What Caused the Latest J.C. Penney Sell-off?

The long-term outlook for J.C. Penney remains bright despite the latest sell-off.

Jan 17, 2014 at 5:55PM

In what seems to be a surprise development, shares of beleaguered big-box retailer J.C. Penney (NYSE:JCP) have tanked a jaw-dropping 12% in just under a week to trade at the current $7.20, despite the company's management recently announcing that they were pleased with J.C. Penney's December holiday performance. So. you might wonder, why are investors punishing J.C. Penney? Is there more than meets the eye with the recent announcement? Meanwhile, J.C. Penney's ailing counterpart Sears Holdings (NASDAQ:SHLD) has seen its shares trade down to hit multi-year lows.

It is instructive to note that J.C. Penney's management did not release specific sales figures during their latest announcement. This rattled investors because J.C. Penney has been releasing its sales figures for the last three months, whenever its sales were improving. Investors have therefore made their own inferences about the near-term prospects of the retailer. Basically, the recent sell-off has been triggered by fears that intense competition in the retail space will push J.C. Penney to look for other sources of liquidity in a bid to continue growing its sales. Here are a few takeaways from J.C. Penney's recent release.

Future profitability to come at a cost
J.C. Penney's return to profitability continues to be pushed out via steadily improving same-store sales. J.C. Penney CEO Myron Ullman recently explained that the retailer planned to do a series of major inventory adjustments via trimming or eliminating unprofitable brands and focusing more on profitable ones.  Under the new changes, some Ron Johnson-era product lines such as Martha-Stewart-designed home furnishings, Joe Fresh clothing, and JCP Menswear will be given the boot. New product lines such as Am Brielle lingerie, JCP Home and Cooks, and the St. John's apparel line will be introduced to J.C. Penney's product portfolio around February this year.

Investors are concerned that J.C. Penney will have to look for further sources of liquidity in 2014 to make the necessary inventory changes. Of course that kind of credit financing will come at a penalty to equity holders.

Big ticket merchandise still stagnant despite considerable product markdowns
Investors are also concerned that some big ticket items such as JCP Furniture are still moving sluggishly even though the company has engaged in heavy promotions and extensive product markdowns. J.C. Penney might have to resort to a fire sale to get its slow-moving furniture out the door and rest its floor space. This will further negatively impact its already-squeezed gross margin.

Heavy product markdowns eating into profitability
In a bid to get rid of the snafu-laden merchandise of the Ron Johnson era, J.C. Penney has turned to extensive product markdowns. This in turn has badly affected its gross margin, which has continued to tick down as the quarters roll on. Through a series of market and economic cycles, J.C. Penney's gross margin has averaged around 37%. However, the company's current gross margin now hovers around just 23%, and it fell a further 300 basis points in the third quarter.

In comparison, J.C. Penney competitor Macy's (NYSE:M) boasts an industry-leading gross margin of close to 40%. Kohl's (NYSE:KSS) still sports an impressive 37.5% gross margin, despite the data point having ticked down an astonishing 600 basis points year-over-year in the third quarter of 2013. Macy's has been busy retooling its merchandising strategy and creating a more personalized experience. Meanwhile Kohl's has focused more on national brands to drive traffic.

CEO Myron Ullman revealed that J.C. Penney's long-term gross margin target lies in the 37%-39% range. Clearly the retailer is a long way from this mark, and it will take some time for it to get there. J.C. Penney relies heavily on its large horde of bargain hunters to drive its sales. The firm depends on extensive product markdowns and heavy promotions to attract these customers to its stores.

It's not like J.C. Penney's gross margin is the lowest in the industry. Costco (NASDAQ:COST), the country's largest warehouse retailer, marks up its products just 15%. This strategy has worked very well for Costco and it has helped the retailer continue to grow even as many big-box retailers are ailing. There is a current trend of widespread bargain hunting across U.S. retail stores, and J.C. Penney might have to stick to lower prices for the time being to keep its customers coming back.

J.C. Penney is still a good turnaround bet
J.C. Penney was recently ranked one of the country's top-ten fashion stores by a recent Market Forces survey. This proves that the retailer's gravitas remains intact, despite all of the recent changes.

Although J.C. Penney was a bit coy about releasing its latest sales figures, the last time it did so was in November when it revealed that same-store sales had improved a remarkable 10.1% year-over-year. During the third quarter call, Ullman revealed that the retailer is working hard to put back in place the necessary components to return its gross margin to its historical level. Investors can expect a natural forward progression in the gross margin as the firm's overhang of undesirable inventory is gradually removed.

J.C. Penney has also been working hard to restore the prominence of its private brands such as St. John's Bay and Worthington. Private brands command significantly higher margins than their national brand counterparts, by as much as 400-500 basis points. J.C. Penney is restoring the initial markups to its merchandise, and it will concentrate on the heavy promotions that it's famous for.

Foolish bottom line
In contrast, ailing Sears Holdings is not a good turnaround bet, as I pointed out in this bearish article. Unlike J.C. Penney, Sears has continued to report awful sales and it lacks a comprehensive turnaround strategy. Its investors are primarily interested in management unlocking value by selling Sears' extensive real estate properties. However, that is akin to burning your house furniture to keep warm, and can only take you so far. It would be wise for long-term investors to open new positions in J.C. Penney by taking advantage of the low price of the shares, or holding on to shares at the very least.

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Fool contributor Joseph Gacinga has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale. The Motley Fool owns shares of Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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