Business Context and Reporting Period
This Form 10-Q covers the 13-week period ended April 29, 2006, for Federated Department Stores, Inc. (now Macy's, Inc.). The reporting period is heavily influenced by the August 30, 2005, acquisition of The May Department Stores Company ("May"). The company is currently integrating May's operations, converting regional nameplates to the Macy's brand, and divesting approximately 80 duplicate store locations. The financial statements reflect the adoption of SFAS 123R regarding share-based payments and include results from discontinued operations (David's Bridal, Lord & Taylor) which are being sold.
Key Financial Metrics
| Metric | Q1 2006 | Q1 2005 |
|---|---|---|
| Net Sales | $5,930 million | $3,641 million |
| Gross Margin | $2,297 million (38.7%) | $1,465 million (40.2%) |
| Operating Income | $20 million | $252 million |
| Net Income (Loss) | $(52) million | $123 million |
| Diluted EPS (Continuing Ops) | $(0.13) | $0.36 |
| Cash from Operating Activities | $(114) million | $56 million |
| Total Debt (Short + Long Term) | $10,183 million | $3,861 million |
| Cash and Equivalents | $241 million | $918 million |
Material Changes vs. Prior Period
- Revenue Growth: Net sales increased 62.9% to $5.93 billion, driven primarily by the inclusion of May's operations. On a comparable store basis, sales were flat.
- Profitability Decline: Operating income dropped significantly to $20 million from $252 million. This was due to $123 million in May integration costs, higher SG&A expenses (36.3% of sales vs. 33.3%), and increased interest expense ($138 million vs. $54 million) from acquisition-related debt.
- Margin Compression: Gross margin percentage decreased to 38.7% from 40.2%, impacted by markdowns in legacy May locations and $6 million in inventory valuation adjustments.
- Balance Sheet Expansion: Total assets nearly doubled to $33.1 billion, and total debt increased to $10.2 billion to finance the $11.7 billion May acquisition.
Guidance, Outlook, and Risks
- Integration Costs: Management anticipates incurring an additional $521 million to $596 million in May integration costs for the remainder of fiscal 2006.
- Cost Synergies: The company expects to realize $175 million in cost savings in 2006 and at least $450 million annually starting in 2007.
- Store Portfolio: Approximately 80 stores are identified for divestiture (accounting for ~$2.2 billion in pro forma 2005 sales). As of June 7, 2006, 56 had been sold or agreed upon. The company plans to add ~400 Macy's locations via nameplate conversion.
- Credit Card Sale: The company is selling its credit card receivables to Citigroup. Transactions completed in May 2006 generated pre-tax gains of approximately $184 million combined, with proceeds used to repay short-term borrowings.
- Subsequent Events: A two-for-one stock split was approved (payable June 9, 2006). An IRS settlement resulted in a $155 million refund and an $80 million tax benefit recognized in Q2 2006.
- Risks: Key risks include the successful integration of May, realization of synergies, disruption to customer/vendor relationships, and general consumer spending levels.
Investor Verification Checklist
- Integration Progress: Verify the pace of store conversions and the actual realization of the projected $450 million annual cost savings.
- Divestiture Execution: Monitor the completion of the remaining store sales and the impact on the balance sheet and cash flow.
- Debt Servicing: Assess the company's ability to service the increased debt load ($10.2 billion) as interest rates fluctuate and integration costs continue.
- Comparable Sales: Scrutinize future comparable store sales trends, as Q1 2006 was flat, indicating potential challenges in the core business outside of the acquisition.
- Credit Card Transition: Confirm the final closing of the Citigroup credit card asset sale and the long-term impact of the new servicing agreement on earnings.