Should LVMH's Sephora Dump JCPenney?

JCPenney's (JCPN.Q) partnership with LVMH's (LVMUY -0.52%) Sephora, which started in 2006, is a rare bright spot for the struggling retailer. Sephora operates 660 stores inside about 75% of JCPenney stores across the United States, and about 460 stand-alone stores across the Americas.

JCPenney CEO Jill Soltau, who took the top job last October, called the partnership "very strong and very exciting" during last quarter's conference call. Soltau claimed that she and Jean-André Rougeot, the new CEO of Sephora Americas, were "on the same page" and saw "great things for Sephora inside JCPenney."

Image source: JCPenney.

However, UBS analysts recently claimed that the partnership benefits JCPenney more than Sephora, and leaves Sephora more vulnerable to its rival Ulta Beauty (ULTA -2.51%), which finished 2018 with 1,174 stores across the U.S. Ulta plans to open about 80 new stores in 2019, while Sephora plans to open 35 new stand-alone stores in the U.S.

UBS notes that Ulta now has stores within a ten-minute drive of 78% of Sephora's JCPenney's locations, which are tethered to the retailer's weak growth and sluggish mall traffic. Let's examine this relationship and see if Sephora should split with JCPenney.

How is Sephora doing?

Sephora belongs to LVMH's "selective retailing" group, which generated 28% of its sales in 2018. The business unit also includes DFS, Starboard Cruise Services, and two high-end department stores in Paris: Le Bon Marché Rive Gauche and La Grande Épicerie.

LVMH doesn't regularly disclose the unit's sales by banner, but Sephora is the unit's largest retailer, with over 2,500 stores worldwide. Here's how the business segment fared over the past year.

YOY = Year-over-year. *Organic basis. Source: LVMH reports.

LVMH attributed Sephora's growth in the first quarter to market share gains, comps growth in Asia, "rapid progress" in global online sales, and a new store opening in New York's Hudson Yards. But during the fourth quarter, LVMH noted that Sephora's growth decelerated in the U.S. due to fewer promotions in the second half of 2018 and lower mall traffic in American malls.

Image source: JCPenney.

To make matters worse, Sephora is chained to JCPenney, one of the weakest mall retailers, as Ulta Beauty's growth accelerates. Here's how JCPenney's comps growth compared to Ulta Beauty's over the past year:

*Shifted basis. Source: Company quarterly reports.

Ulta also overtook Sephora as the favorite beauty destination for U.S. teens in Piper Jaffray's latest "Taking Stock with Teens" survey: 31% of teens named Sephora as their top brand, compared to 44% a year ago. Ulta's mindshare jumped from 28% to 33% during the same period. These numbers all support UBS' argument that JCPenney's partnership with Sephora benefits the former more than the latter.

Ulta also generated $544 in sales per square foot per store last year, compared to $521 in fiscal 2017. JCPenney's sales per square foot fell from $127 in 2017 to $122 in 2018. Neither JCPenney nor LVMH regularly disclose the sales per square foot of Sephora's store-in-stores, but a Fortune report in late 2016 pegged the figure at "almost $600" -- which indicates that far more people visit JCPenney's Sephora stores than its other departments.

What does LVMH think of JCPenney?

LVMH CFO Jean-Jacques Guiony discussed the possibility of JCPenney's bankruptcy during last quarter's conference call. Guiony said he didn't know if JCPenney would go under, but noted that retailers could still operate normally after filing for Chapter 11 bankruptcy.

Guiony declared that those issues and JCPenney's management changes would "not have any effect on Sephora." Financial communications director Chris Hollis also noted that Sephora was still "the number one internet seller for cosmetics" in the U.S.

LVMH seems well aware of JCPenney's challenges, but it also isn't eager to dissolve the 13-year partnership. LVMH would lose most of its U.S. presence if it shuttered its JCPenney locations, which would make it even easier for Ulta to gain market share. Therefore, it makes more sense for LVMH to see if JCPenney's turnaround efforts bear fruit, and gradually expand its number of non-mall stand-alone locations across America.

Maintaining the status quo

UBS makes a good point about JCPenney and Sephora's relationship, but it's doubtful that the status quo will change anytime soon. JCPenney needs Sephora to boost foot traffic at its stores, and Sephora still needs JCPenney to contain Ulta's growth.