Federated Department Stores Q2 2006 Earnings Call Transcript

by: SA Transcripts

Federated Department Stores (FD)
Q2 2006 Earnings Conference Call
August 9, 2006 10:30 am ET

Executives

Karen M. Hoguet - Chief Financial Officer, Executive Vice President

Analysts

Dana Cohen - Banc of America Securities
Teresa Donahue - Neuberger Berman
Jeffrey Stein - KeyBank Capital
Christine Augustine - Bear, Stearns & Co.
Debra Weinswig - Citigroup
Bob Drbul - Lehman Brothers
Dana Telsey - Telsey Advisory Group
Michelle Tan - UBS
Dana Cohen - Banc of America Securities
David Glick - Bingham Research
Christine Augustine - Bear, Stearns & Co.

Presentation

Operator

I would like to thank everyone for holding, and welcome to today’s FDS conference call with Ms. Karen Hoguet. I would like to inform participants that their line will be in a listen-only mode until the question-and-answer session, and also that today’s conference call is being recorded. Ms. Hoguet, I am going to turn it over to you and thanks for using the conference center, Ma’am.

Karen M. Hoguet

Thank you. Good morning, and welcome to the Federated Department Stores’ conference call scheduled to discuss our second quarter earnings. I am 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.fds.com, beginning approximately two 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 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.

We were pleased with our second quarter performance. While our sales were at the low-end of what we expected, we were able to produce those sales at a higher-than-expected gross margin rate. This was the primary reason we beat the high-end of our earnings guidance by $0.05.

Interest expense also came in better than expected, due largely to the higher cash flow from operations. Our earnings per share on a diluted basis, excluding May company merger integration costs and related inventory valuation adjustments, and the gain on our credit sale, was $0.49 per share versus our guidance of $0.39 to $0.44, and last year’s $0.42.

Sales in the quarter were just under $6 billion. Comp store sales in the quarter increased 4.6% versus our revised guidance of 4% to 6%, and our original guidance of 3% to 5%. We were very pleased with our comp store sales this quarter, which as you know are the comp legacy Federated stores. These are the stores that are operating with our strategies that we will be employing going forward.

Sales in the May stores were mildly disappointed, due to the disruption caused by Macy-ization activity in the stores, as well as the assortment transition.

This trend is expected to continue in the May doors in the month of August as we work towards a September Macy’s brand re-launch, but remember that while we had hoped for slightly higher sales trends in the May stores, in total we were still within our range of expectations. Given all the changes being made in the May stores, we are very pleased with that performance.

As we analyze the merchandise line performance, we are focused on the Federated doors, since their performance represents the ongoing strategy.

The stronger businesses in the quarter were dresses, cosmetics, juniors, young men’s, and luggage. The weaker businesses were in home categories, most notably furniture.

As we look at performance by region, our strongest sales were at Macy’s East, Macy’s Florida, and Macy’s Northwest. Until the conversion is complete in September, the trends in the former May doors are not meaningful.

As I mentioned earlier, we were pleased with our gross margin performance and it was better than expected in the second quarter. Our recurring gross margin, which excludes integration-related inventory valuation adjustments, was 42.1%, up from 41.3% last year.

Our markdown rate was lower in the quarter than we expected. In hindsight, we needed fewer markdowns in the second quarter to get the May assortments to our aging standard than we had forecasted, primarily because we had taken so many in the first quarter. Remember, for the Spring season as a whole, our margin on a recurring basis was 30 basis points below a year ago.

Nonetheless, we are pleased that we were able to achieve the margin result that we did while transitioning the assortments in such a significant way as we prepare for September. If anything, inventories in the May doors were a little light, particularly at the end of the quarter.

The inventory valuation adjustments booked in the quarter were $134 million.

SG&A in the quarter was $2.117 billion, or 35.3% of sales. As expected, this was higher than last year’s rate but by less than in the first quarter.

Depreciation and amortization expense was $314 million in the quarter, slightly lower than what we had expected.

May integration costs were $43 million in the quarter.

We also booked gains of $191 million on the sale of the GECC and May credit card portfolios during the second quarter.

Interest expense in the quarter was $99 million. This benefited by approximately $17 million due to the tax settlement, and remember that this settlement, both as you are thinking about interest expense as well as tax expense, will not repeat in future quarters or next year. As I had mentioned earlier, interest expense also benefited from the higher cash flow.

Tax expense was $41 million. This benefited by approximately $80 million due to the tax settlement. Excluding this, the tax rate would have been 37.5% in the quarter, as expected.

