Value Investors Club / Federated Department Stores (FD)

Description

Federated Department Stores is a highly liquid larger cap name that offers investors significant upside potential with reasonable downside protection. Let’s get straight to the point. FD trades at 6.6x EBITDA, 9.5% FCF yield, has $18/share in land value, a fantastic management team and is aggressively buying back more than 25% of the stock. Investors generally miss this equity primarily because the analyst estimates are way too low (resulting in a higher headline P/E multiple) and it is not perceived to be an equity with high growth characteristics. I think the stock can generate over $4 in FCF next year and trade into the low $60s.

One of the key attractions of Federated is that the drivers of earnings growth are largely controllable and not dependent on a strong consumer. The delta between the street’s projections and what you need to believe FD will achieve to like the investment is driven by cost synergies and share buybacks. Management has conservatively laid out estimates for merger synergies that they should be able to beat handily. Sales and margins, particularly in the old May stores, are at depressed levels, and have a new focused management team that will be driving improvement from a low base.

Generally speaking I am very catalyst oriented and this position is no different. For FD, the catalyst is tied to the buybacks. From 2006 though 2007, the company will have bought back just shy of 28% of the shares outstanding and from a timing standpoint, the bulk of the repurchases have only recently started. The company bought back $831mm in Q3, $1.382bn in Q4, and over $2bn since January 31, 2007. This leaves Federated with roughly $2.2bn left on its authorization which should be completed by year end.

With buybacks, synergies, operational rebound potential, private equity put option, one would think FD should trade at significantly higher valuation than 10.5x FCF, I believe that by the end of the year as the story plays out this will correct meaningfully.

Valuation Stats (2007/2008):

EV/EBITDA – 7.3x/6.6x

EV/EBITDA – Cap Ex – 10.5x/8.8x

EV/EBITDA – Main Cap Ex – 8.8x/7.7x

P/FCF – 14.3x/10.5x

P/E – 14.7x/11.4x

Key Point to the Thesis

1) Synergies from FD/May merger will drive earnings going forward

2) May store sales are substantially depressed (25% below 2000 levels); FD management team should be able to bring the sales per foot and margins of May stores near FD levels over the long term

3) Substantial land ownership combined with cheap valuation provides downside protection

4) Strong management team with history of strong operational success

5) Shareholder friendly company with right approach to capital allocation

Business:

Federated Department Stores is the largest department store chain in the US with roughly $27bn in sales and 858 stores. The company was formed through the merger of Federated and May on August 30, 2005 bringing together brands such as Macy’s, May, Bloomingdales, Marshall Fields, etc. This deal strategically fits as it brings together two chains (May & Macy’s) under one name (Macy’s) and allows for management to 1) realize synergies and 2) close the financial disparity between the two chains.

Strategic Fit:

Within the department store sector, May & Macy’s (FD’s business) were actually very similar chains. Both operated with a similar store size (150k-200k sq ft), marketed to a similar demographic customer, and were complementary from a geographical perspective. While the customer had come to think of both chains for different things, there are no structural differences between them. This is how the situation developed. In 2000 FD & May had roughly the same sales per square foot (FD has $201 v May at $200) and May had a higher margins (12.3% for May v 10.6% for FD). While the businesses were very similar at the time, after the slowdown in the economy the companies took different routes. FD focused on quality products, exclusive merchandise and used fewer promotions, while May relied heavily on promotions to move inventory & drive comp store sales. May chose to compete more directly with the Kohl’s of the world rather than focus on differentiation. This shows up in the numbers as sales per square foot and profitability decline significantly for May relative to FD. Since FD has acquired the chain, they have closed a number of stores, liquidated all the inventory at May locations, re-branded the chain entirely as Macy’s, and started a consolidated marketing campaign.

FD MAY

2000:

Sales Per Foot $201.3 $199.6

EBITDA Margin 14.6% 15.9%

EBIT Margin 10.6% 12.3%

2005:

Sales Per Foot $190.8 $164.3

EBITDA Margin 13.9% 11.4%

EBIT Margin 9.5% 7.1%

(I used TTM financials for May prior to the acquisition. It is worth mentioning that if you look at 2006 results, the difference in sales per square foot has widened. I calculate $152.5 for May and $202.2 for FD.)

