3 Reasons Sears and J. C. Penney Will Continue Failing

Until these companies come back to reality, investors should probably stay away.

Apr 1, 2014 at 6:30PM

Many years ago, a shopping trip to buy clothes for school meant a trip to the mall. When kids would pick out toys they wanted for the holidays, they would browse through the Sears Holdings (NASDAQ:SHLD) or J. C. Penney (NYSE:JCP) catalog. Unfortunately for both of these retailers, those days are gone, and they aren't coming back. Sears and J. C. Penney seem stuck in time, and relative to their competition, there are at least three reasons they will continue to fail.

Nostalgia only goes so far
To be fair, I used to be one of those kids looking at the Sears catalog. My family used to make those trips to J. C. Penney for new school clothes. However, in the last few years, we haven't stepped foot in a J. C. Penney, and Sears is a rare stop indeed.

The problem with both companies is they are largely tied to enclosed shopping malls for their primary locations. The mall is no longer the central hangout that it used to be; the most common comment about mall-based stores seems to be, "When did that close?"

In fact, in a recent USA Today article, Sears and J. C. Penney were listed as two of the nine retailers closing the most stores. The mistakes that both companies have made are almost carbon copies of each other.

The truth is, Sears and J. C. Penney are both trying to do what other companies are just better at. Macy's (NYSE:M) is better at focusing on high-end clientele and has the results to show for it. Target and Kohl's are better at selling clothes, and discount retailers like TJ Maxx, Marshalls, and Ross Stores, have better deals.

These are not discount retailers and need to stop pretending
In the last few years, J. C. Penney famously tried to rebrand itself as a discount- priced retailer and failed miserably. After multiple quarters of 20%+ comparable-store sales declines, the company finally recovered somewhat with a 2% increase in same-store sales in the last three months.

Sears hasn't been so lucky, reporting same-store sales declines of 6% to 8% between Sears domestic and Sears Canada and a 5% decline at Kmart. By contrast, Macy's reported a 1.4% increase in same-store sales in the current quarter.

The first challenge for both Sears and J. C. Penney is rebranding themselves as higher-end retailers. In fact, Macy's should be their blueprint for success, as the company carries a gross margin of more than 40% compared to a 28% margin at Penney's and a 24% margin at Sears. Continuing to try and compete at the lower end will only lead to more pain for both stores.

So much money!
The second issue facing both Sears and Penney's is the companies spend too much on selling, general, and administrative expenses relative to their service levels and layout. Macy's spent 25% of revenue on SG&A, but in a store with a 40% gross margin and a reputation for quality service this makes sense.

Sears, on the other hand, has centralized checkout islands and a much lower gross margin. But it spent almost 26% on SG&A at Sears domestic stores and more than 29% on SG&A at Sears Canada. With less of a reputation for service, and lower margins, Sears simply can't afford this type of SG&A expense.

J.C. Penney is suffering in a similar way. The company's SG&A percentage was almost 27% in the current quarter, and again this is far too high. Penney's locations and selection do not scream high-end quality, yet the company is spending more on SG&A than its peers.

Time to face reality
The third problem facing Sears and Penney's is both companies are taking on debt as though their results deserve additional investment. In the last year, J. C. Penney's long-term debt net of cash increased by 73%. In a similar way, Sears' long-term debt increased by more than 35%. As you might have guessed, the more successful Macy's cut its net long-term debt by 10% in the last year.

In the end, it is simple. Sears and J. C. Penney both have gross margins that suggest the wrong pricing strategy. Compounding this error, both companies are spending too much on SG&A and meanwhile are taking on debt.

Sears is divesting businesses and reprioritizing, and J. C. Penney is getting back to its old sales. But if neither company faces these significant problems, it won't matter. I think that investors should stay away from both companies until they realize the error of their ways.

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Chad Henage has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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