5 Highlights From J.C. Penney's Q3 Earnings Call

While sales trends started to improve at several department store chains last quarter, J.C. Penney (JCPN.Q) disappointed investors with a 0.8% decline in comp sales during Q3. This forced the company to cut its full-year sales guidance. But despite the weak Q3 revenue performance, J.C. Penney posted strong earnings growth. It still expects to produce adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) of at least $1 billion in fiscal 2016.

J.C. Penney posted weak sales but solid earnings improvement in Q3. Image source: The Motley Fool.

Following the earnings release, J.C. Penney's management team spent an hour discussing the results and outlook with analysts and investors. In their presentation, they stressed the following five key points.

Warm weather hurt sales

For the quarter, all apparel categories -- men's, kids, and women -- performed below the Company comp with men's apparel posting the best performance. ... Although we are not pleased with the overall performance of apparel, we can tie a majority of the underperformance to unseasonably warm temperatures.
-- J.C. Penney CEO Marvin Ellison

The U.S. experienced the warmest September on record this year. That was bad news for department stores like J.C. Penney, as they generally shift their focus from selling warm-weather summer gear to fall apparel during August. Customers were less interested in buying fall clothing when the weather was still quite warm.

As a result, J.C. Penney's apparel sales slumped last quarter, whereas many other merchandise categories continued to grow. According to Ellison, unfavorable weather trends probably reduced companywide sales by at least 1% in Q3.

Fewer seasonal categories stood out last quarter

Our top-performing categories, which all delivered positive comps for the quarter, included Sephora, Home, Salon, and Fine Jewelry, which you may recall are all key components of our growth initiatives...
-- Ellison

J.C. Penney is adding Sephora boutiques to more of its stores. Image source: The Motley Fool.

J.C. Penney's management is well aware of the danger of relying on favorable weather to drive sales. Over the past year or so, the company has been working hard to increase sales of items that are not weather-sensitive.

Key initiatives in this area have been growing beauty sales by opening more Sephora boutiques and expanding their assortments, rebranding J.C. Penney's salons to drive more customer traffic, and adding new products such as appliances to the home department. These initiatives are already paying off, helping to offset the weakness in apparel sales last quarter. Furthermore, there's a lot of room for growth left in these categories.

Self-inflicted wounds

We opened an unprecedented 113 appliance showrooms in one week in an attempt to capitalize on the Columbus Day selling weekend. ... All of the activity in the stores created a degree of disruption to our business in the months of August and September that negatively impacted overall sales.
-- Ellison

J.C. Penney's return to the appliance business is poised to drive strong sales growth over the next year. However, as J.C. Penney rapidly rolled out appliance sections in many stores during August and September, it inadvertently disrupted sales in other categories.

For example, the appliance rollout drew store management teams' attention away from other categories. J.C. Penney is also still learning how to market appliances alongside its more traditional product offerings. Finally, many stores pulled labor from other sections to help get the new appliance showrooms ready.

Sales trends improved in October (especially late October), as the company got past some of these teething issues. That bodes well for Q4 and the upcoming year.

Solid earnings performance despite revenue weakness

Adjusted EBITDA increased $63 million in Q3 to $174 million reflecting a 57% improvement versus last year's third quarter. ... We continue to execute on all of our sales, margin and expense initiatives and remain confident in our ability to deliver EBITDA of $1 billion this year.
-- J.C. Penney CFO Ed Record

J.C. Penney's management has repeatedly said that the company has multiple potential pathways to meeting its earnings targets. The company showcased that ability in Q3. Even though sales missed expectations, J.C. Penney grew its adjusted EBITDA by 57% last quarter and reduced its adjusted net loss by more than half.

To do that, J.C. Penney continued to reduce overhead costs and store controllable costs. Going forward, the company needs some level of sales growth to continue its earnings turnaround, but it has ample room for profit improvement even if its 3%-4% annual comp sales growth target proves to be unattainable.

Lots of sales drivers for Q4 and beyond

... [W]hen we think about 500 plus appliance showrooms net new; 61 net new Sephora locations; 350 net new center core environments; BOPIS [buy online, pickup in store] in all stores... just timed for holiday, we feel great about our sales possibilities for the holiday season and the fourth quarter.
-- Ellison

While J.C. Penney is ready to respond if it can't meet its sales targets, management remains confident that its revenue growth rate will accelerate starting this quarter.

Ellison noted that a lot of the company's key levers for future sales growth weren't fully rolled out until recently. Most notably, many of the appliance showrooms opened during Q3, so Q4 will be the first time that the company gets the full benefit of them. But there are plenty of other growth initiatives that J.C. Penney rolled out in the middle of 2016.

These new growth shoots already seem to be gaining traction. Together they could drive a return to steady sales growth, reassuring investors who have become nervous about the progress of J.C. Penney's turnaround.