By  on August 11, 2005

NEW YORK — If second-quarter profits are any indication of how Federated Department Stores Inc. will perform as Terry Lundgren takes the retailer into a "new era," Wall Street had better fasten its seat belt.

For the second quarter, net income soared 89.7 percent to $148 million from $78 million in the same period last year, on sales that rose 1.2 percent to $3.62 billion from $3.58 billion. The diluted EPS rose to 84 cents in the quarter from 43 cents in the prior year. The EPS for the quarter was in line with analysts' consensus estimate and within Federated's prior guidance of 80 to 85 cents a share.

Shares of the retailer jumped 3.3 percent on heavy volume midday Wednesday after the retailer posted 95 percent earnings-per-share growth in the quarter ended July 30. By the afternoon session, trading had cooled, and the stock closed up 1.3 percent at $73.69. The stock's 52-week high is $78.05, and the low is $42.80.

Lundgren, chairman, president and chief executive officer of the Cincinnati company, said closing the acquisition with May Department Stores Co., expected to happen during the third quarter after federal antitrust reviews are done, represents "the beginning of a new era for our company, and a period of positive, long-term change that we believe will benefit our customers, employees and shareholders."

Although the retailer did not offer any earnings guidance, the company expects same-store sales to show a gain of 3 percent in the third and fourth quarters. Lundgren said in a statement that sales growth "is expected to accelerate in the second half of the year as the company continues implementation of its strategic priorities to improve assortments, pricing, the shopping experience and marketing."

For the six-month period, net income gained 54.9 percent to $271 million, or $1.56 a share, from $175 million, or 96 cents, in the year-ago period as sales increased 1.9 percent to $7.26 billion from $7.13 billion.

Regarding the $17 billion deal with May Co., Lundgren and his executive team are already working to integrate the companies into one retail giant. On a conference call with analysts, Karen Hoguet, senior vice president and chief financial officer, said Lundgren and other executives were holding "meet and greet" sessions with May Co. executives as a way to share "what Federated is all about.""[We're talking] about our priorities, a little bit about our culture, how we operate," she said.

From a financial perspective, Federated is well-positioned to execute the merger. To partly fund the deal, Federated is selling its credit card receivables to Citigroup. The sale of the credit business is generating $4.5 billion in aftertax proceeds.

Hoguet said on the call that "in a very short time…the acquisition-related debt will be gone" after the sale of the credit card business as well as previously announced store closings. Federated will also use cash to fund the transaction. At the end of the second quarter, Federated had about $1.4 billion of cash on its balance sheet.

It seems May Co. footed most of the charges related to the merger. On Tuesday, the retailer, in its last quarterly report as a separate entity, said its 48.5 percent decline in second-quarter profits was mostly due to $63 million worth of merger-related charges. About $57 million, or 12 cents a share, of those charges was due to accelerated stock compensation when shareholders approved the deal last month.

Looking at Federated's results in the quarter, Hoguet said on the call that "there were no real surprises in the quarter."

"Sales…were strongest in Florida, with above-average performance; also, at Macy's West, Macy's East and Bloomingdale's," she said. "Sales were weaker in our central division and in the northwest."

The cfo added that the retailer's private brands continued to be strong. Hoguet said core categories such as cosmetics and handbags performed the best. "Home [goods] sales continued to be weak in the second quarter," she said. "Within apparel, the women's area was stronger than men's and we saw renewed strength in juniors."

Wayne Hood, equity analyst at Prudential Equity Group, described Federated's quarterly results as "impressive" in his research note.

Hood said the retailer's expense leverage was down 42 basis points "on only a 1.1 percent increase in comp-store sales. As a result, second-quarter operating margin increased 32 basis points to 8.03 percent year-over-year, which was slightly above our 7.94 percent estimate." Hood noted that this was the highest second-quarter operating margin rate for Federated since 2002, when it reached 8.61 percent.In Hood's risk assessment on shares of Federated, the analyst warned that "if the acquisition of May closes, Federated will be faced with turning around disappointing comp-store sales results at various May divisions."

"Continued disappointing comp-store sales results at May could result in unplanned markdowns and a lack of sales leverage, which could place our earnings estimates for the combined company at risk," he said. May Co.'s comps have been lackluster for the past year.

Still, Hood has the stock pegged with an "overweight" rating.

Although Adrianne Shapira, Goldman Sachs analyst, does not rate the stock because her firm is advising the retailer on its merger, she still follows the company. In her report, Shapira said it was noteworthy that Federated was able keep gross margins pretty much in check while bolstering operating margins and increasing its cash position.

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