Three months ago, J.C. Penney (JCPN.Q) finally showed investors tangible signs of progress in its second-quarter earnings report, following a long string of dreadful earnings results. Nevertheless, the company continued to experience sharp sales erosion in Q2.
J.C. Penney is set to release its third-quarter earnings report on Friday morning. The iconic department store chain needs to show investors another quarter of improving profitability and at least some sign that it is stabilizing its sales.
Good progress in Q2 despite plunging sales
In the second quarter of fiscal 2019, J.C. Penney's comparable-store sales plunged 9% year over year and total revenue fell 7.4%. At first glance, that doesn't seem like evidence of a turnaround.
However, earlier in the year, J.C. Penney discontinued appliance sales and stopped carrying furniture in its domestic stores. (It still sells furniture online and at a handful of stores in Puerto Rico.) These merchandise changes drove a third of the retailer's 9% comp sales decline.
Moreover, J.C. Penney has made a long-overdue strategic shift toward maximizing profitability rather than pursuing sales growth at all costs. As a result, gross margin improved by more than 3 percentage points year over year last quarter, rising to 36.8% from 33.7% a year earlier. J.C. Penney also benefited from a significant increase in income from its credit card program last quarter.
The net result was that adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) soared 52% to $160 million and J.C. Penney reduced its adjusted net loss by 53%. In addition, because of J.C. Penney's aggressive efforts to reduce inventory, free cash flow for the first half of fiscal 2019 improved by more than $100 million year over year.
Easy comparisons may pave the way for more progress
J.C. Penney is likely to report another comp sales decline for the third quarter, because of the continuing headwind from exiting the appliance and in-store furniture businesses. That said, its sales trajectory could improve significantly, because of easier year-over-year comparisons. Whereas J.C. Penney's comparable store sales inched up 0.3% in Q2 of fiscal 2018, comp sales plunged 5.4% in last year's third quarter.
J.C. Penney also reported a weak gross margin of 31.9% in Q3 2018, leaving plenty of upside if the retailer continued to manage its inventory well last quarter. While management expects credit income to normalize in the second half of fiscal 2019, the combination of gross margin improvement and a more moderate sales decline should enable J.C. Penney to reduce its adjusted net loss for a second consecutive quarter. By contrast, analysts expect the company's adjusted net loss to widen to $0.56 per share, from $0.52 a year ago.
If J.C. Penney's Q3 earnings report reveals a comp sales decline in the 2% to 5% range and a narrower loss, that would represent another step in the right direction. By contrast, a return to margin erosion or a lack of progress toward stemming its sales declines would suggest that J.C. Penney is getting sicker.
All eyes on the future
Even if J.C. Penney does manage to reduce its losses with gross margin improvement, that alone doesn't represent a path to sustainable profitability. Ultimately, the company needs to get sales growing again.
Merchandise and marketing changes will be critical to driving the hoped-for sales turnaround. J.C. Penney already has some new brands in its stores for the holiday season, although long lead times for merchandise mean we won't fully feel the strategies J.C. Penney's new leadership team implements until next year. Investors should look out for any discussion during the company's earnings call of when sales might start growing again.
J.C. Penney also renovated a store in Hurst, Texas, recently to serve as a concept store. Merchandise is organized by occasion rather than by category, there is an increased focus on personalized style advice, and the store offers "experiential" elements like yoga classes, beauty care and cooking demonstrations, and a cafe. The new store format has only been operating for a couple of weeks, but investors should keep an eye out for any tidbits about that store's performance -- and any plans to roll out similar changes to other stores.
It took years for J.C. Penney to get into its current mess, and it will take years to get out of it, if a turnaround is even possible. Thus, investors shouldn't expect anything game changing in this week's earnings report. Signs of continued progress should be enough to keep J.C. Penney stock moving higher.