By Brian Lund (TMF Tardior)
May 16, 2000

It's a minor consolation to the J.C. Penney (NYSE: JCP) investor that management seems to have a good sense of what is wrong with its sometimes stodgy, but perpetually inefficient business. The self-flagellation in its press releases offers some measure of atonement. Nonetheless, it's painful to hear time and again about store closings, declining margins, weak comparable-store sales, and unlocked value. The latest round of mea culpas came this morning in the first-quarter earnings announcement.

The maddening thing about J.C. Penney is that there are some really good things going on in the company -- really there are -- but negatives are constantly canceling out the positives. For example, the JCPenney stores, catalog and Internet division saw a 15% increase over the year-ago quarter in operating profits, retaining $167 million of the $4.1 billion it took in. That 4.1% operating margin may not look great, but it's a significant improvement over fiscal year (FY) 1999's 3.5%. It came about in part because inventory for comparable stores declined approximately 6% and selling, general and administrative expenses fell 1.2%.

It's great to see increased profits from improvements in operations. The downside, however, is that revenue fell 2.4%, despite an almost 700% increase in Internet sales. Comparable-store sales, or comps, declined 3.1%. Management had forecasted flat comps for the first three quarters of this year. They had to be disappointed with these results. That continues a cruel trend that has plagued JCPenney stores:

          1995  1996  1997  1998  1999  2000Q1
Comps (%) -1.4   3.4  -0.3  -1.9  -1.0   -3.1

One would have hoped that the various initiatives announced last quarter -- closing 40-45 less-productive stores, store upgrades, and the new focus on customer satisfaction -- would have paid off with something a little less, well, negative this quarter. Apparently it will take more time.

Also in the "take more time" category is the Eckerd drugstore division, though its problems are exactly the opposite. Here, sales swelled to $3.3 billion, 9.4% ahead of a year ago. Comps rose 6.9%, continuing its positive trend:

          1995  1996  1997  1998  1999  2000Q1
Comps (%)  5.5   7.7   7.4   9.3  10.5     6.9

So things are going gangbusters at Eckerd, right? Um, no. The drugstore had an operating loss of $30 million for the quarter, mostly due to $78 million in inventory liquidation losses associated with store closings and shrinkage. Excluding the effects of store closings, gross margin declined by 230 basis points as a percent of sales. SG&A expenses increased by 50 basis points this quarter.

You put JCPenney and Eckerd together, and you get the worst of both worlds: slow sales growth, declining margins and slow asset turnover. Let's not forget, too, about the large debt that J.C. Penney assumed to purchase Eckerd in the first place -- about 94% of equity at the end of FY 1999. Throw in a CEO who recently announced his retirement, and you've got yourself a company that only folks looking for bond-level dividend yields would love.

Improvements are happening, however. J.C. Penney retired $625 million, or about 11%, of its long-term debt in the first quarter, and will nix another $480 million by September. The closure of unproductive 45 JCPenney and 289 Eckerd stores continues, which (if done properly) should yield better margins and asset turnover.

Although the proposed spin-off of Eckerd seems to have been tabled indefinitely, the company is considering spinning off its Direct Marketing Services division, which markets and sells insurance products and membership services. Analysts estimate that it could be worth $2-2.5 billion on its $1.1 billion in annual revenues. That's about half of J.C. Penney's current market cap, from about 3% of its revenue base. I'll believe that when I see it.

There is plenty of room for improvement in all of its divisions. The process has begun, but there's a long way to go at J.C. Penney. Still, I think there is unlocked value at the company. We'll see if it can come to light.

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