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Gauging the Fallout From Latest Federated-May Merger Talks

Shares of May Department Stores jumped 9 percent on news that Federated Stores was eyeing it as an acquisition that could fetch $15 billion

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NEW YORK — Will the fourth time be a charm?

Federated Department Stores and May Department Stores are said to be in merger talks once again after three previous attempts stretching back to the Eighties failed to produce a deal. But a merger, if completed this time, would rock the U.S. department store scene, giving Federated unparalleled power over vendors and mall operators alike.

News of the talks sent May’s shares up 9.2 percent on Thursday to $34.25. Intraday trading ranged between between $33.33 and $36.45, while the gain moved shares of May closer to its 52-week high of $36.48. Federated’s shares closed at $55.31, down 3.1 percent. Trading volume on May was 18 million, well above the three-month average of 2.4 million.

Analysts and observers agreed there is no guarantee an agreement will be reached — especially given a price tag for May estimated at up to $17 billion, including debt. A deal would further the consolidation of the U.S. retail sector seen in the Kmart agreement to buy Sears, and in the continued growth of mass behemoths Wal-Mart Stores and Target Stores.

A combination of Federated and May would create a $30 billion retailer with 1,000 department stores nationwide. Massive layoffs would likely result as Federated would consolidate headquarters, back office and buying operations. It also would likely result in the further disappearance of retail nameplates given Federated’s stated aim of focusing its operations on the Bloomingdale’s and Macy’s flags.

Reaction was divided as analysts and investors weighed the impact of Federated buying May, which was first reported in The Wall Street Journal Thursday. Meanwhile, sources in the banking industry said Federated was shopping around its credit card business, valued at $3.1 billion, while executive search firm Spencer Stuart has been retained to troll for May’s next chief executive.

“Federated has been embarked on a very constructive and effective growth-from-within strategy and it’s worked. Certainly there are risks involved in sustaining that growth by taking on a huge acquisitions project,” said Arnold Aronson, managing director of retail strategies, Kurt Salmon Associates. “There is a risk reward situation here that has to be carefully measured.”

One analyst on the buy side for institutional investors, who requested anonymity because of company policy, was more bullish on the deal.

“This deal makes a lot of sense,” he said. “They’ll be a ton of work to transform the May stores into Macy’s stores, but a combined unit can streamline so much selling, general and administrative expenses. Of course, that will result in a lot of jobs lost. I’m predicting that either May will get a new ceo in a few weeks or the deal will get done. Either way, something will happen in the next few weeks.”

Federated and May declined comment.

If Federated bought May, the retailer would have a dizzying number of options, including:

  • Dismantling May’s St. Louis headquarters, which would mean hundreds of layoffs and millions of dollars in cost-savings.

  • Pulling down May’s regional nameplates that have become tired and less relevant to consumers over the years, such as The Jones Store, L.S. Ayres, Famous-Barr, Kauffman and Meir & Frank, and selling off dozens of locations to other department stores and discounters.

  • Selling off May’s credit card operation and its bridal specialty businesses.

  • Flowing private labels INC, Charter Club, Alfani and other Federated brands into May locations. May stores have well under half the private label penetration of Federated stores. Federated also could use the Marshall Field’s name for private labels. Only 7 percent of the merchandise at Field’s bears the Field’s label.

In addition, Federated would be confronted with difficult decisions regarding May’s most recognized store brands — Marshall Field’s and Lord & Taylor. In the case of Field’s, Federated already bid for it last summer, but May took it for a $3.24 billion price tag. While it’s a coveted nameplate, there’s no doubt that Federated would consider the potential for having Macy’s situated on State Street in Chicago, site of the Field’s flagship, among other important Midwest sites. One former Federated official said that would be the plan.

Another key decision would be whether to operate stores that are more moderate in price than either Macy’s and/or Bloomingdale’s. Federated previously had a three-tier pricing strategy, but folded its Stern’s moderate chain.

The two corporate cultures are also very different. May is more centralized with a buying matrix, while Federated operates more regionally, with only its home and private label businesses, representing roughly 25 percent of its total business, conducted centrally. May is also more price promotional, and operates its buying office out of St. Louis, where vendors met May buyers and set up mini showrooms.

Regarding the sale of Federated’s credit card business, investment bankers pointed to General Electric Consumer Card Co., Citibank and HSBC as the leading contenders to scoop it up. Federated’s credit card portfolio is valued at $3.1 billion, and is partly owned by the retailer and GE Consumer.

