Federated Department Stores Q4 2005 Earnings Conference Call Transcript (FD)

Feb.21.06 | About: Macy's Inc. (M)

Federated Department Stores Q4 2005 Earnings Conference Call Transcript (FD)

February 21, 2006

Executives

Karen Hoguet, Chief Financial Officer

Analysts

Deborah Weinstein, Citigroup

Adrian Shapiro, Goldman Sachs

Jeff Stein, Key Bank

Dana Cohen, Bank of America

Christine Augustine, Bear Stearns

Bob Debral, Lehman Brothers

Michelle Tan, UBS

Presentation

Karen Hoguet, Chief Financial Officer.

Thank you. Good morning and welcome to the federated department stores conference call, schedule to discuss our Q4 2005 earnings. I am Karen Hoguet, CFO of the company. Any transcription or other reproduction of the statements made on this call without our consent is prohibited. The replay of the call will be available on our website, www.fds.com beginning approximately 2 hours after the call concludes. Please refer to the investor relations section of our website for 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 effect the company, including the risks specified in the company’s most recently filed form 10K and form 10Q.

Before we discuss the numbers this morning I want to take a minute to talk about our other announcement made earlier this morning.

To maximize the potential of the national Macy’s, we believe we need to take our marketing to an all new level. Since Peter Soxie became Federated’s first ever Chief Marketing Officer about 3 years ago, he has done a great job at working with our divisions to evolve to the Macy’s name and increasingly coordinate our marketing and sales promotion efforts across the company. Having worked in many divisions, including being president of what is now Macy’s Northwest, he has the ability to help transition to a more national approach to marketing. As a result of these efforts, plus now the addition of the May company stores, we are now ready to push even harder to establish Macy’s as a leading American consumer brand. We are so pleased that Anne MacDonald is joining our team as our new Chief marketing Officer. She joins us from Citi’s global consumer group and has worked at Pizza Hut and at 2 ad agencies, Ayer and Grey Advertising. With the foundation laid by Peter, and the partnership with our division marketing executives, we have high expectations for Anne and the cor0porate marketing team.

We are also excited about Peter becoming Chairman and CEO of Macy’s.com with the national Macy’s name, the opportunities for Macy’s.com are enormous. As we announced last month, we are investing approximately $130 million in capital over the next 2 years in infrastructure improvements and service enhancements to help us grow this business. We already have a strong macy’s.com team, led by Ken Anderson in place and Peter’s leadership skills, along with his merchandising and marketing experiences, will be very helpful as we further build that business.

These are both great moves that will enable us to build the national Macy’s brand.

2005 was a big year for Federated. We completed 2 major strategic transactions. The acquisition of May Company and the partnering with Citigroup on our credit business. We have positioned ourselves to compete more effectively going forward and at the same time enhance our profitability and cash flow generation. And with all that going on, the Federated divisions produced operating income on a comparable basis ahead of what we expected to produce in the year. And well ahead of 2004 in both dollars and rates. And we did this in spite of producing lower sales than we had expected. And on top of that, the May operations, which we acquired in late august performed better than what we expected when we closed that deal.

Let’s first spend a few minutes talking about the 4th quarter and then I’ll make a very few comments about 2006, although there is nothing really to add to what we said on our conference call on January 26th. And of course I will then end by opening the call up for your questions.

Our 4th quarter sales were $9.571 billion, up 87% over a year ago. On a comp store basis, Federated sales were up 1.1%, which was the low end of our 1-2% guidance.

May doors contributed sales of approximately $4.5 billion in the fourth quarter. We had guided you to expect May sales of $4.6-$4.7 billion in the quarter. But remember that that guidance included Lord and Taylor. Had Lord and Taylor been included, May sales would have been $4.9 billion, well in excess of what we expected. We were very pleased that the May divisions generated stronger than expected sales. Remember though, that our expectations based on year to date trends at the time the transaction closed, were low. Remember we had expected comp store declines of 5-7% for the fourth quarter.

