Yesterday afternoon, troubled department store operator J.C. Penney (NYSE:JCP) announced that it will close 33 underperforming stores (3% of its roughly 1,100 locations) this spring. The stores getting the ax are spread across the country, although the Midwest will be particularly hard-hit. These store closings will help J.C. Penney save money, but they are still bad news for shareholders.
First, the decision to close these stores means that management has concluded that the business will not bounce back to a level where it would return to profitability anytime soon. Second, closing these stores could worsen J.C. Penney's long-running inventory issues, forcing it to clear even more merchandise at or below cost.
Slow road back from the brink
J.C. Penney shareholders should be thankful that CEO Mike Ullman has stabilized the company's sales after nearly two years of big drops. Unfortunately, sales have stabilized at a level well below what's necessary for J.C. Penney to break even. Not surprisingly, this means that the least profitable of J.C. Penney's stores are racking up losses.
Former CEO Ron Johnson was adamant about avoiding store closures until all other options were exhausted. After J.C. Penney's board pulled the plug on Johnson, Ullman returned as CEO, but he too was focused on winning back customers rather than retrenching.
J.C. Penney's vague "holiday update" from early January already gave investors the sense that sales had not rebounded as fast as expected. These store closings provide further evidence that the road back to profitability will be a long one. Unfortunately, J.C. Penney could run out of cash before it gets there.
Inventory issues may persist
J.C. Penney's biggest problem in the past two years has obviously been its plummeting sales. However, a side effect of repeatedly missing sales forecasts has been a long-running inventory glut. This has pressured gross margin. Through the first nine months of FY13, gross margin was 29.9%, down from 34.5% in 2012, and well below J.C. Penney's long-term target of 37%.
On the company's most recent conference call, Ullman stated that J.C. Penney would continue to experience gross margin pressure from old merchandise that sold poorly until sometime this spring.
With J.C. Penney needing to clear all the inventory from the 33 stores that are closing, investors should now expect gross margin to remain weak for at least the first half of 2014. J.C. Penney will probably use big clearance markdowns in those stores to move as much merchandise as possible in the next few months. However, there will inevitably be plenty of merchandise left over.
J.C. Penney will then have a choice of either selling that merchandise below cost to a liquidator or shipping it back to its warehouses and trying to sell it at other J.C. Penney stores. Selling to a liquidator would entail a significant gross margin hit in Q2, after the stores close. Keeping the inventory in the J.C. Penney system would spread the gross margin damage over a longer period of time. Either way, J.C. Penney's gross margin problems are not over yet.
J.C. Penney's move to close stores probably makes sense from a business perspective. However, it won't save enough money to significantly alter J.C. Penney's prospects. Meanwhile, the company will incur $20 million of cash costs related to store closings and it will likely experience continued gross margin pressure as it tries to clear those stores' inventory.
In short, J.C. Penney continues to look like a stock that investors should avoid until the company shows much more tangible signs of progress. Management is making good moves to bring J.C. Penney back to breakeven over time, but it may be hard for the company to survive without a bankruptcy restructuring to reduce J.C. Penney's excessive debt load.
Fool contributor Adam Levine-Weinberg has no position in any stocks mentioned, and neither does The Motley Fool. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.