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Federated Faces More Trouble Ahead

Marc Lichtenfeld

Don't think the disappointments are over for Federated Department Stores(FD Quote - Cramer on FD - Stock Picks).

The retail heavyweight posted weaker-than-expected first-quarter results Wednesday and notched down its second-quarter outlook amid a soft sales showing.

Look for more of the same as 2007 progresses. I expect Federated will have trouble meeting even the low end of its forecast for the year as the company grapples not only with lackluster sales but also with margin problems.

Federated traditionally is a good retailer. It isn't afraid to change with the times and take risks. It has created a solid array of private-label goods, has sought to improve the customer experience by expanding dressing rooms and is attempting to keep shoppers within its walls by testing cafes in the stores. This is not a company that sits idly by when problems arise.

But make no mistake about it: Problems have arisen. The biggest one is the company's difficulty in attracting shoppers to stores that have recently been converted to the Macy's nameplate.

Federated acquired May Department Stores in 2005 for $11 billion, and the company spent much of last year switching hundreds of May stores, including such venerable brands as Foley's, Filene's and Marshall Fields, to Macy's. Shoppers simply didn't want the change, and Federated said this problem continued in the first quarter.

Management said on the conference call that the difficulties with the new stores were spread nationwide. It would have been better to hear that Macy's was not resonating in one area, because that would have been an easier fix. Reversing the trend around the country will be more complex -- and expensive.

To drive traffic, the company said it will place more ads promoting sales and discounts in the media, including television, newspapers and the Web, instead of sending them via direct mail. Federated said it is seeking to create a sense of "urgency" with shoppers to get them into the stores.

But the way to create that urgency is through promotions. That, in turn, likely will lead to deteriorating gross margin as the company is forced to sell marked-down merchandise.

And while the new advertising strategy may be correct -- especially since the company is still building its database of May customers, so direct mail isn't as effective -- there's no evidence that the marketing initiative will carry any oomph.

Management didn't discuss any new exciting campaign that would make the brand stand out above the rest. And with many retailers struggling and competing for traffic, Macy's certainly won't be the only store ramping up marketing and offering discounts to entice shoppers.

The scary thing is that this can become a slippery slope. If traffic doesn't pick up, either due to company-specific or macroeconomic issues, the competitive landscape will become even more intense, and Federated will have to further boost spending to ensure it captures market share during the critical back-to-school and holiday periods.

The company seems optimistic that things won't get much worse. Federated reiterated its earnings expectation for the year of $2.45 to $2.60 a share. While that is still below Wall Street's estimate of $2.68, it doesn't take the above scenario into play.

Using sales at the low end of Federated's projected range of $6 billion to $6.1 billion, and lower margins than most of Wall Street has projected, I expect Federated to earn $2.22 a share in 2007.

Although analysts might not agree with my prognosis (that's fine with me), it appears investors do. Federated's stock is priced at a sharp discount to its peers. Shares, at about $39.75, trade at a cheap 14.8 times forward consensus earnings estimates for 2007 and 17.9 times my estimate. That compares with a department store average of 19.7 times earnings.

If I'm wrong and Federated is able to ramp sales and convert customers, the stock is a bargain. But I expect investors to continue to be disappointed by more warnings throughout the year as sales languish and margins deteriorate.