The turnaround effort at troubled retailer J.C. Penney (JCPN.Q) appears to be making progress. The company has managed to return to revenue growth, with comparable-store sales rising in each of the past three quarters. The retailer is no longer hemorrhaging cash as quickly as it was during 2013, and although large losses persist, J.C. Penney has bought itself some time to see the turnaround effort through.
However, for investors thinking about buying shares of J.C. Penney on the hopes that the company can eventually right itself, the math just doesn't add up. Even taking at face value the company's optimistic financial performance goals, recently announced during its analyst meeting, the stock is certainly no bargain, and investors should continue to steer clear of this lumbering retailer. Let's take a closer look.
The story so far
The recent history of J.C. Penney began with a massive, disastrous collapse in revenue during the tenure of former CEO Ron Johnson, followed by a slow, painful return to sales growth led by Mike Ullman, who was brought back as CEO to right Johnson's wrongs. Ullman succeeded at preventing the immediate demise of J.C. Penney, and now newly named CEO Marvin Ellison, a former Home Depot executive, will attempt to carry the turnaround baton for the final leg of the relay.
Ellison doesn't have an easy task in front of him. Here's what J.C. Penney looks like today compared with 2010, the last full year before Johnson took over as CEO:
| Metric |
2010 |
Trailing 12 Months |
|---|---|---|
|
Revenue |
$17.76 billion |
$12.16 billion |
|
Operating income |
$832 million |
($856 million) |
|
Gross margin |
39.2% |
31.5% |
|
Operating expenses as % of revenue |
34.5% |
38.5% |
|
Total debt |
$3.10 billion |
$5.35 billion |
|
Annual interest payments |
$231 million |
$399 million |
|
Store count |
1,106 |
1,062 |
Sources: J.C. Penney 10-K and 10-Q, and Morningstar
Revenue is more than $5 billion lower, with operating income taking a $1.6 billion swing in the negative direction. The debt has ballooned, along with the annual interest payments, and the company spends far more operating its stores as a percentage of revenue today than it has historically. The average sales per store have fallen from $16 million in 2010 to just $11.5 million during the past 12 months, as J.C. Penney has closed very few stores over the past few years.
The numbers have improved compared with 2013. Revenue rose slightly, the operating loss narrowed from $1.42 billion, and the gross margin jumped by about two percentage points. But J.C. Penney is still far from returning to profitability, and while some investors may be banking on further improvements to drive the share price higher, even the best-case scenario for the company isn't very attractive.
The best-case scenario
During J.C. Penney's recent analyst meeting, the company laid out its financial performance goals for the 2015-2017 period. J.C. Penney expects to generate an additional $2 billion in annual sales by the end of the period, driven by the following areas, as the company laid out in its companion press release:
- Revitalizing the center core, the highest-traffic area in its stores, as a leading destination for beauty, jewelry, and fashion accessories.
- Improving the productivity of the Home Store with value-driven products and a tailored promotional strategy.
- Maximizing the power, reach, and integration of the company's omnichannel capabilities.
Along with the revenue boost, J.C. Penney expects to achieve $1.2 billion in EBITDA, or earnings before interest, taxes, depreciation, and amortization, in 2017. During the trailing-12-month period, EBITDA was at negative $216 million, so reaching this goal would require quite a large swing.
EBITDA isn't all that useful of a number for valuation purposes, though, so let's try to estimate what the company's net income would be if it hits these targets.
2017 Net Income Calculation
| Metric | Amount |
|---|---|
|
EBITDA |
$1.2 billion |
|
Depreciation and amortization (TTM) |
($640 million) |
|
Interest (TTM) |
($399 million) |
|
Taxes (35% tax rate) |
($56 million) |
|
Net income |
$105 million |
I've made some assumptions here. I'm using trailing-12-month figures for depreciation and interest payments, and both of these figures could change over the next few years. I'm also assuming a 35% tax rate, which was roughly the average tax rate for 2009-2010, before the company began losing money. The end result, net income of around $100 million, should be at least in the ballpark of the actual figure if J.C. Penney hits its target.
The problem is that J.C. Penney is currently being valued at about $2.2 billion, putting the current stock price more than 20 times the earnings that the company hopes to earn in 2017. Adding $2 billion in revenue by the end of 2017 will require annual revenue growth of around 5%, about what the company has managed so far this year. Comparable-store sales rose by 6% during the most recent quarter, although J.C. Penney expects low-single-digit growth during the third quarter.
Can J.C. Penney hit its financial targets? Perhaps, but the company's goals seem notably optimistic, especially on the profitability front, and the stock is priced as if J.C. Penney has already succeeded. An investment that works only if the best-case scenario plays out is one to avoid.
