JCPenney: A Little Progress and a Lot of Problems

Troubled retailer J.C. Penney (JCPN.Q) showed improvement when it reported its first-quarter results last week, and shares of the company rocketed higher on the news. Same-store sales rose, gross margin expanded, and operating expenses were kept in check. While other department stores like Kohl's (KSS -3.58%) and Macy's (M -1.65%) struggled during the first quarter as rough weather ate into their sales, J.C. Penney's results appeared very good, at least on the surface. However, the fundamental problems that the company is facing still exist, and the first-quarter results aren't nearly as good as they seem.

Putting same-store sales into perspective
J.C. Penney grew its same-store sales by 6.2% during the first quarter, or 7.4% using the new calculation method that the company will use from now on. This is an acceleration compared to the fourth quarter's 2% increase, and it's significantly better than the negative same-store sales reported by Kohl's and Macy's.

However, there are two problems here. First, this 6.2% increase is from a significantly depressed level. In the first quarter of 2013, same-store sales declined by 16.6%, and in the first quarter of 2012, same-store sales declined by 18.9%. So while J.C. Penney appears to have performed well, the same-store sales growth needs to be put into perspective.

Same-store sales growth
Growing same-store sales after two years of double-digit collapses is not all that impressive of a feat. While the first quarter this year certainly showed an improvement, it was a small improvement compared to an absolutely dismal first quarter in 2013. J.C. Penney did 6.2% better than absolutely terrible.

The second problem is the source of this same-store sales growth. Store traffic was down during the first quarter, so the entirety of the same-store sales growth came from an increase in transaction size. This isn't surprising, since J.C. Penney's main problem as it recovered from the Ron Johnson era was that it had a bunch of inventory that didn't resonate with its core customers. Working through that inventory and replacing it with products that customers wanted to buy was what drove same-store sales growth. This also accounted for the increase in gross margin during the quarter.

The fact that store traffic still decreased is not a good sign. Store traffic did increase during the month of April, as management pointed out during the conference call, but with Easter being on April 20 this year compared to March 31 last year, the timing of the holiday makes it difficult to tell if store traffic has finally turned a corner. The company has guided for a mid-single-digit increase this year in same-store sales, and this points toward traffic trends not getting much better.

J.C. Penney needs more revenue
Single-digit same-store sales growth is simply not enough, given the massive declines during the previous years. Even though J.C. Penney has managed its operating expenses well its cost structure is still unsustainable, especially compared to the competition:

Even if J.C. Penney manages to get its gross margin back to the high-30s, the company's operating expenses as a percentage of revenue are so high that it will still record operating losses. While J.C. Penney has managed to reduce its operating expenses, it can only cut these costs by so much without closing stores. Management stated during the conference call that the current level of operating expenses will be roughly the run rate going forward, so there likely won't be much more cost cutting.

This means that the only way for the company to become profitable is to grow its revenue, because growing gross margin alone won't be enough. Growing revenue will require store traffic to begin to increase again. We'll have to wait and see if the gains during April are real or just the result of the timing of Easter, but if mid-single-digit same-store sales growth is an accurate projection for the year, then J.C. Penney is still a long way away from turning an operating profit. Also, this is before factoring in nearly $400 million in annual interest payments, based on the $97 million in interest the company paid during the first quarter.

The bottom line
While J.C. Penney showed improvement during the first quarter, a comparison to a dismal first quarter in 2013 makes the results appear better than they really are. Store traffic is still declining, and the same-store sales growth resulted from replacing unwanted merchandise with what customers wanted. J.C. Penney has still not proven that it can get customers back to the stores, and until then, profitability remains a distant dream.