As we look at the quarter, sales were strongest in dresses, handbags, shoes and fragrances while the home store continued to lag. We had the strongest results at Macy’s Florida and Bloomingdale’s among the Federated divisions, and at Foley’s, Hecht’s and Famous Barr, amongst the former May divisions.

Gross margins for the combined companies was 40.9% before inventory valuation adjustments, equal to last year or down 10 basis points excluding last year’s inventory valuation adjustment related to Macy’s home store centralization.

Remember, that last year’s results in the 4th quarter include pre-May, Federated-only.

This year, 2005, the Federated divisions’ gross margin rate was particularly strong in the quarter, due in part to great shortage results.

The former May company’s gross margin rate was less strong, due to markdowns taken to clear unwanted inventory.

Federated ended the year with inventories down vs. a year ago, and in good shape from an aging perspective. This is the old Federated division. And while we made progress with the May inventories, we will continue to work to improve both the quantity and the aging as they transition to our standards.

Also impacting the 4th quarter margin this year was $25 million of inventory valuation costs associated with the May integration, which as you’ve seen are broken out on the P&L. SG&A in the 4th quarter, which excludes May company integration costs, was 27% of sales in the 4th quarter of 2005 vs. 26% for Federated last year or 25.8% last year excluding store closing and consolidation costs, which were part of SG&A.

This year’s SG&A rate was negatively impacted by the sales of Federated’s credit business to Citigroup. Remember the SG&A goes up, the interest expense goes down. So the impact on EBITDA’s negative, but much less so when you look at a pre-tax income number. But in the 4th quarter, this change in accounting resulting from our sales of the receivables was worth approximately $36 million or .4 points as a percent of total sales in the 4th quarter.

We also booked in the quarter $79 million or .8 points as a percent, in non-cash charges as we fair valued the May assets and liabilities. By the way as you go to model the 4th quarter of 2006, note that approximately $70 million of the $79 million will not be included in SG&A in the 4th quarter of 2006. Excluding these 2 items, the SG&A rate would have been flat in 2005 vs. 2004.

May company integration costs booked in the quarter were $106 million. This combined with the $25 million of inventory valuation adjustments results in a total of $131 million, which is within the expected range of $100-$150 million for the 4th quarter integration-related costs.

Operating income from continuing operations, excluding integration costs was $1.325 billion, up from $763 million a year ago or $776 million excluding last year’s store closing and consolidation charges. As a percent of sales, operating income on this basis excluding last year’s store closing and consolidation costs and inventory valuation adjustments was down from 15.2% last year to 13.8% this year. This drop can be explained almost entirely by the sale of credit and the non-cash adjustments associated with increasing May assets to their fair value.

We are very pleased with this operating performance.

Interest expense in the quarter was $127 million, which was below our expected $160 million. $17 million of this is due to a settlement of the IRS exam for fiscal years 1998 and 1999. The remaining variance results from stronger than expected cash flow in the quarter.

Tax expense in the quarter was $389 million or 36.5% of free taxed income. This is lower than the expected 37.7%, primarily due to $10 million of reduced taxes due to the settlement mentioned above and other examinations.

Average share count on a diluted basis in the 4th quarter was 277 million shares. Earnings per share on a diluted basis from continuing operations was $2.45. On this same basis, but also excluding the May integration costs, EPS was $2.74 in the 4th quarter.

So as I said, we are very pleased with the quarter’s results. But I k now you are all asking why did we beat our original estimates by so much? As you know, we beat our original guidance, adjusted to exclude Lord & Taylor by $.39-$.49 a share. The first factor causing the variance is the IRS tax settlement, which as I mentioned impacted both interest expense and tax, which was worth $.08 per share. The remaining variance would be split roughly 70-75% due to higher May operating income than what we expected, driven primarily by the higher sales and to a lesser extent, lower expense. And the remaining variance is due to better Federated operating income driven by higher gross margin and lower expense.

Our operating cash flow remains strong and we have repaid a significant portion of the short term debt issued to acquire May company. Leaving our Debt to Cap at year end at 43%.

