In Search of the Future at Federated Stores

Wall Street will want to see some strategy when it reports earnings.
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Shareholders will probably let the new incarnation of

Federated Department Stores

(FD)

have a mulligan when it reports earnings this week, but their patience won't last forever.

After completing an $11 billion merger with its longtime rival, May Department Stores, and weathering an especially turbulent hurricane season, Federated will deliver its third-quarter results to Wall Street on Wednesday. Analysts are expecting a profit of 23 cents a share for the department store giant, according to consensus estimates reported by Thomson First Call.

(In other retail-related news,

TheStreet.com's

Troy Wolverton looks at the holiday outlook for makers of

consumer electronics while Nick Godt looks at

consumer spending.)

Those results would mark the midpoint of the company's guidance, which called for earnings between 20 cents and 25 cents a share. Last year, Federated earned 42 cents a share, but the circumstances that produced those results bare little resemblance to those the company currently faces.

"Given all the expenses they've been taking in terms of their merger integration and their store closures, and the big difference in share count between this year and last year, it's very difficult to zero in on any apples-to-apples comparison for these results," said Ken Perkins, president of RetailMetrics LLC. "They'll probably come up with some sort of pro forma number for a comparison on Wednesday, but they haven't published it yet."

As a result, Federated's top line offers a better gauge of the changing circumstances at the retailer. Analysts are expecting third-quarter revenue totaling $5.7 billion, up 63% from its sales of $3.5 billion in the same quarter last year.

That gain comes from the addition of 465 department stores formerly owned by May that will turn Federated into a $30 billion, 950-unit retail powerhouse with its reach greatly expanded into the Midwest.

May, which operated major department store chains like Lord & Taylor's, Filene's, Hecht's and Marshall Field's, succumbed to a sale after its former CEO, Gene Kahn, was ousted by its board in January. At that point, the company was trailing Federated in attempts to expand private brands and compete with specialty retailers and discount giants.

Despite that victory, Federated, which has operated Macy's and Bloomingdale's, among other chains, faces its own survival challenges in the shifting sands of retail. Its revenue growth has declined by about 1% on average over the last five years as discounters such as

Wal-Mart

(WMT) - Get Report

and

Target

(TGT) - Get Report

, and specialty players such as

Chico's

(CHS) - Get Report

have nipped away at its market share.

Terry Lundgren, Federated's CEO, has made it clear that he plans to wield the retailer's new size to achieve cost savings and other competitive advantages that will shore up a place for department store chains in the modern retail landscape. He plans to convert all of May's regional chains, except Lord & Taylor and Marshall Field's, to the Macy's nameplate by the fall of 2006.

Meanwhile, to avoid monopolizing certain markets, Federated plans to sell off 26 stores in five states. It also expects to divest 75 other stores. Some investors have pinned their hopes for a higher valuation of the company based on those and other potential asset sales, like the sale of its credit card operations and its bridal business.

In the meantime, Federated is faced with the awesome task of integrating two cumbersome retail conglomerates with weak sales trends into one functioning company. Such integrations have a history of disappointment on Wall Street. Most recently, the mega-merger of Sears and Kmart that formed

Sears Holdings

(SHLD)

has soured after a series of sobering quarterly reports. The stock is down 20% since the beginning of August.

Shares of Federated also have come down over that span by 14%, to around $65, amid concerns that consumer spending may slow this winter. Last week, the company said its same-store sales declined in October by 0.7% compared to the same month last year.

The results disappointed Wall Street, but the company blamed the drop on store closings as a result of Hurricane Wilma. During the month, 36 Macy's stores and five Bloomingdale's stores were shuttered as a result of the storm.

Deutsche Bank analyst Bill Dreher said in a recent research note that he doesn't believe the October sales weakness will translate into lower-than-expected earnings. With a buy rating and a $100 price target, Dreher predicts a bright future for Federated.

"We believe that the industry-rationalizing, consolidating and margin-expanding nature of the deal will earn Federated a stronger multiple," he said.