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Business Context and Reporting Period

This Form 10-Q covers the fiscal quarter ended August 3, 2002, and the 26-week period ended on the same date for Federated Department Stores, Inc. (doing business as Macy's, Inc.). The company operates department stores under the Macy's and Bloomingdale's banners. The reporting period is characterized by the completion of the disposition of the Fingerhut Companies, Inc. (classified as discontinued operations) and the ongoing conversion of former Stern's stores to Macy's and Bloomingdale's.

Key Financial Metrics

Note: Total Debt figures include a $457 million increase in consolidated debt due to the reclassification of the Prime Credit Card Master Trust II as a secured borrowing in July 2002.

Material Changes vs. Prior Period

• Net Income Surge: Net income for the quarter increased 156% to $282 million, driven primarily by a $149 million after-tax gain from the disposal of discontinued operations (Fingerhut). Income from continuing operations increased 7% to $133 million.
• Sales Performance: Net sales were flat for the quarter ($3,486 million vs. $3,488 million) but declined 1.5% for the 26-week period. Comparable store sales decreased 2.8% for the quarter and 2.9% for the 26-week period, attributed to weaker economic conditions.
• Margin Improvement: Cost of sales as a percentage of net sales improved to 58.8% (Q2 2002) from 61.2% (Q2 2001), benefiting from lower markdowns and inventory levels. The prior year included $7 million in inventory valuation adjustments related to Stern's closure.
• Restructuring: The current period had no restructuring charges, whereas the prior year included $27 million in Q2 and $79 million for the 26-week period related to the Stern's division closure.
• Accounting Changes: The adoption of SFAS No. 142 eliminated goodwill amortization, reducing SG&A expenses by approximately $7 million in the quarter compared to the prior year.

Guidance, Outlook, and Risks

Outlook and Guidance

• Earnings: Management expects earnings per share from continuing operations of $0.35 to $0.45 for the third quarter and $2.05 to $2.20 for the fourth quarter.
• Sales: Comparable store sales are now forecast to increase 1% to 3% for the third and fourth quarters, a reduction from prior guidance of 3% to 3.5% due to economic weakness.
• Expenses: SG&A expenses are expected to increase 1% to 3% in absolute terms, though the rate as a percentage of sales is expected to improve.

Risks and Contingencies

• Legal Proceedings: The company is a defendant in a consolidated securities class action lawsuit regarding alleged misstatements about financial condition and credit delinquency at Fingerhut. Additionally, shareholder derivative suits regarding the disposition of Fingerhut are pending, though one was dismissed and the other is under appeal.
• Economic Conditions: Future results depend heavily on general economic conditions, consumer confidence, and spending levels.
• Discontinued Operations: While the core Fingerhut portfolio was sold, negotiations to sell remaining catalog subsidiaries (Arizona Mail Order, Figi's, Popular Club Plan) are ongoing with no assurance of consummation.

Investor Verification Checklist

• Discontinued Operations Impact: Verify the sustainability of earnings by isolating the $149 million gain from the Fingerhut disposal, which significantly inflated net income.
• Debt Consolidation: Confirm the impact of the $479 million increase in consolidated debt resulting from the reclassification of the Prime Credit Card Master Trust II.
• Comparable Store Sales: Monitor the trend of comparable store sales, which declined nearly 3% year-over-year, against the lowered guidance of 1-3% growth for the remainder of the year.
• Legal Exposure: Track the status of the securities class action lawsuit and shareholder derivative suits regarding the Fingerhut liquidation.
• Inventory Levels: Assess the company's ability to maintain lower inventory levels to support gross margin improvements as projected in the outlook.