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With shares of J.C. Penney (NYSE: JCP ) up considerably from their 52-week low last month, investors seem to be gaining confidence in Penney's turnaround efforts. When the company reported its earnings on Nov. 20, a return to comparable-store-sales growth in the month of October was all it took to send shares soaring. But it's clear from digging into the earnings report that J.C. Penney has a very long road ahead of it, especially as it faces rising competition from peers Macy's (NYSE: M ) and Kohl's (NYSE: KSS ) , and that the stock is being supported by hope rather than real progress.
J.C. Penney recorded revenue of approximately $2.8 billion in the third quarter, with comparable-store sales falling 4.8% for the quarter. The good news is that each month in the quarter saw improvement, and that comparable-store sales increased by 0.9% in the month of October. This improvement would seem to point to real progress being made at the troubled retailer.
The company recorded a non-generally accepted accounting principles, or non-GAAP, net loss of $457 million, including a considerable charge related to a tax valuation allowance. Online sales jumped by 24.5% year-over-year, quite an accomplishment, and J.C. Penney managed to pay back $200 million of revolving- credit-line debt. The company now has $1.7 billion in available liquidity, including cash and available credit, and expects this number to increase to $2 billion by year-end.
Too good to be true
There's a big problem with this story. While comparable-store sales did increase in October, this increase was achieved by drastically marking down merchandise. It seems that J.C. Penney is trying to clear out inventory from the Ron Johnson era by offering extreme discounts, sometimes below cost.
While this may boost sales, it does so at the expense of profitability, and a quick look at the income statement for the quarter confirms this issue. While total sales fell by 5.1% during the quarter, the cost of goods sold was nearly flat compared to the same period last year.
This means that J.C. Penney hasn't yet shown any real progress at all. Increasing sales by selling products at less than cost isn't an accomplishment worth celebrating, and the numbers presented by management as "proof" that the turnaround is taking shape should be taken with a heaping helping of salt. Only once this old merchandise is fully cleared out will the real test begin.
Trouble for other retailers
If J.C. Penney continues with its strategy of extreme markdowns during the holidays, competitors like Kohl's (NYSE: KSS ) and Macy's (NYSE: M ) may end up losing considerable market share. Kohl's is especially susceptible, given that the company focuses on low prices, and it may already be feeling the heat of more fervent competition.
In its third quarter, Kohl's reported an 18% decline in profits and lower sales, and the company guided for lower full-year earnings than it had previously indicated. With J.C. Penney practically giving merchandise away, this holiday season will be a tough one for Kohl's.
Macy's may fare a little better, since the store is a bit higher end than its discount-focused peers. Macy's reported a strong third quarter earlier this month, with a 31% jump in profits and a 3.5% rise in comparable-stores sales. More importantly, the retailer showed confidence going into the holiday season, a stark contrast to Kohl's lackluster projections.
J.C. Penney could still potentially steal away sales from Macy's, with the company's forecast proving to be overly optimistic, but so far the heavy discounting hasn't affected Macy's at all. This bodes well for Macy's going into the holidays, with more value-orientated stores like Kohl's likely to take the brunt of J.C. Penney's attempted comeback.
The bottom line
The third quarter only proved that J.C. Penney can boost sales by selling items at below cost, with real improvement yet to be seen. With heavy discounting likely to continue into the holidays, it's unlikely J.C. Penney will turn a profit anytime soon. A recent share offering has bought the company more time, but J.C. Penney has a very long road ahead of it.
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