Income from continuing operations was $282 million, and net income was $317 million.

Average diluted share count in the quarter was 559 million shares. We did resume our buyback program in June and bought back $8.1 million, for a total cost of approximately $287 million. Our remaining authorization is approximately $383 million.

EPS on a diluted basis was $0.51 a share, excluding the integration costs and related inventory valuation adjustments, and the gains on sale of credit, EPS on a diluted basis was $0.49.

The second quarter was a good one from a cash flow perspective as well. We completed the sale of our credit portfolios for a total of $2.042 billion in pre-tax proceeds net of the GECC repurchase. Those transactions are shown in two places on the cash flow statement. The GECC transaction is in the investing section and the May portfolio sales were in the operating section.

In addition, we have now closed on the sale of 60 of the 63 announced sales of overlapping stores. In the first half of 2006, we have brought in $443 million in cash from the disposition of property and equipment.

In total, we generated $2.521 billion in cash flow from continuing operations before financing. This compares to $428 million generated in the first-half of last year.

During the first half, we used $1.742 billion in continuing financing activities, which primarily was to repay debt.

As I mentioned a few minutes ago, we did resume our stock repurchase program in the second quarter. We believe our stock to be a great value and as a result, we believe it continues to be a good use of our excess cash.

As important as a financial result for the quarter, we also accomplished a great deal that does not show up directly or immediately on the financial statements. We finished the systems conversions in all of the consolidated divisions on our time schedule. These conversions went extremely well, thanks to great teams in our systems division and their partners in the retail divisions and other corporate entities.

We will convert the two former May divisions, Macy’s Midwest and Macy’s North, next Spring as planned.

The May doors are all being Macy-ized from a capital standpoint and we are working hard to equip the May store executives and sales associates with the knowledge to be great brand ambassadors.

We finalized the marketing plans for the Macy’s brand launch in early September, and we also began to receive the new assortments late in the quarter. While still early, the reads on the new merchandise in the May doors are all positive.

Let’s talk for a minute about our expectations though for the Fall season.

The bottom line is we are keeping our total sales dollar guidance at $15 billion to $15.5 billion, and raising our earnings guidance a few cents.

For sales, we are shifting more of those plan dollars into the Federated doors based on the Spring trend. Our guidance for comp stores is therefore being raised from 2% to 4% to 3% to 5%.

Some of our other key planning assumptions include the following:

Comp stores sales growth is assumed to be 3% to 5% in each of the third and fourth quarters, with total sales dollars expected to be $5.9 billion to $6.1 billion in the third quarter, and $9.1 billion to $9.4 billion in the fourth quarter. Comp stores, remember, continue to be just the legacy federated comp doors until February, 2007;

Flattish gross margin rates, excluding inventory valuation adjustments in both quarters;

Lower SG&A rates as a percent of sales than last year, with more of a reduction expected in the fourth quarter than in the third. We are on track to achieve the expected $175 million of synergies this year;

We are assuming depreciation and amortization expense of approximately $315 million in the third quarter and $330 million in the fourth quarter;

Interest expense is expected to be approximately $115 million in each quarter in the second-half of the year. This is higher than in the second quarter, due primarily to the non-recurring tax settlement booked in the second quarter; and

The tax rate is expected to continue to be 37.5%.

These assumptions result in our EPS guidance on a diluted basis, excluding integration costs and valuation adjustments of $0.15 to $0.20 in the third quarter and $1.40 to $1.50 in the fourth quarter. Please note that this is the first time we have given guidance for third quarter and fourth quarter separately. I know you all know this, but remember that you just cannot add the quarters together to get full numbers, because of the fact that we are buying back shares.

As to other key planning assumptions, we are still expecting the following:

There is no change in our guidance for integration costs and inventory valuation adjustments. We are still expecting $220 million to $225 million of inventory valuation adjustments for the full year. Most, if not all, of the remaining adjustments are expected to be booked in the third quarter;

The integration related costs for the year are still assumed to be $450 million to $500 million;

Cash one-time costs this year are also still expected to be approximately $1 billion;

Cap-ex is still expected to be $1.6 billion for the full year, and we are still expecting $550 million to $600 million on a pre-tax basis, or $400 million to $500 million on an after-tax basis in proceeds from the sale of the overlapping locations;

The Lord & Taylor divestiture is still expected to close in the third quarter; and

We expect to have an announced transaction for the Bridal Group some time during the third quarter as well.