As of year end, we had approximately $1.2 billion of commercial paper outstanding.

We are glad to be coming off a strong finish to 2005. But that has little bearing on the expected 2006 results. There is really nothing to add or modify at this time from the guidance we provided on January 26th. As we said then, 2006 will be a transition year, as we integrate divisions, transition systems and convert the names of all the May doors to Macy’s. We remain confident that the combined business will be a premier national retailer, capable of achieving historically high EBITDA rates, adjusted for the sale of credit portfolios, of 14-15% in the 2008-2009 time frame, while generating significant cash flow.

And, with those comments, I will now stop and take your questions.

Question-and-Answer Session

Operator:

Our first question comes from Deborah Weinstein with Citigroup

Deborah Weinstein.

Good morning Karen. In terms of the home store centralization, can you provide additional details in terms of what has happened vs. your expectations and what should we expect in 2006?

Karen Hoguet

As we have said repeatedly, the home store has been a disappointment. We don’t think the performance has been any worse than it would have been had we not centralized, but we are not getting the improvement that we had hoped when we made the decision to centralize home. I think in hindsight, the centralization was going to be more difficult to execute with the five different Macy’s marketing calendars; we’re in the process right now of relooking at those processes to help get more of the division by division focus and decision-making and free the merchants up in the central group to do what we really intended for them to do, which is be out in the marketplace to find the best, most exclusive special wonderful products. So, we are hopeful that the results will improve in 2006 although it obviously has taken longer to get better results than what we had anticipated when we centralized.

Deborah Weinstein.

Okay. And with regards to May, can you provide some additional color in terms of what you think are the drivers with regards to better than expected performance in 2005?

Karen Hoguet

I think when we closed the transaction in late August and we looked at their sales trends, relative to last year and relative to plan and thought about the division consolidations that we were announcing in September, we became very concerned about what that might do to their business in the 4th quarter. And frankly, it’s a tribute to the May divisions and the May organization that they were able to perform better than what we had expected at that time. Remember our expectations were for a comp of down 5-7% and they ended up producing a comp about a tenth above last year. So significantly better. And that’s what really drove most of the improvement. Now a lot of that volume was driven by additional markdowns. But nonetheless, often you can take markdowns and not get the sales. So that’s really it. Unfortunately, that really doesn’t translate into 2006 in terms of better performance. We obviously expected significant improvement in the first half of the year and certainly in the 2nd half of the year. So, while the 4th quarter May results are great in terms of the additional cash flow it provided, it doesn’t really give me greater confidence about 2006.

Deborah Weinstein

Okay, great. Thanks so much and congratulations again on a great quarter.

Operator:

The next question is from Adrian Shapiro with Goldman Sachs.

Adrian Shapiro.

Thank you. Karen, clearly we’re all expecting clear benefit as Federated leverages its better, best practices merchandising across May, but I’m wondering a key Federated hallmark is the ability to flex expenses when sales come in a bit light, like we saw this quarter. When do you think that best practice could be shared at May?

Karen Hoguet

I think it’ll be shared very rapidly. If you think about it, the four May divisions are being integrated into Macy’s, so that’ll happen very quickly. And, frankly, that’s been a good practice of May as well, I believe. So I think both companies have a tradition of good expense control. So that’s not something I worry about not happening going forward.

Adrian Shapiro.

Okay. My next question, you had talked about working with consultants kind of culling demographic and psychographic data to match sister May doors to Federated. Can you share with us what you learned and maybe as you more appropriately assort these stores, can you gives us sense percentage-wise how many were under assorted and could clearly benefit from a trading up of assortments?

Karen Hoguet.

That’s a hard question to answer quickly. As we look at stores we look at them in terms of what we call their good, better, best, which relates to price points. But also, lifestyle and whether they’re traditional, neo-traditional, contemporary or fashion. And we cluster stores accordingly. So what we had done last summer was to take our view of how the May stores were being assorted currently and how we think it should be realigned going forward, given the demographics and lifestyle characteristics of those markets. And there’s fairly dramatic change within the May stores from good to better and best and from traditional into more of the Neo- kinds of lifestyle looks. So it will be fairly dramatic as we move forward.

