By  on November 11, 2004

NEW YORK — Federated Department Stores Inc. warmed up to the holiday season with a surprise: It delivered a 10.4 percent rise in profits Tuesday that surpassed Wall Street’s and its own expectations, and remained upbeat for the fourth quarter.

Federated also reported, as a percent of sales, a decline in its expense ratio despite store closing costs and the impact on sales of recent hurricanes. The company also told the Street it was looking at options for its credit card business.

“The stronger trend we saw in October in markets across the country was encouraging. We also experienced a post-hurricane sales recovery in Florida, although not enough to offset the negative impact in September,” said Terry Lundgren, chairman, president and chief executive officer, in a statement.

Shares of Federated rose 0.1 percent to close at $53.85 in trading on Wednesday on the New York Stock Exchange.

For the three months ended Oct. 30, income rose 10.4 percent to $74 million, or 42 cents a diluted share, from $67 million, or 36 cents, in the same year-ago quarter. Wall Street’s consensus estimate pegged EPS at 39 cents, while Federated’s guidance was at 40 cents. Sales were essentially flat at approximately $3.49 billion. Same-store sales rose 0.4 percent in the quarter, below the retailer’s original expectations of a gain of 1.5 to 3 percent, owing in part to weakness in August and the impact from the hurricanes.

Karen Hoguet, Federated’s chief financial officer, told analysts during a conference call that “October sales were consistent with our original expectations, which gives us comfort as we head into the very important fourth quarter.”

She noted the best sales performances in the quarter were at Bloomingdale’s, Macy’s West and Burdines-Macy’s, now called Macy’s-Florida. In terms of category strength, core areas of growth were handbags, jewelry and cosmetics. Also performing well was kids’. Sales of men’s and women’s apparel also strengthened in October.

“Federated had a great recovery [in October],” observed Christine Kilton, analyst at Bear, Stearns & Co. “After the hurricanes, we wondered if customers would really focus on getting their lives back together — and also that maybe the last thing they wanted to do would be to go to the mall. Federated’s performance shows you the strength of the underlying trend all year.”Kilton described Burdine’s, now Macy’s-Florida, as “one of their best performing divisions all year.”

The analyst also noted Federated is “pretty upbeat” over holiday, and expects the retailer will have a good season “given its strategy the last couple of years of moving the merchandise upmarket to better-priced goods and improving its interpretation of fashion trends.” This, coupled with a strong inventory position, has the retailer “in good shape.”

The holiday season is by no means a lock for any retailer. On Tuesday, May Department Stores and Abercrombie & Fitch each reported disappointing third-quarter results. A&F said it was cautious about the fourth quarter, and May was revising its holiday and marketing strategies to attract a younger consumer.

Kilton expects sales of gift cards will continue to increase, with the likelihood of making January a more important contributor to the fourth quarter than in prior years.

“What we find with gift cards is that the majority get redeemed within 30 days, and for most retailers that means the redemptions are counted in fourth-quarter results,” she said.

Kilton said she was also surprised by the level of selling, general and administrative control “Federated showed in the quarter, given that there were store closing costs and centralization and consolidation costs. Some came from better performance out of its credit card operation, which was the swing factor, but a major contributor was the control exercised through all aspects of the company’s operations.”

As a percent of sales, SG&A improved 20 basis points, dropping to 34.8 percent from 35 percent in the same year-ago period.

Hoguet explained that in spite of the added costs associated with the hurricanes, the company was able to bring expenses in lower than expected in part due to “lower expenses spread throughout other parts of the business.”

Hoguet also told investors Federated was reviewing what to do with its proprietary credit business, which is split between Federated and GE Commercial Credit. The agreement expires in 2006, and options include buying back the GE portfolio, selling it all or maintaining split ownership with GE or another party.“You know, one thing that we know for sure is that a well-managed credit business is vital to the retailing success of the company, both in terms of sales and also profitability,” Hoguet added.

George Strachan, analyst at Goldman Sachs, noted in a research report before Federated released results that the retailer could get a 17 percent premium for the sale of its $3 billion-plus proprietary and nonproprietary Visa credit portfolio, similar to what Dillard’s received for its credit business, which would yield almost $3.5 billion in proceeds.

But Strachan said even if “Federated does sell the business, what would it do with the proceeds? Federated’s balance sheet is already underleveraged, it throws off over $750 million in free cash flow per year and an acquisition could be handled with existing resources.”

Federated reaffirmed its EPS expectations for the fourth quarter at between $2.45 and $2.55 a share, with comps showing a gain between 1.5 percent and 3 percent. EPS in the prior year was $2.50. While November comps are expected flat to up 2 percent, December will benefit from two extra pre-Christmas shopping days, which might push a comps gain in the range of 1 to 3 percent. Full-year EPS is expected at $3.73 to $3.83.

“Clearly, if we achieve our fourth-quarter guidance, it will have been a terrific year,” Hoguet said. She added that the company has positioned itself better for 2005 and beyond, making progress on four priorities: assortments to be more differentiated and better edited; simplifying its pricing; improving the in-store shopping experience, and marketing that is more creative and more cost-effective.

For the nine months, income rose 6.9 percent to $249 million, or $1.38 cents a diluted share, from $233 million, or $1.25, last year. Sales gained 3.4 percent to $10.56 billion from $10.21 billion.

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