I know all of you would like us to be providing guidance now for 2007, but as in any other year, and particularly this year, until we see the sales this Fall, we are not going to be comfortable projecting sales and earnings for next year. We do expect, however, to keep moving towards our goal as fast as we can of reaching EBITDA of 14% to 15% in the 2008-2009 timeframe, and we are on track to deliver the synergies of at least $450 million next year.

We are getting very excited as we approach September 9th. There is going to be so much activity and excitement around Macy’s as we re-launch the brand nationwide. This will include the conversion of more than 400 former May company doors to the Macy’s nameplate.

We have been putting up Macy’s signs on the exterior of these buildings over the past few months, but covering them temporarily with banners showing the current store names. These banners will come down during the week of Labor Day.

Inside the converting stores, new Macy’s merchandise assortments have begun flowing in. We have been de-cluttering the sales floors and widening the aisles, and a number of the doors are being reinvented as part of our three-year plan to physically upgrade the May company store base.

By the official brand re-launch date of September 9th, everything should be in place. In that time period, we will be launching a significant Macy’s brand marketing effort -- national advertising, local events, and special store promotions to drive traffic so shoppers can see what is new and exciting in our stores. This includes both existing Macy’s stores, as well as those being converted.

At this point, we are not discussing our specific launch marketing plans, but I think you will be impressed when you see it.

Some national activity already has begun. A good example is Macy’s sponsorship of the third season of the Project Runway show on the Bravo Network. Our Ink brand has played a central role in that show, and in particular, the episode that ran last Wednesday, which was followed by special Ink merchandise that was in our stores and on macys.com the very next morning.

A tremendous amount of work has gone into the May company integration already, and we have accomplished everything we have set out to do on our aggressive timetable. I cannot begin to tell you how proud I am of our organization. I hope you are hearing the confidence and optimism we are feeling. We certainly have a lot of work still to do, and we expect that our offering will continue to evolve and improve as we learn from customer reaction this fall.

We do believe we have the right strategies and we have a very talented team, whom we and you can count on to execute these strategies and deliver the desired financial results.

With that, I will take your questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question comes from Dana Cohen of Banc of America. Your line is now open.

Dana Cohen - Banc of America Securities

Hey, Karen, it’s Dana. A couple of questions, starting with the comp guidance for the back-half of the year versus the May business. I understand the rationale of saying that was the trend in the first-half, but given the magnitude of the changes at the business, why are you assuming a similar trend in the back-half, particularly at the May business and also flat gross margins?

Karen M. Hoguet

What has happened is because the May stores are going into the Fall from a lower base, we are still expecting the same delta, but because the trend in the Spring is lower, we expect the Fall to be lower as well.

We are still expecting the same improvement. It is just from a lower number.

Dana Cohen - Banc of America Securities

What about the gross margin as well? One would think with better product, the markdowns taken last year, shouldn’t the gross margins get better?

Karen M. Hoguet

You know what, I think it takes time for customers to get used to new assortments, and so as we said, we do expect flattish gross margins, and we will see.

Dana Cohen - Banc of America Securities

Then, just one nit question -- on discontinued assets, why was there a sequential increase from the end of the year?

Karen M. Hoguet

With the bid on Lord & Taylor coming in…

Dana Cohen - Banc of America Securities

Okay, that number gets adjusted.

Karen M. Hoguet

Got it.

Dana Cohen - Banc of America Securities

Okay, thank you.

Operator

Our next question comes from Teresa Donahue of Neuberger Berman.

Teresa Donahue - Neuberger Berman

Good morning, Karen. My question has been answered, thanks.

Operator

Our next question comes from Jeff Stein of KeyBank Capital. Your line is now open.

Jeffrey Stein - KeyBank Capital

Karen, just wondering if some of the observations we are seeing here in Cleveland, Ohio might be true elsewhere. It seems that at the Kaufmann’s division, virtually the entire home store has already been converted. I am wondering, the comment you made with respect to positive indications on the assortments early on in the former May doors, if that is referring in fact to the home store.

Also, could you comment on some of the newer things that we are seeing here in the home store, namely your dorm headquarters program. It looks like you are adopting perhaps best practices from May with their tech gifts department.

Karen M. Hoguet

I will hopefully remember all those questions, Jeff.

In terms of the home store, it did convert a little bit faster than apparel. What I was responding to was the private brands coming in. I confess. I do not know how home is doing in those Kaufmann stores. My comment was relating to the private brands that were coming in to the stores.