Operator:

Our next question comes from Jeff Stein at Key Bank.

Jeff Stein.

Good morning Karen. I’m wondering if you might share with us what kind of impact the better than expected shrinkage had on the 4th quarter. And would that give you confidence to accrue for shrinkage at a lower rate during 2006 and has that been baked into the guidance?

Karen Hoguet.

We’re not quantifying exactly what the impact was, Jeff. Remember it has a big impact in the 4th quarter because it relates to inventory before that. So it is sort of a year end adjustment. And, we do have a low shortage accrual imbedded in our 2006 plan already. I don’t think it’s as low as we ended up producing in ’05 but it’s very close.

Jeff Stein.

Okay. Karen, could you talk a little bit about your ad spending budget. Given the fact that you just hired a new Chief marketing officer and it’s understandable you want to promote this as a brand; do you have any thoughts on ad spending as a percent of sales for the combined companies on a go-forward basis and how that would compare against what Federated had been spending stand-alone?

Karen Hoguet.

That’s a tough question to answer Jeff because it’s confused by markets where we have overlapping locations and we will be closing stores. But clearly, we and Anne as well are committed to bringing down marketing as a percent of sales by spending our dollars more efficiently over time. The specific numbers have not yet been decided. And also, shifting more of that advertising into branding and national marketing, as opposed to some of the more traditional ways of advertising for department stores.

Jeff Stein.

Okay. Thank you.

Operator:

Our next question comes from Dana Cohen, Bank of America.

Dana Cohen.

Good morning Karen. A couple of questions. The first is, can you just remind us how long are these clearance sales going to be going for?

Karen Hoguet.

Into…through March into the beginning of April.

Dana Cohen.

The second question is, when are you going to move to the national calendar and then when would be the first debut of the marketing?

Karen Hoguet.

Well, for the old Federated divisions, the calendars in 2006 are almost common. So that’s already happening within the old Macy’s divisions. And, starting in September when we relaunch the Macy’s brand name by converting all of the May doors to Macy’s, that’s when those doors also will be incorporated.

Dana Cohen.

So would it be like Labor Day weekend type of promotions would be the beginning of it?

Karen Hoguet.

The next weekend. The weekend after that, I believe. I don’t have the calendar in front of me, but it’s around the 9th, 10th.

Dana Cohen.

Okay. And, then the last question, I believe the merchandising week was a couple of weeks ago…it would have been the first time the merchants would have gone to buy for Federated for the May divisions. Any feedback from them in terms of how that went and sort of just how it’s working?

Karen Hoguet.

It actually started last November, which was the first buy that we tried to do for the combined company. We’ve had multiple markets since then, primarily in the private brand. I think it’s working well. One of the things that we’re focusing a lot of attention on is trying to bring the new May people that have joined us on board. We had two 2 ½ day sessions here in Cincinnati a couple of weeks ago to bring people in, meet all of our senior managers, hear about what makes Macy’s tick, hear about the four priorities. I think the organizations are working well together, even at this early stage.

Dana Cohen.

Great. Thank you.

Operator:

The next question comes from Christine Augustine of Bear Stearns.

Christine Augustine.

Thanks. Karen, could you just clarify the logistics for the going out of business sales? Once they’re done, you’ll still have markdowns probably higher than a year ago because there’s inventory at May; the ongoing stores that’s going to get converted. Is that correct?

Karen Hoguet.

Separate them into two subjects. In the going out of business, it’s really clearance sales, its clearance sales. In the clearance sale stores those will end on a certain day. For the stores that are not in clearance mode, we will be taking markdowns throughout the spring season to clear and transition the inventories as we Macy-ize them.

Christine Augustine.

Okay. So, once you finish the clearance sale, do you just job out whatever’s left or do you do any sort of consolidation or do you just sort of say, here’s the end date and now we’re shuttering the store?

