Federated's Rocky Road

One analyst takes a bearish view of the store operator's mega-merger.
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After the mega-merger debacles at major American companies such as

Time Warner

(TWX)

and

Hewlett-Packard

(HPQ) - Get Report

, it seems Wall Street would be wary of combining two stumbling behemoths under the same roof.

Not so at

Federated Department Stores

(FD)

, the longtime operator of Macy's, Bloomingdale's and a string of other department store chains. Last year, it acquired its chief competitor, May Department Stores, in a landmark deal that added Marshall Field's, Filenes and Lord & Taylor to its portfolio.

Out of the 16 analysts covering the stock on Wall Street, 11 now have bullish ratings on shares of Federated; some of these analysts have disclosed that their firms have an investment-banking relationship with the company. The remaining five analysts are neutral on the stock.

While no one has a negative rating, one independent analyst covering Federated says investors should steer clear -- and he happens to boast Wall Street's best track record on the stock.

"The grand plan behind the merger of Federated and May is to take a page from

Wal-Mart's

(WMT) - Get Report

playbook and get bigger in order to gain more clout with suppliers and reduce costs as a result," says Ivan Feinseth, director of research with Matrix USA. "To me, that's not how you grow your business if you're Federated. You grow your business by growing your sales organically and winning back customers."

Winning back customers is a tall proposition for the department store conglomerate. Established department stores have lost market share in recent years at the high end to specialty chains such as

Chico's

(CHS) - Get Report

and at the low end to discounting giants such as Wal-Mart. Meanwhile,

J.C. Penney

(JCP) - Get Report

has revitalized its business by revamping its merchandise, its sales floors and its online sales channels. While Federated wrestles with sorting out its merger, J.C. Penney is poised to grab market share of its own.

Much of the Federated's short-term plans are based on consolidation. It's selling off May's Lord & Taylor chain and converting its other regional chains to its Macy's nameplate by this fall. It also plans to sell several other stores, as well as its bridal business.

After all the speculation about real estate deals involving

Sears Holdings

(SHLD)

, investors are attracted to retail plays that have a real estate component. But Feinseth doesn't factor real estate gains into his investment rating on Federated.

"Most of their real estate is leased, so they don't own it," Feinseth says. "To the extent that they have below-market leases, those leases probably exist in undesirable places."

Feinseth also takes a negative view of the shopping experience at Federated's stores compared with those at competitors such as

Nordstrom

(JWN) - Get Report

, and he questions the rationale behind some of the company's strategy.

"Why would they ever re-brand Marshall Field's to Macy's?" he asks. "When you're in Chicago, it's Marshall Field's. Macy's is New York. I don't know how they want to take a brand name like Marshall Field's that is so entrenched in certain markets and just get rid of it."

Shares of Federated are up over 7% so far this year, and last week the company wooed investors by reporting a 59% jump in its fourth-quarter profit and a 1.1% gain in same-store sales. The results from continuing operations beat Wall Street's expectations, but Federated Chairman and CEO Terry Lundgren issued a conservative outlook, calling 2006 "a transition year." He indicated that earnings will be difficult to predict amid store closings, inventory clearances, brand conversions and systems integrations.

The retailer stuck with its tepid 2006 guidance, saying it expects to earn $3.45 to $3.70 a share in the current fiscal year, including integration costs of 5 cents to 15 cents a share. Analysts currently forecast earnings of $3.96 a share, apparently concluding that Federated's guidance is overly conservative.

While Wall Street often lives and dies by such earnings-per-share metrics, Feinseth values stocks using a methodology called EVA, or "economic value added." In gauging profits, he ignores accounting profits, which can be easily manipulated, and looks instead at a company's return on capital minus its cost of that capital. He then rates stocks using a screening system that combines various operating performance, risk and valuation factors.

It sounds complicated, but it's really just an attempt at getting a clean measure of the returns that a company is generating with the money it got from its shareholders. That performance is then combined with measures of a company's credit position and its price to come up with an investment strategy.

Feinseth's results are impressive, according to the Bloomberg Absolute Return Rank, an analytical tool on Bloomberg terminals that ranks analysts' performance on a stock on the basis of the timing of their buy, hold and sell recommendations. Feinseth was recently ranked No. 1, 2 or 3 on 87% of the 1,000 stocks covered by his firm for which his performance is ranked. He's ranked No. 1 on 58% of those stocks -- one of which is Federated.

Using EVA metrics, Feinseth calculates that Federated logged a return on capital in the fourth quarter of 6%, while its cost of capital was 7.1%. On the basis of this performance, he estimated that Federated is destroying shareholder value at a rate of about $250 million a year, and 63% of the companies in the Russell 2000 are outperforming it on a value creation basis.

On a risk basis, the retailer wins some points for its large size, but with negative free cash flow and $2.6 billion in long-term debt, it's still riskier than 65% of the companies on the Russell 2000.

Despite the negatives, Federated still qualifies for a hold rating from Matrix USA because its valuation is so low. Feinseth calculates that 85% of Russell 2000 companies have a higher valuation than the retailer, but that's hardly a reason for a long-term investor to choose Federated over its peers.

"It's not a really cheap stock based on their economic earnings power, but it's not overpriced," Feinseth says. "I'm not a fan of these kinds of big mergers to begin with. Federated's return on capital is trending higher now, so it could eventually go positive if everything goes right, but the stock is still not a compelling value here just because it's cheap. There are too many problems."