J.C. Penney (JCPN.Q) is set to release its second-quarter earnings report this Thursday. The stakes have never been higher. In recent weeks, shares of the struggling department store giant have plunged below the $1 mark, over tariff fears and reports that J.C. Penney is looking into options for restructuring its debt.
The upcoming earnings report could calm investors' fears or stoke them further, depending on how J.C. Penney performed last quarter and management's commentary during the earnings call. Here are some of the key issues that investors should be focusing on.
Has the gross margin recovery begun yet?
While its sales declines have drawn more media attention, gross margin erosion has been the primary cause of J.C. Penney's deteriorating profitability in recent years. As recently as the 2015 and 2016 fiscal years, gross margin averaged about 36% of sales at J.C. Penney. That figure fell to 34.6% in fiscal 2017 and 32.5% in fiscal 2018.
Gross margin has plunged at J.C. Penney since 2016. Image source: J.C. Penney.
Rising competition and the cost of fulfilling e-commerce orders caused some of the pressure on gross margin. However, those weren't the biggest problems. The introduction of lower-margin appliances to J.C. Penney's merchandise mix, attempts to boost sales with low-margin online-only products, an uptick in "shrink" -- the industry term for lost and stolen merchandise -- and recurring inventory gluts were far bigger culprits.
Last fall, J.C. Penney estimated that it could improve its annual pre-tax profit by hundreds of millions of dollars by reducing shrink to normal levels and improving its inventory management. That would potentially be the difference between returning to profitability and continuing to post big losses.
Gross margin fell by another 0.5 percentage points in the first quarter of fiscal 2019. However, management noted that clearance sales related to J.C. Penney's decision to exit the appliance business and stop selling furniture in its stores artificially depressed gross margin during that period. Excluding that headwind, gross margin would have increased slightly.
With the appliance clearance headwind gone and total inventory down 16% year over year by the end of the first quarter, J.C. Penney's gross margin may have started to improve last quarter. If it didn't, investors will want to know why not -- and when to expect progress on this key metric.
J.C. Penney stopped selling appliances earlier this year. Image source: J.C. Penney.
Any firm numbers on the impact of tariffs?
President Trump's recent decision to impose a 10% tariff on approximately $300 billion of Chinese imports as of Sept. 1 helped drive the most recent plunge in J.C. Penney stock. After all, this new round of tariffs targets items including apparel, accessories, and certain home goods.
However, while some pundits have warned that this could be the straw that breaks the camel's back for J.C. Penney, they may be overestimating the threat. As CEO Jill Soltau noted on the company's earnings call in May, J.C. Penney has less exposure to goods sourced in China than many of its competitors. It has been working hard for nearly a year to further reduce its exposure to China. The company also should be able to push suppliers to share the cost of the tariffs.
The tariffs will still have some impact on J.C. Penney's profitability, but it could be fairly small compared to the potential gains from the company's gross margin initiatives. Investors should listen carefully to management's comments during the earnings call for any details on the likely cost of the tariffs and how J.C. Penney will respond.
How will J.C. Penney manage its debt?
J.C. Penney's persistent losses and high debt load mean that there is a meaningful risk of the stock eventually being declared worthless in a bankruptcy proceeding. Thus, shareholders -- and anyone thinking of investing in J.C. Penney -- should have a keen interest in learning more about the company's debt restructuring efforts.
Formal discussions between J.C. Penney and its creditors haven't begun yet. However, options being considered include offering higher interest rates in exchange for pushing out some of J.C. Penney's major debt maturities or giving creditors additional protections in exchange for other concessions, according to Bloomberg.
Management may not offer much in the way of details about this potential debt restructuring, given that the process is just beginning. But any hints about the company's thinking could help investors evaluate whether a debt restructuring would reduce the upside for shareholders in the event that J.C. Penney's turnaround efforts ultimately prove successful.
