Is Federated As Flush As It Looks?

A little digging into the numbers tells a very different postmerger story

Ever since Federated Department Stores Inc. (FD ) acquired May Department Stores in August, 2005, Wall Street has cheered the creation of the retail colossus. Investors have taken heart in the company's rising free cash flow--the cash from operations left over after investments back into the business. Anticipation of large cost savings and increased market share has helped fuel a 43% rise in shares since the deal's announcement in February, 2005. Even a shortfall in first-quarter earnings, reported on May 16, and weak results from old May stores haven't dampened the enthusiasm. Says Federated CEO Terry J. Lundgren: "The merger is not just going well. It's going extremely well."

A hard look at same-store sales and cash-flow numbers, however, shows that it may be too soon for rejoicing. Much of Federated's cash flow stems from the $4.4 billion windfall it got when the retailer sold its credit-card portfolio to Citigroup in a series of transactions in 2005 and 2006. While Federated's net income fell 29% last year, to $995 million, largely because of acquisition costs, cash flow from operations soared, more than doubling from 2004's $1.5 billion. But exclude the receivables sales to Citigroup and make adjustments for the May acquisition, and operating cash rose just $2.2 billion last year and $1.5 billion in 2005. That's much less than the $3.7 billion and $4.1 billion, respectively, that a quick glance at Federated's cash-flow statement shows. "My concern is that cash flow is being driven by the liquidation of receivables that is not going to recur," says Jeremy Perler, a retail analyst at the Center for Financial Research & Analysis, a forensic accounting firm.

Federated's calculations show its free cash flow up slightly in both 2005 and 2006, even after stripping out the $4.4 billion. Says Chief Financial Officer Karen M. Hoguet: "The company has continued to produce very strong cash flow, and it has allowed us to return significant value to shareholders."

Same-store sales numbers, a vital metric of retail performance, are also murky. Since the completion of the $5.3 billion deal, Lundgren has remade the May chain, closing some outlets and converting the rest into Macy's stores. By the time the closures were done, Federated had added 400 stores, bringing its total to 858. But the owner of Macy's and Bloomingdale's has offered little precise detail on the performance of former May stores. Until this February, it didn't include those locations in its calculation of sales at stores open at least a year--a critical measure of performance.

Edward Weller, an analyst at San Francisco-based ThinkEquity Partners, believes leaving out the weaker-performing May stores boosted Federated's same-store performance last year. Since it started including the May stores, Federated's results show monthly same-store sales rising an average 0.4% Through April, down from a 7.2% Average gain in the prior three months, when May stores were excluded. A Federated spokesman says: "We have provided an appropriate level of detail." CFO Hoguet says Federated didn't break out the earlier numbers because its same-store definition includes only stores it has operated for one fiscal year, and the first full year was 2006. The approach, while a legitimate choice, may not provide the most clarity for investors. It contrasts, for instance, with the approach of rival Bon-Ton Stores Inc., which broke out same-store results for its Carson's acquisition in the first quarter after its 2006 deal. Federated says it's not an apples-to-apples comparison, since Bon Ton kept Carson's a separate company.

UNDERSPENDING TROUBLES

The murky financials could bea concern for investors because Federated has recently boosted capital spending after lagging rivals for several years. From 2003 to 2005, BusinessWeek's calculations show that it spent well below depreciation levels, the benchmark for simply maintaining assets. Macy's rivals J.C. Penney and Kohl's spent much more than depreciation. In 2005, Penney's depreciation was $372 million, and it spent $535 million in outlays. For Kohl's, depreciation was $340 million and expenditures were $828 million. Last year, Federated doubled capital spending, to $1.4 billion.

Federated counters that it is not underspending at all. It says that "marking to market" the stores it acquires--reassessing their value in light of current market conditions--raises the value of its assets and thus increases depreciation costs. Georgia Tech accounting professor Charles W. Mulford, who studies retailers, observes, however, that the new, higher-asset value is a more accurate reflection of replacement costs.

Federated prefers to calculate capital expenditures as a percentage of sales. By that measure, it spent 2.9% of sales on capital improvements in 2005, about the same as Penney. Sleepy rival Dillard's Inc. (DDS ) spent more, at 6%. In 2006, Federated's outlay was 5%.

Getting a true handle on Federated's performance is difficult. But one thing is certain: Federated can't count on more help from one-time events such as credit-card sales. Now it's up to the May acquisition to deliver.

By Robert Berner

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