JCPenney: A Little Progress and a Lot of Problems

Troubled retailer J.C. Penney (NYSE: JCP  ) showed improvement when it reported its first-quarter results last week, and shares of the company rocketed higher on the news. Same-store sales rose, gross margin expanded, and operating expenses were kept in check. While other department stores like Kohl's (NYSE: KSS  ) and Macy's (NYSE: M  ) struggled during the first quarter as rough weather ate into their sales, J.C. Penney's results appeared very good, at least on the surface. However, the fundamental problems that the company is facing still exist, and the first-quarter results aren't nearly as good as they seem.

Putting same-store sales into perspective
J.C. Penney grew its same-store sales by 6.2% during the first quarter, or 7.4% using the new calculation method that the company will use from now on. This is an acceleration compared to the fourth quarter's 2% increase, and it's significantly better than the negative same-store sales reported by Kohl's and Macy's.

However, there are two problems here. First, this 6.2% increase is from a significantly depressed level. In the first quarter of 2013, same-store sales declined by 16.6%, and in the first quarter of 2012, same-store sales declined by 18.9%. So while J.C. Penney appears to have performed well, the same-store sales growth needs to be put into perspective.

Company

Q1 2012

Q1 2013

Q1 2014

J.C. Penney

-18.9%

-16.6%

6.2%

Kohl's

0.2%

-1.9%

-3.4%

Macy's

4.4%

3.8%

-1.6%

Same-store sales growth
Growing same-store sales after two years of double-digit collapses is not all that impressive of a feat. While the first quarter this year certainly showed an improvement, it was a small improvement compared to an absolutely dismal first quarter in 2013. J.C. Penney did 6.2% better than absolutely terrible.

The second problem is the source of this same-store sales growth. Store traffic was down during the first quarter, so the entirety of the same-store sales growth came from an increase in transaction size. This isn't surprising, since J.C. Penney's main problem as it recovered from the Ron Johnson era was that it had a bunch of inventory that didn't resonate with its core customers. Working through that inventory and replacing it with products that customers wanted to buy was what drove same-store sales growth. This also accounted for the increase in gross margin during the quarter.

The fact that store traffic still decreased is not a good sign. Store traffic did increase during the month of April, as management pointed out during the conference call, but with Easter being on April 20 this year compared to March 31 last year, the timing of the holiday makes it difficult to tell if store traffic has finally turned a corner. The company has guided for a mid-single-digit increase this year in same-store sales, and this points toward traffic trends not getting much better.

J.C. Penney needs more revenue
Single-digit same-store sales growth is simply not enough, given the massive declines during the previous years. Even though J.C. Penney has managed its operating expenses well its cost structure is still unsustainable, especially compared to the competition:

Even if J.C. Penney manages to get its gross margin back to the high-30s, the company's operating expenses as a percentage of revenue are so high that it will still record operating losses. While J.C. Penney has managed to reduce its operating expenses, it can only cut these costs by so much without closing stores. Management stated during the conference call that the current level of operating expenses will be roughly the run rate going forward, so there likely won't be much more cost cutting.

This means that the only way for the company to become profitable is to grow its revenue, because growing gross margin alone won't be enough. Growing revenue will require store traffic to begin to increase again. We'll have to wait and see if the gains during April are real or just the result of the timing of Easter, but if mid-single-digit same-store sales growth is an accurate projection for the year, then J.C. Penney is still a long way away from turning an operating profit. Also, this is before factoring in nearly $400 million in annual interest payments, based on the $97 million in interest the company paid during the first quarter.

The bottom line
While J.C. Penney showed improvement during the first quarter, a comparison to a dismal first quarter in 2013 makes the results appear better than they really are. Store traffic is still declining, and the same-store sales growth resulted from replacing unwanted merchandise with what customers wanted. J.C. Penney has still not proven that it can get customers back to the stores, and until then, profitability remains a distant dream.

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  • Report this Comment On May 27, 2014, at 2:44 AM, blockfrom3062 wrote:

    I lost count on how many articles Motley Fool has written that are anti-JCP. After a while one gets the idea that Motley Fool is trying to use it's pulpit to drive the price down and discourage support. In a year when they have gained market share and the price is much higher than it is today, I'd like to see a Motley Fool article showing her they erred. Bet you'll never see that article.

  • Report this Comment On May 28, 2014, at 6:47 AM, longjcptoppick wrote:

    this Motleys FOOLS Writer is an IDIOT.. he bashes JCP while he pumps macys... REPORTED this writer to SEC.. to see if they could arrest THIS MOTLEYS FOOLS WRITER.. all should ignor this IDIOT. BELONG JCP... better than ever.. will pass MACYS..

    J.C. Penney: In The Long Term, A Lot More Room To Run

    May. 22, 2014 11:33 AM ET | 90 comments | About: J.C. Penney Company Inc. (JCP)

    Disclosure: I am long JCP. (More...)

    Summary

    JCP's operations are beginning to hum.