In terms of the dorm headquarters, it has done well, but like the rest of home, not as well as we had liked, but it is obviously a category we remain committed to.

Then, in terms of the tech gifts and just gifts in general, that was one of the best practices that we are taking from May. We think as they went through the fourth quarter last year, they did a better job on that gift business and that is something that we are rolling out to all of the Macy doors.

Operator

Our next question comes from Christine Augustine from Bear, Stearns. Your line is now open.

Christine Augustine - Bear, Stearns & Co.

Thank you. Good morning, Karen. Can you address what sort of trends you are seeing in California? Can you discuss within your comp guidance if you are assuming some transfer from the closed duplicate stores? Did you see any cost-savings in the second quarter?

Karen M. Hoguet

Let me start with, and in no particular order, our sales guidance does assume sales transferring from the closed doors into the Federated or May doors, depending on which one closed, so that is part of the guidance.

In terms of California, as I mentioned, it was not one of the areas with the strongest sales. That is really all I can say there.

In terms of expense savings, we are beginning to see expense savings, but at the same time, until the names convert, there is still some duplicate expense.

Christine Augustine - Bear, Stearns & Co.

So on the transfer, correct me if I am wrong, but I think you were expecting maybe a third to go to the remaining federated. Is that what happened in Q2 and do you think that will continue?

Karen M. Hoguet

We have never given that guidance because every location is different. There is really not a rule of thumb, but we did better in the bay stores where there was not transfer, where it was not a closing of a duplicate location, and we did a little bit better than what we had expected but we had expected big pick-ups, so I think the answer is the Federated doors are doing well in both cases.

Christine Augustine - Bear, Stearns & Co.

Great, thank you very much.

Operator

The next question comes from Debra Weinswig from Citigroup Investment.

Debra Weinswig - Citigroup

Good morning, Karen. You had mentioned that you had hoped that we are hearing the confidence and optimism that you are, and we certainly have. Being in the stores, you can certainly feel it. It is almost tangible. But where have you been surprised by how things have progressed in the stores in terms of personnel, et cetera? Especially, how is that translating, or how should we think about that in light of the higher comp and earnings guidance for the back-half?

Karen M. Hoguet

You know something, people ask us this question a lot. I honestly cannot think of any place we have had any significant surprises, up or down, so I am not quite sure how to address that question.

Debra Weinswig - Citigroup

Basically, everything has progressed as expected? Has anything on the personnel side in terms of how many people in the May stores are reacting? Has there been anything positive there?

Karen M. Hoguet

Obviously we all felt that an important part of this combination was attracting May talent, and we feel really good about the people that we have been able to attract and retain, and obviously contributing a great deal to the company. So that is good.

We have spent a lot of time training and educating the sales associates on the new private brand, so that if a customer came in and was used to buying brand X, we actually put together what I call cross-reference tables to assist the sales associate to say if you liked X, try Y. It fits the same or the styling is the same. Hopefully all of that pays off well as we go into September.

Debra Weinswig - Citigroup

Thank you.

Operator

Our next question comes from Bob Drbul from Lehman Brothers. Your line is now open.

Bob Drbul - Lehman Brothers

Good morning, Karen. When you look at the May doors today, is there a percentage that you believe are fully converted? How close are the ones that are not done to where you want them to be as you head into September?

Karen M. Hoguet

Most of them are not completed. The assortments are going to continue to come in through the month of August, so again, I cannot think of any where I would tell you it is complete now. I may be wrong. There may be one or two, but this is going to be an ongoing process through August.

Bob Drbul - Lehman Brothers

Okay, and when you talk about the May inventories, where they ended last quarter, and as you head into Fall, are the May store inventories for Fall going to be at a much higher percentage than Federated, because they were so lean on inventories, or will they be sort of equally balanced?

Karen M. Hoguet

We frankly managed to receive flow in sales expectations, so we have a sales expectation for each store, and based on that, a receive plan that would be the same for a May store as a Federated store.

Bob Drbul - Lehman Brothers

When you look at the private label offering in the month of -- let’s say for September when you get to September, will it be at the level that you want it to be at private label, or will you be ramping the private label offering up throughout the Fall and into the holiday?

Karen M. Hoguet

We will continue to be increasing the private brand percentage in the May doors over the next couple of years. It will take us that long to get the percentage up to the Federated average.

Bob Drbul - Lehman Brothers

Great, and then just one last question -- can you comment at all about the Marshall Fields division? There has just been a lot of noise around the backlash in Chicago or whatever. Can you just talk a little bit to the performance and your expectations for that division, when it converts?

