J.C. Penney: Explosive Turnaround or Short-Term Rebound?

Source: J.C. Penney.

J.C. Penney (NYSE: JCP  ) has risen by an explosive 60% over the last three months as investors are gaining confidence about its chances to implement a successful turnaround, but the company is not out of the woods yet. With J.C. Penney scheduled to report earnings this week, in addition to imminent earnings reports from competitors Macy's (NYSE: M  ) and Kohl's (NYSE: KSS  ) , investors have important reasons to pay close attention to announcements in the sector over the coming days.

Signs of improvement
On Feb. 26, J.C. Penney delivered encouraging news to investors, announcing a material improvement in sales during the quarter and optimistic guidance for the rest of the year.

Total sales during the quarter ended on Feb. 1 increased by 1.6% to $3.78 billion when excluding the 53rd week in 2012. Comparable-store sales grew by 2% versus the same period of the prior year, which signals stabilization and even perhaps the beginning of a turnaround.

Gross margin came in at 28.4% of sales, an increase of 460 basis points versus 23.8% in the year-ago quarter. However, J.C. Penney is still in the red, and margins remain materially below the profitability levels reported by competitors.

While Kohl's had a challenging quarter during the period ended on Feb. 1, it reported an increase in gross margins to 34% of sales versus 33.3% during the same quarter in 2013.

Macy's is doing materially better than other department stores, delivering industry-leading gross margins at 40.6% of revenues during the quarter ended on Feb. 1. This was stable compared to the prior year.

If J.C. Penney is going to turn a profit in the coming quarters, it will need to start generating higher margins, which is not easy to do considering that the retail industry is notoriously competitive when it comes to pricing lately.

One of the biggest reasons for optimism regarding J.C. Penney is that management provided fairly strong guidance, both for the coming quarter and the full year.

The company expects comparable-store sales to increase between 3% and 5% during the first quarter of fiscal 2014 and by mid-single digits during the full fiscal year. In addition, the company is forecasting gross margin to "improve significantly" versus 2013, both in the coming earnings release and through the full year.

Time to deliver
J.C. Penney will be reporting earnings after the market close on Thursday, while Macy's is scheduled to report on Wednesday before the open and Kohl's will announce earnings on Thursday morning. This means investors will be getting valuable information to evaluate J.C. Penney, both on a stand-alone basis and in comparison to peers, this week.

Based on the latest earnings report, it's hard to tell whether sales are really stabilizing or if J.C. Penney delivered a short-term bounce in November via unsustainably aggressive promotions. The company had previously announced an increase of 10.1% in comparable-store sales during the month of November, so a 2% overall increase for the November to January quarter could have been achieved in spite of lackluster performance in December and January.

If J.C. Penney can deliver in accordance with guidance for an increase of between 3% and 5% in same-store sales during the February to April quarter, this would provide a lot of validation for the bull thesis by showing that the company is in fact stabilizing sales in a permanent way, as opposed to relying on unsustainable short-term discounts to inflate revenues.

While Macy's delivered an increase of 2.3% in comparable-store sales during the last quarter, management is forecasting comparable sales during the current fiscal year to grow in the range of 2.5% to 3%. Kohl's suffered a decline of 2% in comps during the last quarter, and management is expecting comparable sales to be between flat and a 2% increase during the first quarter of fiscal 2014.

An increase of between 3% and 5% in comparable sales for J.C. Penney would not only mean that the company is clearly improving but also outgrowing the competition. Especially if J.C. Penney can manage to continue to raise profit margins to levels more in line with those of the competition, this would be a big positive for investors.

On the other hand, disappointing sales and margins would indicate that management is overpromising and underdelivering, not exactly a good sign when it comes to evaluating the company's prospects for a turnaround.

Foolish takeaway
J.C. Penney has delivered encouraging news for investors lately, but it's still not clear whether the company is implementing a sustainable turnaround or if improvements in the latest earnings report were only transitory. The coming earnings release from J.C. Penney could be crucial in terms of evaluating the risks and potential for gains in the medium term.

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