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The Scary Warning From J.C. Penney and Best Buy

By Rich Duprey – Jan 21, 2014 at 8:00PM

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The retail landscape is about to undergo a major upheaval.

As bad as the Christmas holiday results were for Best Buy (BBY -1.41%) that sent its stock plunging almost 30% in one day, it's only a taste of what's to come, as the rest of the retail market spills forth its own earnings secrets and even more skeletons tumble out of the closet. With fellow troubled retailer J.C. Penney (JCPN.Q) giving us a glimpse of what's in store, investors should be looking for ways to exit their retail positions sooner rather than later.

As is now known, sales at Best Buy dropped 2.6% for the nine-week period that ran through Jan. 4 as same-store sales dropped 0.9% from the year-ago period. Mind you, that was a decline over a period when it had a chance to lap an easy comp that was flat. All it had to do was post better than the no growth it saw in 2012 and it could've claimed success, but despite being what CEO Hubert Joly calls a time of "promotional intensity," Best Buy still couldn't lure more customers into its stores.

Forget the lies about a recovering economy; that false foundation is built upon the Federal Reserve's injection of liquidity steroids into the market, allowing stocks to rise beyond all sense. What we're witnessing here is the real condition of the economy, and it's not pretty. Retailers hit the panic button starting last November, and it continued right through the end of the year. Now we're seeing the fruits of those efforts, and it's increasingly clear they're dying on the vine.

We saw it start last week with J.C. Penney and its "update" that was devoid of anything specific. A terse, three-sentence release saying it was pleased about how it's doing was enough to make skittish investors bail. Its stock dropped 10% on the day. Coupled as it was with the news that it was closing 33 stores and letting 2,000 employees go, we can quickly see the vulnerability in its turnaround plan. Both Penney and Best Buy are fighting for their corporate life, and the signs are ominous.

Source: J.C. Penney.

Both retailers have pulled out all the stops in a bid to attract customers, going so far as to maintain market share in exchange for profit. Penney's third-quarter earnings saw the start of the process when gross margins worsened as it launched large sales campaigns to woo back customers. While that's the page consumers and analysts said was missing from the retailer's playbook, it was clear it was going to have a deleterious impact on margins. Gross profits came in at 29.5% of sales, down from 32.5% last year, though flat sequentially, but as holiday sales only increased the need to cut prices to move product, we shouldn't expect fourth-quarter numbers to be any better. In fact, I expect them to be a lot worse.

Just look at what Best Buy is signaling. What it calls its "investment in pricing" is really the gutting of margins, and it expects them to come in 175 to 185 basis points below last year's already weak effort.

Although Penney and Best Buy are among the weakest players in their space, the fact that they were simply doing what everyone else was doing suggests retailers in general are going to be hard-pressed to show any gains.

Kohl's looks very much to be heading the way of Penney. Where it saw a slight sub-3% increase in sales in the third quarter, comp growth barely registered a gain at all as margins contracted 8% year over year. Even retail giant Wal-Mart has warned of a slowdown in the fourth quarter as cautious consumers warily spent on the holidays. It's why department stores felt the need to get an early start to the Christmas season, open on Thanksgiving Day, run shopping marathons to give consumers the ability to buy whenever the feeling struck them (including apparently at 3 a.m. if necessary), and offer ridiculous pricing to lure shoppers in the door.

While Best Buy and Penney have seen better online sales results, that only serves to underscore how very much the market is weighted against their bricks-and-mortar business model. Amazon.com will likely be a bright spot this year, as it noted that on Cyber Monday alone, more than 36.8 million items were ordered worldwide, a 39% increase from last year's 26.5 million items.

I've warned investors for months now that all they'd get from retailers this Christmas is a lump of coal, that despite industry cheerleaders trying to jawbone sales higher, this year was going to be worse than most. The cracks are now appearing and we're about to see that J.C. Penney and Best Buy were only the first signs of the worsening retail landscape.

Another retailer at death's door?
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Fool contributor Rich Duprey has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Amazon.com. We Fools don't 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.

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