Why J.C. Penney May Be a Better Turnaround Bet Than Sears

While J.C. Penney (JCPN.Q), Sears Holdings (SHLDQ), and Best Buy investors eagerly wait for elusive turnarounds, these beleaguered big-box retailers seem to be held together feebly by blue kinesiology tape. These three have witnessed more false dawns than Groundhog Day, and every time one of them turns a corner it quickly crashes into a wall.

That's why J.C. Penney investors were so excited when the company released its latest results, which revealed that chief executive Mike Ullman might finally be succeeding in turning his battleship around. Same-store sales improved 2% from the year-ago quarter, a 680 basis-point improvement. Its online division grew sales 26.3%. The company had free cash flow of $246 million and finished the year with more than $2 billion in available liquidity, which was something of a miracle considering that many sell-side analysts had expected J.C. Penney to go bankrupt during the year. Another bright spot in the company's earnings call was the 460 basis-point improvement in its gross margin, which rose from 23.8% to 28.4%.

Although the gross margin is still way below its historical average of around 38%, this is a sure sign that the company might be finally getting rid of its Ron Johnson-era merchandise. Heavy product markdowns on this merchandise led to J.C. Penney's low gross margins in the previous quarters. J.C. Penney's naysayers can squawk that 2012 was pretty awful so the year provided an easier benchmark for last year's metrics. The good news, however, was that J.C. Penney's absolute metrics such as free cash flow and liquidity were still quite impressive.

Meanwhile, ailing Sears continues to rely on its extensive real estate properties, some of which it intends to convert to data centers while it will sell the really prime ones. Sears reported that it lost $1.4 billion for the whole of fiscal 2014, with same-store sales plunging 7.8%. Ailing peer Best Buy at least turned a profit of $310 million in the fourth quarter of fiscal 2013, much better than the year-ago quarter's loss of $461 million.

J.C. Penney's strategy vs. Sears' turnaround strategy
J.C. Penney's turnaround strategy radically differs from that of Sears. Under former CEO Ron Johnson, J.C. Penney discarded its traditional retailing practice of marking up its products and then offering fat discounts and coupons on its merchandise, instead adopting an 'everyday low price' policy. Mr. Johnson reasoned that the company's heavy discounting policies not only cut into its pricing power, they also considerably diminished its gravitas in the eyes of its customers. He scrapped several brands that he considered rather drab and introduced newer ones such as the Martha Stewart and Joe Fresh lines.

However, J.C. Penney's customers were not happy and store traffic nosedived. By the end of 2012, sales had tanked 25%. The overambitious CEO tried feverishly to lure customers back but nothing seemed to work.

It was not until Myron Ullman returned to the helm that J.C. Penney stuttered back to life. He revealed sometime late last year that Penney was trimming or eliminating unprofitable brands such as JCP Menswear, Joe Fresh clothes, and several brands of Martha Stewart-designed furniture. Mr. Ullman also announced that the retailer planned to introduce new brands such as JCP Home, Cooks, and the Am Brielle lingerie line.

To get rid of the old merchandise, J.C. Penney has been offering heavy product markdowns and this has inevitably beaten down its gross margin. However, Mr. Ullman has revealed that the turnaround is almost complete, so investors can expect to see a natural upward progression of the gross margin. A quick caveat: although Penney's historical gross margin resides north of 37.5%, it is unlikely to zoom there quickly since the company plans to continue discounting its goods to keep its customers coming back.

J.C. Penney also plans to close 33 of its unprofitable stores. About 25% of these stores are concentrated in the Wisconsin area. However, it is unlikely that the company will close many other stores soon. This is due to the fact that anchor stores routinely sport long-term leases which are expensive to break. Penney might therefore prefer to continue to operate the unprofitable stores rather than break their leases and pay the price.

That is in and of itself a good thing, since the losses from these underperforming stores are already priced into J.C. Penney's shares. If J.C. Penney's turnaround continues moving along its current trajectory, then these unprofitable stores could potentially become goldmines for the company's shareholders.

Sears has a very different turnaround strategy from that of J.C. Penney. Its management and shareholders have continued to tout the unrealized value of its numerous real estate properties, many of which it intends to convert to data centers.

However, the real value of these properties continues to be a subject of debate, especially after the highly controversial Baker Street Report left Wall Street's opinions on the company divided right down the middle. 

Sears Holdings: Two views
The table below shows how Sears' assets are valued by two opposing firms, Baker Street and Credit Suisse; one has a bullish stance and the other is decidedly bearish.

Research analyst Rich Kurtzbein, who follows data centers for 451 Research LLC, warns that the viability of converting Sears' shopping malls is questionable at best.

Sears, unlike J.C. Penney, does not seem to be very intent on turning around the flagging fortunes of its ailing retail stores. That's why its sales have continued to decline one quarter after the other.

Foolish takeaway
J.C. Penney is not the falling knife which it has been labeled by its detractors, it is rather a company that is serious on making a comeback. Meanwhile Sears is busy selling off its extensive real estate properties to fund its operations and keep investors happy while its retail fortunes continue on a tailspin. That strategy is comparable to burning your house furniture to keep warm; eventually you will be left with no furniture to burn. J.C. Penney is a better turnaround bet than Sears.