J.C. Penney Company, Inc. Earnings: Better Than Feared

Investors didn't have much hope for J.C. Penney's (JCPN.Q) third-quarter earnings report after the department store operator released a dreadful financial update in late October. In it, J.C. Penney acknowledged that getting rid of old inventory and transitioning to a new women's apparel assortment was tougher than expected. As a result, it slashed its full-year guidance for gross margin, earnings per share, and free cash flow.

However, on Friday, J.C. Penney reported that its third-quarter results weren't quite as bad as its recent guidance update had suggested. The company still didn't have a good quarter, but it is in better shape to survive the current period of retail turmoil than many investors seem to think.

J.C. Penney earnings by the numbers

In last month's update, J.C. Penney projected that comparable store sales increased 0.6% to 0.8% during the third quarter. In the end, the company's revenue trend was even better, as comp sales rose 1.7% in Q3. According to CFO Jeff Davis, the discrepancy was driven by strong sales during a promotional event held on the last weekend of the quarter.

Data source: J.C. Penney Q3 earnings report. Chart by author.

On the other hand, J.C. Penney's gross margin pressure was just as bad as expected. Gross margin declined by more than 3 percentage points to 34% in the third quarter, compared to 37.2% in the year-ago period. Still, thanks to the higher sales volume, J.C. Penney reported an adjusted loss of $0.33 per share. This was better than the $0.40 to $0.45 estimate that the company had provided in its guidance update, but worse than its $0.21 per share loss a year earlier.

On a more encouraging note, free cash flow was roughly flat on a year-over-year basis, as J.C. Penney's inventory reduction efforts offset the negative impact of posting lower earnings.

J.C. Penney posted weak earnings for the third quarter. Image source: J.C. Penney.

The full-year guidance stays the same

Despite posting better third-quarter results than expected, J.C. Penney stuck to the revised full-year guidance it published in late October. This may indicate that the company is taking a more conservative approach to forecasting, after missing expectations for two straight quarters.

That said, J.C. Penney does expect gross margin to be flat or up slightly in the fourth quarter. While the company will face a somewhat easier year-over-year comparison, that would still represent a significant break from the recent trend. Thus, at least one part of J.C. Penney's forecast doesn't seem especially conservative.

Can investors trust J.C. Penney's management?

J.C. Penney stock rocketed higher by as much as 20% following the earnings report on Friday. However, it is still down by about 70% from its 52-week high, reached last December. Clearly, investors are no longer confident in the company's trajectory and don't trust management.

Based on J.C. Penney's strong sales performance last quarter and its momentum in the appliance business, the company is well-positioned to meet its 2017 sales forecast and return to comp sales growth on a full-year basis in 2018.

By contrast, it will be challenging for J.C. Penney to deliver the gross margin recovery that management is projecting for the fourth quarter. Growth in online sales and appliance sales has been putting pressure on gross margin for more than a year now. J.C. Penney has a variety of initiatives in place to offset these headwinds, but they haven't been sufficient recently.

Thus, the fourth quarter could be critical for restoring investor trust. If J.C. Penney can deliver another quarter of comp sales growth while stabilizing gross margin, investors might finally gain confidence that J.C. Penney's weak 2017 was just an anomaly.