Is J.C. Penney a Turnaround Story or Not?

jcpenney.com

J.C. Penney (NYSE: JCP  ) might seem difficult to figure out in regard to its turnaround potential, but there's faint writing on the wall. Many investors want to know if they would be better off in Macy's (NYSE: M  ) .

A big turnaround?
In the first quarter, J.C. Penney's sales increased 6.3% year over year. More importantly, comps (sales at stores open for at least one year) improved 7.4%. This impressive performance has been attributed to remerchandising many areas of the store and a new marketing campaign. However, a lot of it also has to do with J.C. Penney returning to a promotional approach, which has attracted many of its once-loyal customers again.

Selling, general, and administrative expenses have also decreased to 36% of sales from 40.9% of sales on a year-over-year basis. This is mostly thanks to lower corporate costs and reduced advertising. Additionally, gross margin has improved to 33.1% of sales from 30.8% of sales, primarily thanks to a change in product mix.

J.C. Penney is doing a better job at managing expenses, but when it comes to comps performance, keep in mind that this is a comparison with a quarter during the Ron Johnson (former CEO) era when comps declined 17%. His approach of modernizing the store, scratching promotions, and offering more "current" merchandise in order to attract younger consumers fell flat on its face.

In other words, it's easy for J.C. Penney to show improvement compared to such a disastrous time period in its history. And not all of the first-quarter numbers were great if you look beyond the surface.

Numbers don't lie
J.C. Penney reported a net loss of $352 million in the first quarter compared to a net loss of $348 million in the year-ago quarter. However, this quarter's loss came in at $1.15 per share versus $1.58 per share in the first quarter of 2013. Also note that $22 million of the loss in this year's first quarter was due to restructuring and management transition charges, a temporary event. But even if you subtract the $22 million, that still leaves a very long road to profitability.

In January, J.C. Penney announced the closing of 33 stores as part of its strategy to return to profitability. And on May 15, it obtained a $2.35 billion senior secured asset-backed credit facility (replacing a $1.85 billion asset-backed credit facility) for better pricing terms and $500 million of incremental liquidity during the peak season. This will increase 2014 liquidity by $100 million. This helps, but it might not be enough.

In J.C. Penney's 10-Q, it stated that first-quarter traffic declined year over year. That is difficult to imagine given what took place during the Ron Johnson era. This decline in foot traffic, combined with increases in conversion rates, transaction count, and average units sold, likely indicates that while J.C. Penney has done a good job of reattracting its loyal customers, it hasn't attracted many new customers. This is a net negative.

If this trend remains the same, then the only way J.C. Penney will be profitable again is via aggressive downsizing. Investors aren't often a big fan of this approach. The biggest problem for J.C. Penney is increased competition, and this competition has resulted in younger consumers seeing J.C. Penney as a dated brand. Unlike J.C. Penney, Macy's has been ahead of the curve, which is proven by the numbers below. 

Positive outlook
Macy's also recently reported its results for the first quarter. Diluted earnings-per-share increased 9% year over year, but sales and comp sales declined 1.7% and 1.6%, respectively. This would usually make investors worry, but not when guidance is strong.

For fiscal-year 2014, Macy's expects comps to increase 2.5%-3% and earnings per share to come in at $4.40-$4.50. On top of that, Macy's has increased its dividend by 25% and its share repurchase authorization by $1.5 billion. Any company that makes these moves is optimistic on its future.

Below is a basic chart comparing the 10-year revenue performances of J.C. Penney and Macy's. Keep in mind that Ron Johnson was hired as CEO of J.C. Penney in 2011. Mike Ullman has since been rehired to replace him. The point here is that Mike Ullman was also CEO of J.C. Penney prior to 2011. Now look at which company was outperforming the other prior to 2011.

JCP Revenue (TTM) Chart

JCP Revenue (TTM) data by YCharts

The Foolish bottom line
J.C. Penney has turnaround potential, but it would be a long and difficult road. Foolish investors prefer to stick with companies that have high odds of long-term success. Therefore, you might want to consider Macy's before J.C. Penney.

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