Karen M. Hoguet

You are referring to Macy’s North. I think at this point, we will just have to see what happens in September. We are fairly optimistic that when the Chicago customer, which is the only one of their markets where we have had that backlash, we are hoping that when they see that we are still keeping the best of Marshall Fields, but enhancing that greatly with all that Macy’s offers, that the customer will be pleased and it will do good things for the business. Obviously we will have to see when we get to September.

Bob Drbul - Lehman Brothers

Thank you very much.

Operator

Our next question is from Dana Telsey from Telsey Advisory Group. Your line is now open.

Dana Telsey - Telsey Advisory Group

Thank you. Good morning, Karen. Any progress or updates on selling the Bridal Group, and any thoughts and plans there? I think it was by the end of the third quarter that may be completed. Also, as you look at the gross margin for the second-half of the year, do you see the opportunities coming from increased private label percentage? Thank you.

Karen M. Hoguet

In terms of the Bridal process, that is going as we had expected and expect to announce a deal by the end of the third quarter, so there is no news there, but it is ongoing as we had planned.

In terms of the gross margin for the Fall season, remember as we think of the private brand, we are not greedy in terms of gross margin. We are trying really hard to make our private brand offer good value to the customer, and so also, as you are building private brands, sometimes it takes a while for the customer to react and therefore, there could be more markdowns this Fall.

Again, we will see how the Fall plays out, but at this point, our best guess is that margins will be flattish in both the third and fourth quarters.

Dana Telsey - Telsey Advisory Group

Thank you.

Operator

Our next question is from Michelle Tan of UBS. Your line is now open.

Michelle Tan - UBS

Thank you. Just a couple of questions. First, looking at the Federated legacy stores being a greater portion of the mix in the second-half, does that change anything from a profitability standpoint?

Also, following up to Dana’s question on private brand, looking at the old private brand that May had and what Federated is brining in, we know Federated had stronger private label brands. Can we also assume that those brands were more profitable than the private brands that May had? Thank you.

Karen M. Hoguet

Well, May had a different strategy with their private brands than we did. Again, we do not focus on increase in gross margin on our private brand. We are trying to increase comp store sales, and that is a different approach than what May did. So our margins are not going to be higher, necessarily than the May margins but it is going to sell a whole lot better, and that is really what we are focusing on.

I am not sure I understand your first question.

Michelle Tan - UBS

The first question is basically, as you look at the mix of sales volume…

Karen M. Hoguet

You have seen our guidance. I do not think -- there is really not a change there.

Michelle Tan - UBS

Yes, okay.

Operator

Our next question comes from Dana Cohen of Banc of America. Your line is now open.

Dana Cohen - Banc of America Securities

My question has been answered. Thank you.

Operator

Our next question is from David Glick of Bingham Research. Your line is now open.

David Glick - Bingham Research

Good morning, Karen. Congratulations on the quarter. You had commented on the strong divisions for the quarter being East, Florida, and the Northwest. I was wondering if you might give us some color on which were the underperformers. What I am trying to really get at is are you seeing any improvement in the central swath of the country? You touched briefly on Macy’s North, but are you starting to see some improvement in the Atlanta division? How is St. Louis shaping up? That is the first question.

Then, you said furniture was weak in the second quarter. I know there is a big furniture event, which is an important event, at the end of Q2, and whether there are any signs of life there in the furniture business.

Karen M. Hoguet

In terms of furniture, we do not comment mid-event, so we will see as we get through the month of August.

In terms of your first question, it is really too early to see. I think we need to get the assortments converted. That is fairly optimistic that there will be trend changes in those stores as the assortments change.

David Glick - Bingham Research

How about in Atlanta, which was a pre-existing division, obviously with more stores, but has that business improved in that division, in South?

Karen M. Hoguet

You know, we feel okay about what is happening in the core south stores, so we will see.

David Glick - Bingham Research

Very good. Thank you.

Operator

Our next question comes from Christine Augustine of Bear, Stearns. Your line is now open.

Christine Augustine - Bear, Stearns & Co.

Karen, I wanted to also ask you about the AUR trends. They were pretty strong in the first quarter. Did they continue into the second quarter?

Karen M. Hoguet

You know something, I do not have that in front of me, Christine. Sorry. I suspect they did, but again, I just do not have the facts in front of me.

Operator

At this time, Ms. Hogan, I am showing there are no further questions.

Karen M. Hoguet

Great. Thank you all very much. Take care.

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