think was in the beginning of November.

Karen M. Hoguet

Last year the peak borrowing was just under $1.0 billion and we will be nowhere close to that this year as you can tell by being at $150.0 million now.

Lizabeth Dunn - Thomas Weisel Partners

And a follow-up to the mark-down question that was asked earlier. I think there was an article in Women’s Wear Today talking about vendors complaining that department stores were asking for markdown money earlier. Can you talk about that and particularly in context, your comment that October regular-priced business was down significantly.

Karen M. Hoguet

This is the time of year where both sides will begin to talk about the dance that goes on at this time of year, every year. I don’t think that there is money being asked for earlier, but I think both sides are going to feel pressure in a year like this where business has been tough. So there will be lots of speculation between now and the end of the year on this subject.

Lizabeth Dunn - Thomas Weisel Partners

But you’re not seeing anything unusual?

Karen M. Hoguet

I don’t think so. Again, we and the vendors have an interesting relationship and both sides will be trying to come to the right point of view here. Look, we’re in this for the long term with our vendors and we believe passionately in maintaining good partnerships and we will do that but part of that is having us help each other out in these kinds of environments.

Operator

Your next question comes from Howard Bryerman – Evergreen Investments.

Howard Bryerman – Evergreen Investments

Could you just refresh my recollection of what are the bank maintenance covenants?

Karen M. Hoguet

There are two covenants. One is at EBITDA to interest, which is set at 3.25. And as of the third quarter that calculates to 5.06. And a leverage test, where the covenant is .62 and again, it calculates to .49.

Howard Bryerman – Evergreen Investments

Where do expect the leverage to be after the busy season?

Karen M. Hoguet

We don’t project that.

Howard Bryerman – Evergreen Investments

I notice that you did say you wouldn’t project free cash flow but do you disclose what you think cash would be at the end of the year?

Karen M. Hoguet

No.

Howard Bryerman – Evergreen Investments

Can you use the revolver to pay down subordinated debt if you need to refinance the 09s?

Karen M. Hoguet

We could.

Howard Bryerman – Evergreen Investments

And just on the heels of, obviously you have very strong relationships with your banks, but these are unchartered waters now and banks are obviously thinking about themselves before they think about their customers. Are you confident that in 2009 should you need to draw on the revolver to refinance the 09s you can do that?

Karen M. Hoguet

Remember, we are going to have a lot of cash so yes, if we use cash to pay down the debt, we will need to draw on the revolver more by next year. But that’s a year away. And our hope would be that the credit markets would open up for us sometime between now and then.

Howard Bryerman – Evergreen Investments

I’m in agreement with you, but using my own calculations, even with free cash flow at the end of the year, you still would need to go to the bank facility in order to retire the two issues that come due next year.

Karen M. Hoguet

You will have to do your own math on that.

Again, we would try very hard not to, for lack of a better word, abuse the privilege of our bank line. If you think about it, when we refinanced the $650.0 million this year, and at the time it felt expensive, obviously now it looks great. Many ifs, why don’t you just use the bank line. And our answer was no, we don’t want to overuse that line, given our relationships there.

Howard Bryerman – Evergreen Investments

So they have no problems refinancing subordinated debt?

Karen M. Hoguet

I can’t speak for them. But they know that we will do everything in our power to not abuse the line.

Operator

Your next question comes from Eric Miller – Barclays Capital.

Eric Miller – Barclays Capital

Just a follow-up on some of the questions around refinancing and as you think about maintaining maximum liquidity how do you think about open-market debt repurchases over time, if you think about some of your paper trading in the low $0.50 to $1.00 prices.

Karen M. Hoguet

It would be a great deal but for right now I am borrowing from the bank. So let’s get through Christmas and then we can have that discussion.

Eric Miller – Barclays Capital

So next year as you think about whether to tap the banks or how you pay down your debt, is that something you would think about in terms of capital structure and returns?

Karen M. Hoguet

It is certainly something to look at. It does look extremely cheap right now. But again, as I said, we need to get through Christmas and see how 2009 is looking before we come to any conclusions on that.

I think the truth is we are going to stay focused on running the business.

Eric Miller – Barclays Capital

I was just following up on the comment you made around committed to investment-grade to the best of your ability. Obviously you can’t control what the rating agencies do in this environment but as you think about debt pay-downs over time, what the best returns would be. It would seem like some of your paper trading in the 50s and 60s would certainly seem attractive, if you had that liquidity, over the course of the next 6, 12 or 18 months.

Karen M. Hoguet

And that’s why when we get through Christmas and see what the 2009 looks like, see what the liquidity looks like and we will put all of those thoughts together.

Operator

Your final question comes from Bernard Sosnick – Gilford Securities.

Bernard Sosnick – Gilford Securities

You have made very clear that merchandising success and better tailoring of merchandise locally has helped Macy’s perform relatively well versus the peers. The peers have had trouble, have increased the drum beat of promotional advertising on TV and I’m wondering whether or not there are going to be some adjustments that are required in Macy’s approach, which has been to be somewhat quieter and use direct mail. Are these means of addressing customers and driving sales working as well or might they need adjustment?

Karen M. Hoguet

We do use a lot of television for our promotional efforts, more and more since we converted all the stores to Macy’s. So our marketing people are evaluating the effectiveness of not only every type of marketing but also the specific events, trying to reallocate dollars into the ways that are working best.

But direct mail still is working very well for us.

Operator

There are no further questions.

Karen M. Hoguet

Thank you all very much for your interest. Follow up with Susan or with me with any other questions you may have.

Operator

This concludes today’s conference call.

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Source: Macy’s, Inc. Q3 2008 (Qtr End 11/01/08) Earnings Call Transcript
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