    The sell-side and buy-side are not yet on board which is their mistake.

    The long-term free cash flow generating ability of the Company should be worth much more.

    I continue to be amazed at how J.C. Penney (JCP) the stock trades compared to JCP the business. Since the stock offering in the fall, the Company has stabilized and now grown comps in the face of severe industry headwinds, brought back private label and promotions which have improved margins, and guided to FCF neutral on the year. All of this in the face of a brutal retail environment. Bon-Ton Stores (BONT) by contrast just reported another weak quarter though they did manage 35%+ gross margins which is where JCP is headed this year as well if not better. JCP debt has responded by rocketing to the highs while the stock is well off its lows, it continues to trade well below the $9.65 offer price and the intrinsic value.

    20,279 people received this article by email alert

    Add your email to get alerts on JCP too:

    Get email alerts on JCP »

    Why the disconnect? I do believe that CEO, Mike Ullman, bears some of the blame. While I can not argue with his operational success if not genius in rapidly reversing the nosedive under Ron Johnson and credit the board for bringing him back in the face of withering criticism from Ackman, who resigned from the board and sold his stock over the issue of CEO control (among other things), I can fault Ullman's ability to manage the street and his stock price. From the ham-handed way the offering was handled to the two line holiday same store sales release that panicked investors that Christmas was a disaster when in reality it was on plan and one of the best showing of any department store chain. The 6-7% comp. in Q1 simply blew away expectations and left the bears scrambling for ways to knock the stock down. If Ullman is to be the permanent CEO, he must do more to manage investors and his stock price or he should go.

    Here is where the story gets interesting. The bears have been mostly using static analysis to say J.C. Penney was going bankrupt. There last two quarters and FCF neutral guide for year end tell you that is just not going to happen. A new credit line with an extra $500mm also tells you that equity dilution is far less likely if not a zero possibility. For most of the time since I started posting on JCP after the offering, the bears have been saying that Chapter 11 or massive dilution was inevitable and that JCP was stuck at $12 billion in sales and low 30s gross margins, never mind that every comp does mid to high 30s and that sales were $17 billion before Ron Johnson came on board.

    One thing to beware from the sell side and buy side commentators is a shift in story. The facts have clearly changed as even the most hardened bear will say that J.C. Penney is on the mend. The bear argument has now shifted to one of valuation which is a slippery slope since JCP is very cheap to its long-term earning power. Two of the biggest bears, Wells and Imperial are essentially using this argument to help the shorts and intercapital arbs cover in a bad macro tape at levels that are too cheap to be believed. For the last several quarters, Wells has been using JCP's good numbers and contorting the facts to say the Company is really still going bankrupt. Now that his theory has been blown out of the water (q4 and q1 results plus a 20 point drop in 5 year CDS to the mid teens from the mid 30s shows just how wrong Wells has been), the analyst has shifted to saying that the stock is overvalued. Valuation is more of an art and a science, but JCP appears to be on track to undo most of not all of the RJ damage. I am even running scenarios where the company actually gets to higher than $17 billion in sales, as it takes share from Sears (SHLD), Kohl's (KSS), Macy's (M) and BONT.

    What would a back to the future JCP look like? If JCP were to get back to $17 billion in sales and 39% margins which is where it was under Ullman before the RJ debacle (assuming no additional growth from the economy as they recapture share) and were able to keep SGA around $4 billion (it was bloated before that is one thing RJ got right and Ullman has continued), EBITDA goes to the $2.6 billion to $2.7 billion range by 2016. The Company pays off most if not all of its debt by then. A modest 6x multiple yields about $50 a share. If one looks at pretax free cash flow, the Company would generate about $7.35 a share, 10x that number is $75 for the stock. That is the money that the long-term bulls are playing for.

    I think this can happen by 2016, which gives Ullman 3-4 years. If it takes longer so be it, but the point I would make is as long as we are fcf neutral we have unlimited time for this to play out. Also it is obvious that JCP is taking share from bont, m, kss, shld, etc. based on the recent reports. The assumptions would be:

    Rev: 17003.308

    Gross Profit:6631.29

    SGA: 4000

    Net Debt: 0

    Multiple: 6x EV/EBITDA

    With 400mm of cap-ex, should generate about 7.35 of FCF per share This is why stock was in 30s even before Ackman.

    Bears will say that is impossible given where they are now, but bears have been calling for negative comps and near term bankruptcy and that looks silly now. These numbers are really just getting back to what JCP did under Ullman a few years ago with a lot of debt pay down and some SGA improvement and capital efficiency that they have already shown able to do. Who is really being more unrealistic? These numbers aren't even that exciting, what if JCP actually gets some of the sales productivity that Johnson and Ackman were dreaming of when they bought the stock in the 20s and 30s? Much higher numbers are possible.

  • Report this Comment On May 28, 2014, at 6:48 AM, longjcptoppick wrote:

    J.C. Penney: In The Long Term, A Lot More Room To Run

    May. 22, 2014 11:33 AM ET | 90 comments | About: J.C. Penney Company Inc. (JCP)

    Disclosure: I am long JCP. (More...)