Retail analysts Dana Cohen at Banc of America Securities and Stacy Turnof of Merrill Lynch both noted in research reports Thursday that, should a merger or sale take place, May’s credit card business also will likely be sold.

Analysts and bankers said a sale of May, if it were to go through, would fetch a purchase price of at least one times sales, or $15 billion, and possibly as high as $17 billion. That price tag would beat the $11 billion merger of Sears and Kmart, announced two months ago. A $17 billion deal, Banc of America’s Cohen wrote in her report, includes the purchase of 311 million May shares at $36 a share, along with the assumption of $6.2 billion in debt. And should a merger not take place, the sale of the credit card business “will still occur,” Cohen predicted in her research note.

Sources Thursday said Federated and May have been in merger talks on three different occasions, in the late Eighties when May was run by David Farrell, in the mid-Nineties and again about two years ago. On Sunday and Wednesday this week, Terry Lundgren, Federated’s chairman, president and ceo, declined to comment on the May-Federated rumor, as reported.

Sources said there are several compelling reasons for the takeover, but they also have plenty of reservations about it. One thing they all advise is for Federated not to be hasty, mainly because the retailer has been on a successful course, and an acquisition of this size could veer Federated off course.

One Wall Street source said, “The merger doesn’t make sense. It’s highly dilutive to the Federated shareholders, creates a huge amount of debt and undoes all the things that Terry [Lundgren] has been trying to do in terms of consolidation. He’s worked for three years to have two nametags [Macy’s and Bloomingdale’s] from which Federated is about to receive all the benefits with huge increases of profitability. May will definitely distract him, and whether or not the Street will understand this, is a big question.”

However, the merger would produce the second-largest department store operation in the country, surpassing J.C. Penney, but still below Sears. That means greater buying clout — a prospect that had some vendors quaking on Thursday — and a multitude of cost-saving opportunities, including wiping out corporate administrative and buying offices in St. Louis and divisional headquarters around the country. Secondly, Federated gets instant entry into Texas, where it has no stores, and the Chicago market, where only a handful of Bloomingdale’s stores operate.

It’s noteworthy that Lundgren has been showered with kudos for elevating Federated’s sales and merchandising, and the look of the stores. But it’s also said that Lundgren desires to make his mark on the industry and change the retail landscape, much like the retail executives under whom he mentored, such as Allen Questrom, former ceo of Penney’s and of Federated.

“He’s adventurous, but he’s not extreme,” said one market source who knows Lundgren.

Lundgren and the Federated team already have lived through several consolidations, including merging Macy’s and Broadway in the Nineties, but the market source said it would be prudent for Federated to wait and see if another interested May buyer emerged. This type of player, such as a private equity firm, could sell off pieces of May that would interest Federated.

Industry management consultant Emmanuel Weintraub echoed a prediction on time frame for a deal: “Either May’s board will decide that its vision is to sell, or that its vision for May entails the hiring of a chief executive to execute that vision.”

Merrill Lynch’s Turnof predicted in her research report that a merger between the two would result in Federated converting May stores over to the Macy’s nameplate. “A merger could be a positive sign for other retailers such as Nordstrom, Saks or Neiman Marcus. At our Merrill Lynch field trip this morning, Nordstrom indicated that it would be interested in some of the locations that could be for sale if a merger were to occur (in addition to the 50 locations that they have previously identified),” she wrote.

As for the store base, Turnoff added that May owns 70 percent of its real estate while Federated owns 50 percent. And while Federated has a heavier concentration in the West, May’s stores are concentrated in the Midwest and the Northeast. Cohen said the two operations probably have a 20 percent overlap, with Southern California and Boston being the two most affected regions.

“About 10 percent, or 68 real estate investment trust-owned malls, contain Federated and May stores, with 14 of those malls having more than two overlap stores,” said Michael Bilerman, real estate investment trust analyst at Citigroup Global Markets.

The REIT analyst predicted that a merger would entail store closures, since “94 malls where there exists a department store overlap between the companies, representing approximately 20 percent of each company’s mall locations.” He also noted that past experience shows it may not be that easy to shutter stores. “May’s 32 Lord & Taylor [store closures] has shown that disposing or closing mall anchor real estate is difficult and time consuming, given the operating covenants and/or reciprocal easement agreements in place between the tenant and landlord,” Bilerman wrote. He explained that a mall anchor will typically have an operating covenant for 20 years dictating that it must continue to operate the store and not close it, and a sale or closure of the store becomes more difficult because the mall anchor would still be bound by the agreement.

According to Bilerman, 460 of May’s 485 total stores, after its announced store divestitures, are based in malls. In contrast, Federated operates 435 mall-based stores in its 459 total unit count. There are 101 malls with both a May and a Federated store, and 68 of those are owned by REITs.

