Please ensure Javascript is enabled for purposes of website accessibility
Free Article Join Over 1 Million Premium Members And Get More In-Depth Stock Guidance and Research

3 Charts That Explain J.C. Penney's Problems

By Timothy Green - Mar 20, 2014 at 2:22PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

J.C. Penney may have staved off bankruptcy for now, but the troubled retailer has some serious structural problems that are going to be very difficult to overcome.

While J.C. Penney's ( JCPN.Q ) latest earnings release showed that the troubled retailer wasn't in any immediate danger of collapse, the company is still facing serious problems that will be extremely difficult to overcome. It's easy to point to positive same-store sales growth as proof that the turnaround effort is succeeding, but cherry-picking positive numbers from a sea of negative numbers isn't a good investment strategy. Here are three charts, using peers Macy's ( M 2.58% ) and Kohl's ( KSS 2.06% ) for comparison, that sum up the issues facing J.C. Penney.

The grossest of margins
J.C. Penney's gross margin began to fall even before Ron Johnson took over in November of 2011, most of the way through fiscal 2012. Johnson brought in new brands and switched to an "everyday value" strategy, alienating customers and sending sales plummeting by nearly 25% during his first and only full year. Gross margin fell as well, and even after Johnson was replaced, the unwanted merchandise continued to drive down the this number.

Data from Morningstar for 2010-2013, and earnings reports for 2014

In fiscal 2014, the gross margin fell below 30%, about ten percentage points below its 2011 peak. Macy's has surpassed 40% in each of the past five years, and the more discount-orientated Kohl's has stayed above 35%. J.C. Penney guided for a significant improvement in the gross margin for the current year, but the next chart shows why even getting back to historical levels doesn't solve the problem.

Costs are out of control
As J.C. Penney's revenue has collapsed, the company has attempted to slash operating costs in order to compensate. But without significant store closings, there is a limit to how low costs can go before the customer experience begins to suffer. During the past two years, J.C. Penney's operating expenses have reached an unsustainable level.

Data from Morningstar for 2010-2013, and earnings reports for 2014

Back in 2010, both J.C. Penney and Macy's spent about 35% of revenue on operating expenses. The two companies began to diverge even before Ron Johnson took the helm, with Macy's becoming more efficient each and every year. By fiscal 2014, Macy's had cut operating expense to just 30.2% of revenue, down from 36% in fiscal 2010. Macy's has even started to rival the efficiency of Kohl's, closing the gap significantly over the past few years.

J.C. Penney went the other way, with lower revenue driving this number above 40%. With the gross margin lower than 30%, and the best-case scenario being that the company brings this number back up to around 40%, even if everything goes right for J.C. Penney, a loss is still essentially inevitable. Add in the nearly $400 million in annual interest payments, the result of ballooning debt, and it's clear that J.C. Penney will not be profitable any time soon.

J.C. Penney's cost structure is not sustainable given its revenue, and the company is in a race against time. It needs to grow revenue fast enough to bring its operating costs as a percentage of revenue back to historical levels, while at the same time increasing its gross margin by ten percentage points, all before the company's liquidity runs dry. 

Bankruptcy is still on the table
How much time does J.C. Penney have? Well, S&P raised the company's credit outlook to stable following the company's earnings, and this was taken as a sign that bankruptcy is no longer a possibility. But the wording of the upgrade makes it clear that J.C. Penney has bought itself a year at most, and that after that, anything goes:

The outlook revision reflects our view that performance has begun to stabilize, and we forecast further modest gains over the next year. As a result, we are revising our liquidity assessment to "adequate" from "less than adequate." However, in our view, the capital structure is unsustainable, but the company does not have any meaningful maturities over the next 12 months.

So while bankruptcy in the next year is unlikely, it becomes a real possibility again if things don't improve fast enough. One way to quantify bankruptcy risk is the Altman Z-score, which I've calculated below for J.C. Penney.

This is the version of the Altman Z-score for non-manufacturers, and any value below the red line means that the company is distressed, having a high probability of going bankrupt in the next two years. This is by no means a perfect predictor of bankruptcy, but it shows how dire J.C. Penney's situation has become. J.C. Penney's Z-score fell into the distress zone in fiscal 2013 and got worse in fiscal 2014, reflecting continued losses and growing debt. The balance sheet is in a precarious condition, and although the company likely has enough liquidity to survive this year, there are no guarantees after that.

The bottom line
Absolutely everything has to go right, and quickly, for J.C. Penney to ultimately survive. The company's cost structure and capital structure are both unsustainable, and revenue needs to grow much faster than it did during the fourth quarter. To quote Warren Buffett, "Time is the friend of the wonderful business, the enemy of the mediocre." J.C. Penney is certainly not a wonderful business, and time is running out.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

J. C. Penney Company, Inc. Stock Quote
J. C. Penney Company, Inc.
Macy's, Inc. Stock Quote
Macy's, Inc.
$27.83 (2.58%) $0.70
Kohl's Corporation Stock Quote
Kohl's Corporation
$52.12 (2.06%) $1.05

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning service.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 12/07/2021.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Our Most Popular Articles

Premium Investing Services

Invest better with the Motley Fool. Get stock recommendations, portfolio guidance, and more from the Motley Fool's premium services.