    Summary

    JCP's operations are beginning to hum.

    The sell-side and buy-side are not yet on board which is their mistake.

    The long-term free cash flow generating ability of the Company should be worth much more.

    I continue to be amazed at how J.C. Penney (JCP) the stock trades compared to JCP the business. Since the stock offering in the fall, the Company has stabilized and now grown comps in the face of severe industry headwinds, brought back private label and promotions which have improved margins, and guided to FCF neutral on the year. All of this in the face of a brutal retail environment. Bon-Ton Stores (BONT) by contrast just reported another weak quarter though they did manage 35%+ gross margins which is where JCP is headed this year as well if not better. JCP debt has responded by rocketing to the highs while the stock is well off its lows, it continues to trade well below the $9.65 offer price and the intrinsic value.

    20,279 people received this article by email alert

    Add your email to get alerts on JCP too:

    Get email alerts on JCP »

    Why the disconnect? I do believe that CEO, Mike Ullman, bears some of the blame. While I can not argue with his operational success if not genius in rapidly reversing the nosedive under Ron Johnson and credit the board for bringing him back in the face of withering criticism from Ackman, who resigned from the board and sold his stock over the issue of CEO control (among other things), I can fault Ullman's ability to manage the street and his stock price. From the ham-handed way the offering was handled to the two line holiday same store sales release that panicked investors that Christmas was a disaster when in reality it was on plan and one of the best showing of any department store chain. The 6-7% comp. in Q1 simply blew away expectations and left the bears scrambling for ways to knock the stock down. If Ullman is to be the permanent CEO, he must do more to manage investors and his stock price or he should go.

    Here is where the story gets interesting. The bears have been mostly using static analysis to say J.C. Penney was going bankrupt. There last two quarters and FCF neutral guide for year end tell you that is just not going to happen. A new credit line with an extra $500mm also tells you that equity dilution is far less likely if not a zero possibility. For most of the time since I started posting on JCP after the offering, the bears have been saying that Chapter 11 or massive dilution was inevitable and that JCP was stuck at $12 billion in sales and low 30s gross margins, never mind that every comp does mid to high 30s and that sales were $17 billion before Ron Johnson came on board.

    One thing to beware from the sell side and buy side commentators is a shift in story. The facts have clearly changed as even the most hardened bear will say that J.C. Penney is on the mend. The bear argument has now shifted to one of valuation which is a slippery slope since JCP is very cheap to its long-term earning power. Two of the biggest bears, Wells and Imperial are essentially using this argument to help the shorts and intercapital arbs cover in a bad macro tape at levels that are too cheap to be believed. For the last several quarters, Wells has been using JCP's good numbers and contorting the facts to say the Company is really still going bankrupt. Now that his theory has been blown out of the water (q4 and q1 results plus a 20 point drop in 5 year CDS to the mid teens from the mid 30s shows just how wrong Wells has been), the analyst has shifted to saying that the stock is overvalued. Valuation is more of an art and a science, but JCP appears to be on track to undo most of not all of the RJ damage. I am even running scenarios where the company actually gets to higher than $17 billion in sales, as it takes share from Sears (SHLD), Kohl's (KSS), Macy's (M) and BONT.

    What would a back to the future JCP look like? If JCP were to get back to $17 billion in sales and 39% margins which is where it was under Ullman before the RJ debacle (assuming no additional growth from the economy as they recapture share) and were able to keep SGA around $4 billion (it was bloated before that is one thing RJ got right and Ullman has continued), EBITDA goes to the $2.6 billion to $2.7 billion range by 2016. The Company pays off most if not all of its debt by then. A modest 6x multiple yields about $50 a share. If one looks at pretax free cash flow, the Company would generate about $7.35 a share, 10x that number is $75 for the stock. That is the money that the long-term bulls are playing for.

    I think this can happen by 2016, which gives Ullman 3-4 years. If it takes longer so be it, but the point I would make is as long as we are fcf neutral we have unlimited time for this to play out. Also it is obvious that JCP is taking share from bont, m, kss, shld, etc. based on the recent reports. The assumptions would be:

    Rev: 17003.308

    Gross Profit:6631.29

    SGA: 4000

    Net Debt: 0

    Multiple: 6x EV/EBITDA

    With 400mm of cap-ex, should generate about 7.35 of FCF per share This is why stock was in 30s even before Ackman.

    Bears will say that is impossible given where they are now, but bears have been calling for negative comps and near term bankruptcy and that looks silly now. These numbers are really just getting back to what JCP did under Ullman a few years ago with a lot of debt pay down and some SGA improvement and capital efficiency that they have already shown able to do. Who is really being more unrealistic? These numbers aren't even that exciting, what if JCP actually gets some of the sales productivity that Johnson and Ackman were dreaming of when they bought the stock in the 20s and 30s? Much higher numbers are possible.

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