“The real challenge here is rationalizing the store base, rationalizing the brands and the whole merchandising concept,” said Irwin Cohen, senior adviser, Peter J. Solomon. “The other stuff is merger 101.”

Bob Pressman, executive vice president of the national retail division of Studley Inc., said a merged Federated-May might “create more leverage from the retailers in negotiating mall sites, but at the end, most of these anchors get favorable deals anyway.”

“They get low-cost build-outs or favorable land deals,” Pressman explained. “Typically, the money is not made in the anchors, it’s made in the inland stores, so there is not much else landlords can do for anchors that they haven’t already done.”

Pressman went on to say that an acquisition by Federated is “more of a merchandising play and a customer profile play than a real estate play. Each of the companies has its own specific customer profile and merchandising targeting [its] customers.”

Still, Pressman described the prospect of Federated buying May as a “unique” deal because there are so few retailers that own their own real estate.

“Both of these two are in a long tradition of owning their own real estate,” Pressman said. “Their views are similar, which is that, when you have a large store and make a large investment, it’s cheaper to own than lease. A merger would make it an incredibly valuable and largely owned real estate portfolio.”

Consultant Kurt Barnard observed, “Nothing better could happen to the May Co. than a marriage with Federated. May’s downfall over the years is that it shielded itself from all new ideas and from the changes in competition. The problem predates Gene Kahn.”

From some vendors’ viewpoint, a merger between the two could result in a sensible fit.

Pam Prahl, chief operating officer of junior jeans vendor Mudd USA Inc., said an acquisition of May by Federated could reduce the amount of price promotion in the department store channel, much of which is the result of those firms’ head-to-head competition.

“Federated has already moved forward with that, and I think you’re seeing less promotion and coupons coming out of the Federated group. They’re dealing with less inventory, but being more productive,” she said.

As far as her business, she said her reaction would depend on how the deal affected merchandising decisions.

“I don’t look at it as a negative, but it also really depends on what their internal strategy would be with their merchandisers and buyers,” she said. “If they’re planning on consolidating everyone to New York, I don’t think that’s the right thing to do for their business.”

Overall, Prahl — who spent three years in merchandising at May prior to joining Mudd — said the two firms would be a logical fit.

“They have similar strategies, but they’re executed a little differently,” she said. “Federated obviously has been doing it a little bit better due to their sales volume, their profitability, the value of their stock.”

Recent Initiatives
Federated:

  • Planned conversion of all non-Bloomingdale’s regional department store nameplates to the Macy’s nameplate, effective March 6, to allow expense management and leverage the Macy’s name via national advertising.

  • Launched new Macy’s Home Store organization in early February 2004 to accelerate sales and differentiate product in its home furnishings unit. Macy’s Bridal Club, a wedding registry program, launched in June 2004.

  • Launched collaboration with Liz Claiborne in July 2003 to simplify merchandising strategies, minimize excess ownership and maximize sales.
May
  • Acquired Marshall Field’s from Target Corp. in July 2004 for $3.2 billion.

  • Divested 32 underperforming Lord & Taylor stores throughout 2003 and 2004.

  • The company’s bridal group, which includes over 200 David’s Bridal stores, acquired 225 tuxedo stores in new markets such as the West and Midwest, thereby doubling the number of tuxedo stores in the U.S. over the past few years.
— Meredith Derby



By The Numbers
FederatedMay
Revenue:$15.61 billion$13.9 billion
Profit Margin:4.54%4.39
Operating Margin:8.93%6.96%
Free Cash Flow:$830 million$997 million
Total Cash*:$212 million$94 million
Total Debt*:$3.88 billion$6.86 billion
Enterprise Value:$13.33 billion$15.92 billion
Source: Edgar, Yahoo Finance, company reports for the trailing 12 months *Figures are for most recent quarter

Taking Stock
FederatedMay
52-Week High:$59.40 $36.48
52-Week Low:$42.80 $23.04
Source: Yahoo Finance


StoreCheck
May NameplatesNumber of Stores
Lord & Taylor54
Filene’s, Kaufmann’s102
Robinsons-May, Meier & Frank75
Hecht’s, Strawbridge’s81
Foley’s70
Famous-Barr, L.S. Ayres, The Jones Store43
Marshall Field’s62
David’s Bridal425
Federated NameplatesNumber of Stores
Macy’s423
Bloomingdale’s6
Source: Company Web sites


— With contributions from Scott Malone and Amy S. Choi

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