By  on August 16, 2007

Macy's is still feeling merger aftershock.

With consumers shopping former May Co. doors converted to Macy's less than originally hoped, and merger costs continuing to be digested, the retailer's second-quarter earnings fell 76 percent.

The integration difficulties forced Macy's to cut its outlook for the second half and full year, and the news sent the retailer's shares on a seesaw ride on the New York Stock Exchange Wednesday. They initially fell sharply, but ended the day down only 2 percent to close at $31.10, from $31.73.

The retailer now expects full-year earnings of $2.15 to $2.30 a share, down from a prior forecast of $2.45 to $2.60. Comps are estimated at minus 1 percent to plus 1 percent in the third quarter, and flat to up 2 percent in the fourth quarter. Earnings for the third quarter are expected at 5 cents to 10 cents, and $1.70 to $1.80 in the fourth quarter. For fiscal 2007 as a whole, sales are seen reaching $26.5 billion to $26.8 billion. Merger integration costs for the year are expected to total between $150 million and $160 million, somewhat higher than originally estimated.

But, while challenges remain, it's not all dark for America's department store.

"While the second quarter was below our initial expectations, we did see improving sales trends through the quarter in former May Co. stores and in home-related merchandise categories," said Terry Lundgren, chairman, president and chief executive officer, in a statement. "We are optimistic that our business can and will improve in the second half of the year, despite what appears to be a more challenging economic environment."

On Wednesday, Macy's reported merger costs took earnings down to $74 million, or 16 cents a share, from $317 million, or 51 cents, in the prior year. There was also a slight sales decline to $5.89 billion, compared with sales of $5.99 billion in last year's period. Same-store sales slipped 2.6 percent.

Macy's bought May Co. two years ago for $17 billion, including debt, and converted about 400 May doors to Macy's units. Excluding merger costs, second-quarter earnings per share were 29 cents, at the high end of revised guidance of 20 cents to 30 cents, but below original guidance.Operating income totaled $250 million, or 4.2 percent of sales for the second quarter, compared with $422 million, or 7 percent of sales, for the year-ago period. Second-quarter operating income included $97 million in May Co. integration costs. Excluding these costs, operating income for the second quarter was $347 million, or 5.9 percent of sales.

The difficulties in integrating the former May Co. doors haven't stopped Macy's from seeking other opportunities. In a surprising new wrinkle, Macy's could decide to buy a wholesale brand, as disclosed by Karen Hoguet, Macy's chief financial officer, during Wednesday's conference call.

Responding to a question from Dana Telsey, ceo of Telsey Advisory Group, about buying fashion brands up for sale at companies such as Liz Claiborne Inc. and Jones Apparel Group, Hoguet replied: "We do believe that having brands and having exclusive merchandise is important. So, as you would expect, we might consider some of those. Obviously, it would be wrong of us to ignore what's happening in terms of the major changes."

Claiborne is considering selling the Dana Buchman, Ellen Tracy and Sigrid Olsen brands, among others, and Jones is mulling over selling some moderate labels, possibly L.E.I. and Norton McNaughton. It wouldn't be the first time Macy's bought a brand. Years ago, it bought the California-based American Rag label.

Hoguet said private brands could grow to represent 20 percent of volume, from the current 18 percent, and that another 30 percent of the store is represented by exclusive or limited-distribution products. Key private brands include INC, Alfani, Tools of the Trade and Charter Club.

Summing up the second quarter, Hoguet said, "It all boils down to three key messages: We're not happy with our performance. We hoped sales would have been stronger. Having said that, trends in the later part of quarter in home-related merchandise and former May Co. doors give us reason to be optimistic that we can improve the sales trend in the back half of the year. Thirdly, the economic environment is feeling more challenging than we anticipated at the beginning of the year."

Macy's hoped sales would surpass $6 billion during the second quarter. The shortfall led to increased markdowns and lower gross margins. Apparel was particularly weak. Reduced costs helped offset some of the negatives. "It was still a tough quarter," Hoguet admitted.But Macy's executives saw a silver lining. They cited:

- A narrowing performance gap between Macy's legacy and former May Co. doors. "The gap will continue to narrow through the fall season, but won't disappear entirely," Hoguet said.

- Good early reads on fall fashions, particularly novelty jackets and coats, pants with waist interest and wider legs and denim.

- High hopes for the new Martha Stewart Collection, Macy's biggest brand rollout ever. The line officially launches next month, though much of the furniture, tabletop and textiles started arriving at stores last month.

- Effective inventory and expense controls and better coordination between merchandising and marketing.

- Momentum at macys.com and Bloomingdale's, with solid openings over the past year in San Francisco and Costa Mesa, Calif., and Chestnut Hill, Mass. A Bloomingdale's unit in Chevy Chase, Md., opens next month. "The upscale customer segment still continues to be strong and we don't know yet the potential for macys.com. It is very encouraging," Hoguet said.

Home sales improved last quarter, particularly for furniture in July, when Martha Stewart products began to be sold. "Early sell-throughs are very encouraging," Hoguet said about the Martha Stewart line. "Thirty-five percent of bridal registries included Martha products, and that was without the full assortments on the floor....We are feeling better about our home business than we have in awhile, but customer demand is less than expected."

But, Hoguet said, the economy in Florida weakened dramatically, hurting both Macy's and Bloomingdale's there.

While the company took a lot of markdowns to clear slow-selling goods, it concluded the quarter with clean inventories, Hoguet continued. Furthermore, Macy's benefited from merger-related synergies, particularly in logistics and advertising, and lower retirement expenses, which were offset by higher depreciation and higher direct-to-consumer expense including a recently opened distribution center in Portland, Tenn.

"We have learned a lot over the past 12 months," Hoguet said. "The financial results are not as strong as originally envisioned, but we do believe we have an understanding of the remaining issues."

Second-quarter 2006 operating income included $177 million in integration costs and related inventory valuation adjustments, and gains of $191 million on the sale of credit receivables. Excluding these items, operating income for the second quarter of 2006 was $408 million, or 6.8 percent of sales.The verdict on the merger is still out, however.

"The Macy's-May merger was the largest department store transformation in the last 25 to 30 years," said Arnold Aronson, managing director of retail strategies, Kurt Salmon Associates. "Some of the complications would really have to be expected in such a massive merger, but the principle is very sound. The consolidation of management expertise, real estate positioning, economy of scale and clout in the marketplace will greatly benefit [Macy's] in the long term. In the next year or two, Macy's will be very close to the original projections anticipated."

However, merger issues were not adequately anticipated, Aronson added, noting that May Co. consumers were not ready for Macy's better-bridge assortments and still have an appetite for May Co.'s acute price promoting and coupons, which Macy's is responding to by reinstating a lot of coupons. "In the long run, many [former] May doors can evolve into better assortments in a gradual way," Aronson said. "This will end up being one of the stronger and most successful retail mergers."

"For all the strategic imperatives of the Macy's-May merger, the reality is that many of the May stores didn't rise to the productivity norm of Macy's," said Isaac Lagnado, president of Tactical Retail Solutions Inc. "Many of the May stores, not to mention Macy's stores, still need renovation — sometimes major renovation and remerchandising. That has always been a notoriously slow exercise for department stores and remains so. The effects on sales velocity are clear."

"I wouldn't give [the merger] a score," Telsey said. "The goal is to have a large customer base that sees Macy's as their destination department store."

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