Karen Hoguet.

Yes. I’m sure that the point at the end of time that merchandise goes somewhere.

Christine Augustine.

Okay. Can you comment at all on this potential strike at Macy’s Herald Square?

Karen Hoguet.

All I can say is obviously we’re in negotiations and we hope that we can reach an agreeable solution without a strike.

Christine Augustine.

And then just finally on the inventory position at quarter end, I know you mentioned shrink was a big part of your gross margin, but what about the markdown tools that you’ve got? The 20/20 for example? How would you say…is that as you expected fro the year or better than you expected?

Karen Hoguet.

20/20 overall has helped sales and has sped turnover and increased gross margin slightly. As a result, we believe in part of 20/20. So I do think the markdown performance is better as a result of 20/20, but that had been assumed in our plan.

Christine Augustine.

Great. Thank you.

Operator:

The next question comes from Bob Debral with Lehman Brothers.

Bob Debral.

Hi, good morning Karen. The first question is, on the going out of business sales, is that all going to be incorporated in your markdown assumptions or will there be a lot of vendor support through that process?

Karen Hoguet.

First off, they’re not going out of business sales they’re clearance sales. And I don’t think we’ll get vendor support there.

Bob Debral.

Okay. On the store disposition transactions that you’ve announced so far, will you have any more on the transactions like the Westfield transaction that you swapped stores? Do you expect many of those to take place going forward?

Karen Hoguet.

Many swaps?

Bob Debral.

Yes.

Karen Hoguet.

I don’t anticipate any others at this point but, there are still some stores that are not spoken for.

Bob Debral.

Okay Great. And the final question I have is, on the May inventory, you talked a lot about the Federated store inventory year over year. Can you give us the percentage declines that the May stores were down on receipts at the end of the year?

Karen Hoguet.

That’s something…I don’t know that number Bob, I’m sorry.

Bob Debral.

Okay. Thank, Karen.

Operator:

The next question comes from Michelle Tan from UBS.

Michelle Tan.

Great. Thanks. Hi Karen. On I guess the consolidation of the back office operations that’s set to kickoff soon, March 1st, can you let us know whether we’re going to get any further clarity on the progress there in terms of headcount reduction?

Karen Hoguet.

I do not plan to do that. The truth is it’s all been factored into our guidance for ’06.

Michelle Tan.

Okay. And then also, on the 4th quarter, you gave us the delta between the original guidance and the 274 reported number. Can you give us a little more clarity also on what changed between the 260-265 guidance?

Karen Hoguet.

I started to do that and then I though, oh, it will get too complicated. In the 235 to the 265, that first inquiry?

Michelle Tan.

No, the second one so from the 260-265 vs. what you reported at 274.

Karen Hoguet.

I’m trying to split it. So that first was a combination of the tax settlement as well as some improvement in May and the Federated improvement. The 260-265 to the actual 274, it was almost entirely May company improvement. Hence the surprise is, we understood Federated and the May company forecasting was different than ours. I’m just glad it went that way.

Michelle Tan.

Okay, thanks. That’s helpful. And then just one final question. On the liquidation sales, can you tell us anything, any surprises so far in terms of disruption at your other locations?

Karen Hoguet.

I think it’s been as we expected. Some but not as much as you would think. So really no big surprises at this point.

Michelle Tan.

Okay, great. Thank you very much.

Operator:

The next question comes from Christine Augustine.

Christine Augustine.

Oh, you know what Karen; could you just explain the share count? If I’m not mistaken I think the guidance was 280 and it was 277. Is it just something to do with options dilution?

Karen Hoguet.

Yes.

Christine Augustine.

Was it the May side where you didn’t have as much dilution as you thought or can you clarify that at all?

Karen Hoguet.

I don’t know the answer to that, but obviously we knew how many share we had issued as a result of May. So I don’t know.

Operator:

There are no other questions in cue at this time.

Karen Hoguet.

Thank you all very much.

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