2 for Tuesday: Take Advantage of Federated's Sale Price

You can find good deals among the retailers' stocks. Take Federated Department Stores(FD), for example.

The stock is cheap, the business boasts top-of-the-line brand names, and the management is strong. If any retailer is a good bet to weather the coming storm, this might well be the one.

At around $32 a share, Federated is trading at a price-to-earnings ratio of just 9.4 times its 2002 per-share estimates of $3.40. That's one of the cheapest levels it's been at since February 2000, when Wall Street, its perception clouded by the tech bubble's high, convinced itself that e-tailers like Amazon.com (AMZN) would send bricks-and-mortar department stores the way of the dodo bird.

Federated for Sale The retailer boasts a cheap P/E ratio now

But Federated is still around, and it probably will be for a very long time. With revenue of more than $18 billion, Federated is the nation's largest department-store chain, operating more than 400 stores under some of the best, most enviable brand names in the business, including Bloomingdale's, Macy's, The Bon Marche, Burdines, Goldsmith's, Lazarus and Rich's.

Listing the Positives

It is also a well-managed company. Some members of Federated's senior management team, currently headed by CEO James Zimmerman, are no strangers to adversity. Zimmerman, along with Allen Questrom (who once served as Federated's CEO but is now at the helm of J.C. Penney (JCP)), brought Federated public in 1992 and pulled Macy's out of bankruptcy shortly thereafter.

Since then, Federated has played a leading role in consolidating the department store industry. In July, for example, Federated closed on its $200 million acquisition of Liberty House, Hawaii's largest retailer. The company is likely to become the dominant player in the longer term.

Company Statistics Federated Department Stores, Inc. (FD)
Stock Price:	$32.68
52-Week Range:	$26.05-$49.90
Market Capitalization:	$6.30 billion
Float:	144.5 million shares
Short Interest Ratio:	4.54
Institutional Ownership:	95%
Source: Yahoo finance

Aside from owning some of the most prized assets in the industry, Federated is also well known for its strong merchandising strategy, evidenced by its tremendously successful private-label business, or apparel and product lines that are available only in Federated stores. These include I-N-C International Concepts, Charter Club, Alfani and, most recently, Greendog, a new line introduced in 2000 for children ages 2 to 12.

Currently, private-label merchandise represents 15% of Federated's total department store sales. Private-label sales are growing faster and earn higher gross margins than the designer labels Federated sells.

Federated still expects to open seven to nine stores per year and to continue with improvements on existing stores. The company is also experimenting with new, smaller store formats, such as a 100,000-square-foot Macy's that opened in Palm Beach, Fla., last year and a 65,000-square-foot Bon Marche that's expected to open soon in Helena, Mont.

Compare those with the typical mall-sized department store, which measures about 250,000 square feet. The smaller-stores strategy gives Federated the flexibility to fit into the faster-growing shopping districts that it calls "lifestyle centers," which generally have smaller retail spaces available. This is important because fewer large regional malls are being built in saturated major cities.

Tough Times Ahead

Despite the strong long-term outlook, the near term will be undeniably rough for retail stocks, including Federated, which really took the Sept. 11 attacks on the chin. It was among the hardest-hit retail stocks, falling 18% from its Sept. 10 close of $31.77 to its 52-week low of $26.05 Sept. 21. After all, think about where its flagship Bloomingdale's and Macy's stores are.

Revenue and Earnings Per Share
	Revenue	Earnings Per Share
1999	$17.7 billion	$3.62
2000	$18.4 billion	$3.08
2001(est.)	$18.6 billion *	$2.87
2002(est.)	$18.7 billion *	$3.40
*Estimates from Yahoo Finance Source: Company reports

But Federated is buckling down for difficult times, starting with an Oct. 18 announcement that it expects full-year earnings for the period ending in January to be between $2.85 to $3 a share, before restructuring charges. That's down from the $3.60 to $3.80 a share that it forecast in August and lower than the year-ago $3.08.

Comparable-store sales, which are sales from stores open at least a year, plunged 12.9% in September, and the company expects comp-store sales to fall between 7% and 10% in October as well as in the fourth quarter. The lower sales base and significant markdowns that will be taken to clear out merchandise will kill store operating margins.

As a result, Federated is doing everything it can to control costs, such as cutting orders for the fall season, clearing out inventory and slashing capital spending. Capital spending is going from $850 million in 2000 to $750 million in 2001. In setting budgets for 2002, the company probably will base its plan on very conservative assumptions as well.

One final issue is Fingerhut, the catalog retailer that Federated purchased in 1999 to jump-start its direct-to-consumer segment (i.e., Internet sales). That was an unmitigated disaster. But Federated has restructured the division to drive profitability rather than growth, and it is still expected to contribute earnings before interest and taxes this year of between $75 million and $125 million. Now that Federated has admitted its mistake in acquiring Fingerhut, it may end up selling the division at some point.

Notwithstanding a bumpy road, there are some positives here. Surprisingly, just 5% of Federated's sales come from Manhattan. A hefty 24% of sales come from the New York metropolitan area, which includes suburban shopping districts such as Paramus, N.J. Those locales are doing better than the company average right now. Federated should produce strong free cash flow of about $700 million this year, thanks to inventory reductions and lower capital spending. The company's debt-to-capital ratio is a manageable 50%.

So if you're looking to take advantage of attractive valuations in the retail sector, consider Federated. The stock is trading at a big discount to its peer May Department Stores (MAY), which is selling at a P/E of 12.2. Assuming Federated got back to its historical average P/E of 12.5 (right around where May is trading now), this could be a $40 stock.

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