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Business Context and Reporting Period

Company: Federated Department Stores, Inc. (operating brands include Macy's, Bloomingdale's, The Bon Marché, Burdines, Goldsmith's, Lazarus, and Rich's).

Reporting Period: Fiscal year ended February 1, 2003 (52 weeks).

Operations: The Company operates 394 department stores and 61 furniture galleries across 34 states, Puerto Rico, and Guam. During the period, the Company completed the liquidation and sale of its Fingerhut Companies, Inc. subsidiary, which is now reported as discontinued operations. The Company also announced plans to integrate Rich's and Macy's stores in the Atlanta area under a combined nameplate.

Key Financial Metrics

Margins: Operating margin improved to 8.7% in 2003 from 7.1% in 2002. Cost of sales decreased to 60.0% of net sales from 61.2%.

Material Changes vs. Prior Period

• Profitability Turnaround: The Company returned to profitability with $818 million in net income, reversing a $276 million net loss in the prior year. This improvement was driven by a $180 million gain from the disposal of discontinued operations (Fingerhut) and improved operating income from continuing operations.
• Discontinued Operations: The sale of Fingerhut assets generated $924 million in cash. Proceeds exceeded estimates, resulting in a $307 million pre-tax adjustment to the loss on disposal recorded in the prior year.
• Comparable Store Sales: Comparable store sales decreased 3.0% in 2003 compared to a 5.3% decrease in 2002. Sales were strong in private brands and furniture but weak in soft home categories.
• Debt Reduction: Total debt decreased by approximately $517 million due to the repayment of $1,015 million in borrowings, including $598 million of receivables-backed financings and $400 million of senior notes.
• Accounting Changes: The adoption of SFAS No. 142 eliminated goodwill amortization, reducing SG&A expenses. Additionally, a $261 million reduction in shareholders' equity was recorded due to increased minimum pension liability.

Guidance, Outlook, and Risks

2003 Guidance: Management forecasts earnings per share from continuing operations of $3.05 to $3.25 for fiscal 2003. Comparable store sales are forecasted to be flat to down 1.5% for the full year.

Management Commentary: The Company expects store closings and consolidation costs (Rich's-Macy's) to negatively impact near-term sales and income but anticipates long-term benefits to operating income and cash flow. Pension expense is expected to increase by $15-20 million in 2003 due to lower assumed rates of return and discount rates.

Risks and Contingencies:

• Legal Proceedings: The Company is a defendant in consolidated securities class action litigation alleging false statements regarding financial condition and credit delinquency at Fingerhut. Management intends to defend vigorously.
• Debt Covenants: The Company must maintain an interest coverage ratio of no less than 3.25 and a leverage ratio of no more than 0.62. While currently compliant, a deterioration in results could trigger a default.
• Pension Obligations: The Pension Plan is underfunded by $207 million, and the Supplementary Retirement Plan is underfunded by $216 million. Future expense is sensitive to changes in discount rates and asset returns.

Investor Verification Checklist

• Verify the sustainability of the $180 million gain from discontinued operations, as it is a non-recurring item.
• Monitor the execution of the Rich's-Macy's consolidation and the associated $68 million in restructuring costs.
• Assess the impact of the $261 million pension liability adjustment on future cash flow requirements and equity.
• Review the status of the securities class action litigation regarding Fingerhut disclosures.
• Track comparable store sales trends, specifically in the "soft home" categories which underperformed.