Customers Aren't Coming Back to J.C. Penney

The turnaround effort of troubled retailer J.C. Penney (JCPN.Q) hit a serious snag during the third quarter. Comparable-store sales, which management had previously said would be in the mid-single digits, came in flat, with the company unable to improve on the dismal third quarter of 2013. Losses narrowed and margins rose, but J.C. Penney's inability to meaningfully grow sales after a roughly 30% collapse over the past few years is a troubling sign. With store traffic continuing to decline, it's becoming increasingly clear that the customers J.C. Penney lost during the Ron Johnson era aren't coming back.

An awful quarter
On the surface, J.C. Penney's third quarter doesn't look all that bad. Compared to competitors Kohl's (KSS 2.83%) and Macy's (M 1.44%), which both reported declining comparable-store sales during the third quarter, J.C. Penney's flat comps seem like a relatively good result. But a simple comparison ignores the results of the past few years, when J.C. Penney's sales fell off a cliff, and the comparison is much less kind when all of the data are considered:

Sources: J.C. Penney, Kohl's, and Macy's 

While both Kohl's and Macy's suffered from declining comparable-store sales during the most recent third quarter, those results are actually far better than J.C. Penney's performance. J.C. Penney needs to be growing sales, probably in the double-digit percentages, in order to have any chance at recovering to pre-collapse levels any time soon, and anything short of this should be considered a disappointment.

J.C. Penney's profitability did improve during the quarter, but the company is still losing money at an unsustainable rate. Gross margins have improved dramatically, reaching 36.6% during the third quarter, up from 29.5% during the same period last year, and operating expenses fell, but net income still came in at a loss of $188 million. That's a lot better than the $489 million loss during the third quarter of 2013, but only in the sense that it's less terrible.

Where are the customers?
J.C. Penney desperately needs to grow sales, and in order to do that it needs to get customers to come back to its stores. Even as sales increased during the past few quarters, store traffic has continued to decline, and the company has guided for continued traffic declines during the holiday quarter.

The idea that J.C. Penney can easily reclaim the $5 billion in sales that it lost over the past few years is simply not realistic. To quote Warren Buffett, "It takes 20 years to build a reputation and five minutes to ruin it." J.C. Penney ruined its reputation, driving its core customers away, and getting them back is not going to be easy.

Unfortunately for the company, there's little chance to return to profitability without a significant increase in sales. Historically, J.C. Penney has enjoyed gross margins in the 36%-39% range, so there's not much more room for improvement there. The company hasn't closed many stores, so the revenue per store has declined dramatically. In other words, without closing stores, cost cutting alone can't save the company, especially considering the $400 million in annual interest payments that will continue to drag down profitability.

Store traffic across the retail industry has been declining in recent years, and this means that J.C. Penney is fighting its competitors for a smaller number of store visits. Like many retailers, J.C. Penney is turning to online sales to help boost the top line, but those results were disappointing during the third quarter as well. Online sales increased just 3.4% year over year, far lower than the 29.8% increase in the third quarter of 2013.

It's been six quarters since former CEO Ron Johnson was replaced, and the fact that store traffic is actually lower today than it was under Johnson's tenure is a testament to how difficult it has been to regain the trust of customers that fled. There are so many other options available for value-conscious consumers, from department stores like Kohl's to discount chains like Ross Stores, and growing sales means that J.C. Penney needs to steal market share away from those competitors. Its success so far has been minimal.

J.C. Penney only has so much time; it will burn through its liquidity within a few years at the current rate that it's losing money, and there's not much more room for cost cutting. In fact, J.C. Penney guided for SG&A expenses to rise year over year during the fourth quarter. Profitability remains a pipe dream until J.C. Penney can convince customers to return to its stores, and there's been little progress on that front so far.