There is no structural reason management shouldn’t be able to close this gap and effectively bring margins and sales productivity up to the levels of FD. If this is achieved EBITDA will grow by an incremental $750mm adding FCF of $1.15 per share. That being said, you do not need to underwrite this improvement to own the stock.

Synergies:

The company has guided to $450mm in synergies, which I believe to be conservative for the following reasons: 1) This estimate does not include any reductions in advertising (I est. at $150mm). 2) The FD/MAY deal is different from other M&A transactions in that it is a full name plate change. By consolidating two stores into one there will be significant leverage of single brand advertising in addition to the closing of redundant sourcing offices, and incremental DC shutdowns. 3) Management has historically been conservative with synergy guidance and 4) Recent results indicate that the company is greatly exceeding synergy targets. Overall, I believe $700-$750 is a more appropriate range.

While we can run theoretical numbers from layoff and corporate office closings, I think the most significant data point is the synergies achieved in Q4 alone. Revenues declined by 4% compared to last year and the company achieved almost 200bps of leverage on the SG&A line. While part of this improvement was due to lower pension expense, I estimate that the company pulled $200mm out of the business in the fourth quarter or $800mm on an annual run rate. Given the significance of the synergies realized, I think it is very likely the company will show substantial earnings growth from SG&A leverage over the next 12 months.

It is also worth reviewing management’s history of conservatism with respect to synergies. If you look back to the Federated/Macy’s merger of 1994 you will find a number of similarities to the FD/MAY merger (good UBS report on it). Like FD/May, the 1994 deal created the largest department store chain in the country at the time, had opportunity in private label goods, had the same management team, and beat significantly on the targeted synergies. It is worth noting that management delivered margins of 140bps in excess of their targets in the years following the deal. While it is unclear exactly how much came from cost synergies v normal improvements in the business, you can get close to $5 per share in normalized FCF by taking the 140bps of margin beat and add it to the midpoint of FD’s L-T target of 14%-15% EBITDA Margins on 2009 sales.

Land Value:

I believe the land value for FD is worth around $8bn. While the 10-K coming out should give us some better disclosure, I have tried to piece together the pro-forma land ownership from older filings. As indicated from historical filings, May owned 66% of its stores and ground-leased an additional 11%, while Federated owned 44% and ground-leased an additional 19.2%. Using these numbers, I believe the combined FD owns approximately 81mm square feet directly and an additional 23mm square feet in ground-leases. If you apply $100 in value per foot to the owned footage and assign no value no value to the ground-leases, you will get a value of around $18 per share. While some of the following deals are for smaller boxes, it is worth pointing out that these values are significantly higher than my assumption for price/foot.

Kids R Us sold to ODP (2004) - $120

Vornado buys Broadway Mall (2005) - $127

Vornado buys Boston Design Center (2005) - $174

Kimco buys Pan Pacific Properties (2006) - $177

Centro Buys Heritage (2006) - $112

Vornado buys Federated Filene’s Building (2006) - $152

Basic Snapshot of Numbers:

The numbers below provide a brief snapshot as to what the business looks like if you take 2006 EBITDA, add in incremental synergies from here, and grow the business by a 3% comp number through 2008.

TMT EBITDA $3,538

Add Inc Synergies $500

3% Comp CAGR $250

Adj EBITDA $4,288

Adj FCF $3.91

When you look at these numbers, you can get real upside to the stock from current levels without assuming the May stores will improve to Federated performance levels. If you believe the company can close the gap, you can get an incremental $1.15 of FCF and a stock under 6x EBITDA. I would also like to point out that I am assuming the company continues to buy back $1.75bn of stock. I believe this level of buyback is conservative as it 1) is materially below current run rates and 2) assumes the Net Debt/EBITDA declines slightly. Just to give you a sense of implications of the buybacks, you can get an additional $.20 per share if you assume FD repurchases as much stock in 2008 as they plan to in 2007.

