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Why J.C. Penney Can Do All the Right Things and Still Fail

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There's a style of analysis that I'm going to call "Common Sense Math," which is all too often overlooked. It's the kind of thing that comes into play when football announcers say that a team hasn't won against Hyattsville University at home since 2010 -- but has also only played one other game there. J.C Penney (NYSE: JCP  ) announced yesterday that it had a rip-roaring holiday weekend, increasing November comparable store sales by 10.1%. In the face of weakness across the rest of the sector, that's pretty amazing.

It's amazing unless you're growing from a small base and doing it by slashing margins, that is.

150% of $10 is only $15
As others have pointed out, J.C. Penney didn't release November sales figures last year. However, the company did post a 28% drop in total sales for the quarter. That means that any growth this year was going to be on top of a huge decrease in 2012. Adding 10% onto that low base probably isn't enough to signal a turnaround.

The second problem is that J.C. Penney has been watching its margins drop all year long. Last year, the company managed a gross margin of only 31.3% for the full year. So far this year, the company is down to a gross margin of 29.9%.

How comparable sales work
There are two controls for increasing comparable-store sales -- average sale and number of sales. When investors look at comparable-store sales, we're really looking for an increase based on an increase in both the number of sales and the amount of those sales. A strong business is one that gets more people in the door and has them pay more for the things they buy.

A good example of strength right now is Michael Kors. Clearly, Kors and J.C. Penney are looking at different audiences, but Kors understands something that J.C. Penney doesn't. The high-end company has increased its comparable sales by increasing overall revenue and by selling at higher margins.

What J.C. Penney has been doing is trying to increase its total sales by selling stuff cheaper. This tactic increases the number of sales, but gives the business less bottom-line income for each sale. While it can work to rebuild traffic in a flagging business, it can also become a crutch that customers rely on, eventually refusing to pay anything like full price.

The long road ahead for J.C. Penney
A 10% increase in November might be good news. Without seeing the income statement for the month, investors can't know for sure. Even if the increase is small and even if it means a hit to the company's gross margin, it still might be the right thing to do. J.C. Penney is in a position where "right" and "good" aren't always going to align. If it can rebuild its consumer base without completely cannibalizing its gross margin, then it might be worth a temporary hit.

Even if it is good news, I'm still not tempted by the stock. With so many other good businesses out there, J.C. Penney is just a bridge too far. It may be cheap, it may have huge bounce potential, but it could also fall apart -- even by doing the right things. That looks less like a strong company and more like a brand that's not in control of its own destiny.

One company still in the driver's seat
Not everyone is at the mercy of the market in the same way that J.C. Penney seems to be. Even though the market stormed out to huge gains in 2013, opportunistic investors can still find huge winners. The Motley Fool's chief investment officer has just hand-picked one such opportunity in our new report: "The Motley Fool's Top Stock for 2014." To find out which stock it is and read our free, in-depth guide, simply click here.

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9/23/2016 4:00 PM
JCP $9.78 Up +0.02 +0.20%
J.C. Penney CAPS Rating: *