Will J.C. Penney Shock Investors With Another Strong Quarter?

The beleaguered retailer reports first-quarter earnings this week after a surprisingly strong fourth quarter.

May 13, 2014 at 11:50AM

J.C. Penney (NYSE:JCP) will report first-quarter results on May 15. The century-old chain had a rough couple of years pursuing -- and promptly dropping -- a daring turnaround strategy. But the holiday season was unexpectedly kind to the company, and it's possible for metrics to improve to the levels of Macy's (NYSE:M) or Nordstrom (NYSE:JWN). But what does the first-quarter report need to show to make J.C. Penney a contender? 

Jc Penney Store

Source: J.C. Penney

Analysts estimate J.C. Penney to report $2.7 billion in revenue and a loss per share of $1.25. But the company has missed revenue and earnings-per-share estimates in three of the past five quarters. So it's important to dig deeper into the results.

What should investors watch for in J.C. Penney's first-quarter earnings report? 

Comparable-store sales
The department stores have all suffered comps slips in recent years, but J.C. Penney was hit particularly hard during then-CEO Ron Johnson's turnaround attempt. The chain's comps for 2012 were down 25%. But J.C. Penney showed surprising strength in the recent fourth-quarter report.

J.C. Penney's comps were up 2% in the fourth quarter compared to Macy's and Nordstrom's growth of 1.4% and 2.6%, respectively. And J.C. Penney's performance was made more impressive by the fact that it was attached to a fiercely competitive holiday shopping season.

The company predicted comps growth of between 2%-5% for the first quarter. Further comps improvement in the first quarter would show that J.C. Penney is really on the road to recovery. But missing that mark -- or turning in another large drop -- could show that the fourth-quarter comeback was a glitch.

Inventory turnaround 
Myron "Mike" Ullman returned as J.C. Penney's CEO in 2013 and promptly began the Herculean task of undoing an overhaul that was halfway complete. Inventory turnaround took a major hit while Ullman worked to clear out Johnson-introduced inventory that failed to connect with shoppers while reintroducing popular brands.

J.C. Penney was forced to use steep markdowns to move a backlog of inventory that was driving up the days inventory outstanding, or DIO. Generally, lower DIOs are better because that shows a company is successfully moving its products. J.C. Penney's DIO historically ran higher than Nordstrom but lower than Macy's. But the metric has risen past Macy's in the last two years. 

JCP Days Inventory Outstanding (Quarterly) Chart

J.C. Penney days inventory outstanding (quarterly) data by YCharts

YCharts calculates quarterly DIO by dividing average inventory by cost of goods sold, or COGS, and then multiplying by 91.5, which is 365 days divided by four to represent a quarter. Investors can work out this calculation alone, but it's much easier to use a service such as YCharts for this number and a quick competitor comparison.

And then turn your attention to the final key to J.C. Penney's recovery.  

Gross profit margin improvement 
Those steep promotions that J.C. Penney ran to clear out inventory and potentially improve DIO in the long run also did a number on the company's gross profit margin. I previously detailed the formula for gross profit margin; a higher number is better since there's enough money left over after costs trickle down to net income.

J.C. Penney's gross profit margin has plummeted over the past two years, whereas the company's numbers used to interweave with the results of Macy's and Nordstrom. The company's margins dropped because the growth difference between revenue and COGS has widened in favor of COGS. 

JCP Profit Margin (Quarterly) Chart

J.C. Penney profit margin (quarterly) data by YCharts

Standard promotions such as sales and coupons have historically flowed from J.C. Penney. When Ron Johnson tried to do away with coupons, customers fled the scene. But while promotions of any kind can impact potential margins, the inventory troubles took more of a toll than general coupons. 

So inventory turnaround and gross profit margins are deeply connected. And combining both can give an investor a relatively quick -- but deep -- look at J.C. Penney's overall health. 

Foolish final thoughts  
J.C. Penney and Nordstrom report first-quarter earnings on the same day, while Macy's reports the day before -- providing investors an opportunity to quickly compare the performances. The fourth-quarter report was better than expected, but the first-quarter report could help prove whether that performance was a fluke or a sign of things to come.

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