While the growth rate should be significantly higher over the next few years, I did want to spend a second and outline the core growth in the business. On a 3% comp, I believe the company can conservatively grow its EBITDA by $125mm per annum. When you put this together with $1.75bn of buybacks each year, I think the company can post EPS growth in the mid teens. I believe it is reasonable for this stock to trade at a mid teens multiple getting you to a value above $60 per share.

FCF Generation:

FCF should be above Net Income going forward as Cap Ex is slightly below D&A and there is little change in working capital (runs at 1.4% of sales). D&A is just shy of $1.3bn while Cap Ex is planned at $1.2bn this year and slightly lower in 2008. Of the $1.2bn, 15% is related to new stores and 30% of the remaining capital spend is classified as discretionary. While I am not expecting the cap ex to drop off significantly down the road, I do believe you can get a little over $.25 per share of incremental FCF on a normalized basis.

Financial Projections:

	1/31/2007	1/31/2008	1/31/2009	1/31/2010
Revenues	26,970	27,304	28,487	29,572

Gross Profit	10,951	11,171	11,727	12,174

EBITDA	3,538	2,816	3,345	4,679

EBIT	2,273	2,776	3,205	3,439

EPS	$2.10	$3.02	$3.89	$4.65

Gross Margin	40.6%	40.9%	41.2%	41.2%
EBITDA Margin	13.1%	10.3%	11.7%	15.8%
EBIT Margin	8.4%	10.2%	11.3%	11.6%

FCF:
Net Income	1,148	1,291	1,519	1,661
D&A	1,265	1,240	1,240	1,240
Working Capital	-	(5)	(18)	(16)
Capital Expenditures	(1,317)	(1,200)	(1,100)	(1,100)
Total	1,096	1,326	1,641	1,785

FCF Per Share	$2.00	$3.10	$4.20	$4.99

For my projections, I have assumed a 2.7% comp for 2007 with the May business at 1.3% and Federated at 4.1%. For 2008 & 2009, I have modeled in 2% comps for the Federated stores and 5% for the May stores as I believe May will start to show improvement. I am keeping gross margins relatively flat (slight improvement in 2007) and assuming the SG&A grows at 2.5% per foot (excluding the synergies). For the synergies, I have modeled in $290mm for 2007 and an incremental $150 in 2008. As for the share count, I am assuming $1.75bn of stock repurchases for 2008 & 2009 at $50 and $55 per share, respectively. It is worth mentioning that despite the higher comps for May in 2008 and 2009, the sales per square foot difference between FD & May will still be substantial ($215 for Federated v $170 for May in 2010).

Private Equity:

While there has yet to be any rumors of private equity interest in the stock, I do think it is a good candidate for a buy-out. With the high levels of FCF generation, low leverage and embedded land value, I think one could still pay a decent premium to current levels and easily achieve 20%+ IRR. While I am not betting on a deal here (believe management is doing the right thing), I do believe this provides investors with some downside protection to the extent there is a problem.

Risks:

While I am less concerned about the consumer here (improvement in business is tied to cost savings and mismanagement of May stores), there are some industry headwinds in 2007. In 2006, the overall industry did receive some one time benefits from the closures of stores, mainly from Mervyn’s & and FD/May merger. These closures did benefit FD as well as most of the large players in the industry (can see it in the comps of FD, KSS, JCP, JWN, etc.). Now, as we lapse these closures in 2007 and experience some incremental square footage growth from JCP & JWN, I believe there will be a slight industry headwind. See below.

	2005	2006	2007	2008
Incremental Capacity Change:
Mervyns		(1,839)	1,079	-
FD		(1,079)	1,603	151
JWN		-	(6)	155
JCP		-	588	370
Total		(2,918)	3,264	675

Industry Revenues	114,719	115,315	117,621	119,974
% Impact		-2.5%	2.8%	0.6%

Catalysts:

1) Massive buybacks, 2) significant earnings beats, and 3) cheap valuation with high levels of FCF

Catalyst

1) Massive buybacks, 2) significant earnings beats, and 3) cheap valuation with high levels of FCF

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			2007	2008
Price:	44.36	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	20,200	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT