Is J.C. Penney on the Path to Higher Profits?

J.C. Penney  (NYSE: JCP  ) appears to be gaining ground in the retail sector, as the company showed an improvement in sales performance during the third quarter. For the quarter ended Nov. 2, comparable store sales improved in October and sales, along with the gross margin, grew sequentially during the quarter.

Despite comp store sales declining 4.8%, this was an improvement of 710 basis points from the second quarter. October's comparable store sales ended the quarter on a high note with a positive gain of 0.9%. The company's website, jcp.com, had quarterly sales of $266 million , up by almost 25%.

The third quarter sees a rise in missing inventory
The company attributes the performance improvement to continued efforts in improving the shopping experience for customers and providing them with the right merchandise. In its earnings release, J.C. Penney spoke highly of its employees and attributes much of the recent success to them. The company's various management and performance issues in recent months led to significant layoffs and poor morale for current employees.

This may have played a role in the significant rise in inventory shrinkage during the third quarter, which negatively affected gross margin by 1.1% more than in the previous quarter. The industry average for inventory shrinkage per year is about 1.5% of total merchandise, an amount that nearly matches J.C. Penney's quarterly increase.

In the latest earning call, CEO Myron Ullman suggested that a new merchandise security system was to blame. Merchandise previously tagged with security sensors was causing interference with a new system that uses more modern radio-frequency technology. During the period when the sensors were removed and the new system was put in place, the company believes that it became easier for merchandise to end up stolen or missing .

How do J.C. Penney and other retail giants expect to finish the year?
Going into the holiday season, J.C. Penney and competitors Macy's (NYSE: M  ) and Kohl's (NYSE: KSS  )  face a challenging retail environment. J.C. Penney expects comparable-store sales and gross margin to grow sequentially in the fourth quarter over last year, although a specific percentage was not provided. Merchandise inventory should total about $2.85 billion by year-end, and liquidity is expected to be over $2 billion .

Kohl's believes it will see higher customer traffic during the holiday shopping season due to its wide merchandise selection. The company's third quarter results saw a drop in sales of 1% and flat comparable-store sales compared to last year. Net income in the third quarter dropped by 18%. Kohl's fourth quarter guidance is somewhat pessimistic; the company expects total sales to decline 2%-4%, and comparable-store sales to decline 0%-2%. The annual earnings per share forecast for fiscal 2013 was downgraded to $4.08-$4.23 from a previous estimate of $4.15-$4.35 .

Macy's noted much stronger third quarter sales results. Comparable-store sales rose by 3.5%; when including departments licensed to third parties, such as Michael Kors and Sunglass Hut, which is owned by Luxottica, sales rose 4.6%. EPS for the quarter was $0.47 per share, which was up 31% over last year for the 15th consecutive quarter of growth.

Macy's anticipates that success in the fourth quarter will be driven by its selection of exclusive products from popular brands and designers. The company plans on hiring an additional 83,000 seasonal employees to support the sales effort. The earnings guidance set in August remains unchanged – comp sales growth is expected to be 2%-2.9% by the end of fiscal 2013. Diluted EPS should range between $3.80-$3.90.  

My Foolish conclusion
J.C. Penney appears to be moving forward after dealing with a variety of management and operational issues that sent investors running for the exits. Results in its recent quarter could be the start of a more positive trend for the company. However, the steep rise in inventory shrinkage is worrisome. It could be a sign of continued employee discontent at the retailer, or just an unfortunate event related to the new security system. It will be interesting to see if the company reports a fourth quarter improvement in inventory shrinkage, which would be a sign that the new security system is working. Overall, J.C. Penney remains a work in progress within a challenging retail environment.

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