Last week, J.C. Penney (NYSE:JCP) presented a three-year plan to return to profitability. The company has identified several areas where it has opportunities to recapture some of the business it lost during the tumultuous Ron Johnson era.
By adding at least $2 billion in sales over the next three years, J.C. Penney believes it can quadruple EBITDA (earnings before interest, taxes, depreciation, and amortization) to $1.2 billion. J.C. Penney executives presented several concrete initiatives designed to drive this sales growth.
However, while J.C. Penney's same-store sales grew more than 6% in the first half of 2014, its momentum is already slowing. Moreover, its financial plans don't adequately account for the fact that competitors are also making progress. Additionally, J.C. Penney has a weaker financial profile than most rivals, with low margins and a heavy debt burden. In the long run, J.C. Penney still faces a significant risk of bankruptcy.
Stabilization has occurred
In 2012 and early 2013, then-J.C. Penney CEO Johnson made major changes that didn't resonate with customers. These included eliminating most discounts in favor of everyday low prices and bringing in new national brands. Current CEO Myron Ullman should be applauded for stabilizing sales in the year and a half since he was called back to save the company.
In the fourth quarter last year, J.C. Penney reported a 2% gain in same-store sales; this represented its first quarter of same-store sales growth since the second quarter of 2011. In the first half of this year, J.C. Penney's same-store sales gains accelerated to more than 6%. In addition to winning back some sales volume, J.C. Penney boosted its gross margin to 36% as of the second quarter (up from 30.2% in the first half of 2013).
Meanwhile, the department store chain has continued reducing operating expenses, further improving margins. Lastly, by keeping capital expenditures in check, the company expects to produce a little bit of free cash flow this year, after burning through more than $2.7 billion in 2013.
Plans for the future
At J.C. Penney's investor day last week, company executives presented plans to boost sales by $3.5 billion over time, of which they think 60% is achievable in the next three years. Of the $3.5 billion target, $1 billion would come from "center core" initiatives, $750 million from boosting home section sales, $800 million from omnichannel improvements, and the rest from market share growth.
J.C. Penney defines its center core category as items customers expect to find in the middle of its stores, including "beauty, footwear, jewelry, handbags, accessories, and intimate apparel". While J.C. Penney has solid market share in beauty and fine jewelry (and is a major apparel retailer), it lags competitors in the other center core areas.
The company plans to boost sales in these areas primarily by changing the way these goods are presented. For example, in footwear, J.C. Penney is moving the men's shoe department to a new location, allowing it to expand the women's footwear section. In the pilot stores, these changes led to a significant improvement in sales throughout the location.
J.C. Penney intends to boost home section sales by returning its focus to "soft" home categories such as bedding, bath, and window. It is also revamping its presentation and pricing strategies. In omnichannel, J.C. Penney plans to drive revenue by reemphasizing online sales, improving its mobile site and apps, and rolling out new ship-to-store and ship-from-store initiatives.
Does this strategy work?
All of these initiatives provide credible ways for J.C. Penney to meet customers' needs and should be a positive for sales. However, in many ways, the "new" strategies are just a return to what the company was doing during Ullman's previous tenure as CEO.
From 2007-2011 -- the last five years of Ullman's first stint at the helm -- the company posted very unsatisfactory results. Sales plummeted from $19.9 billion in 2007 to $17.6 billion in 2009 due to the Great Recession, while net income dropped even more dramatically.
J.C. Penney began to recover in 2010, as same-store sales rose 2.5%. However, it quickly lost momentum, and by mid-2011 sales had completely stagnated. It was around that time that Johnson was hired to revitalize J.C. Penney. This gambit failed, but it is important to remember that J.C. Penney's problems arose under a strategy similar to what it is now implementing.
The limits of J.C. Penney's strategy can also be seen from the modest goals laid out last week. Of the more than $5 billion in sales volume lost between 2011 and 2013, J.C. Penney expects to regain less than half that amount by 2017. The projected 2017 sales level of $14.5 billion would be more than 25% below what the company achieved in 2007.
Competition still on the rise
J.C. Penney has been losing market share for years, and despite the recent rebound, it is likely to continue losing share in the long run. After posting better than 6% same-store sales growth in the first half of 2014, J.C. Penney recently reduced its third-quarter guidance. It is now calling for low single-digit (rather than middle single-digit) same-store sales growth.
Indeed, J.C. Penney's sales growth for the past few quarters has been exaggerated by easy comparisons. In the first half of 2013, comparable-store sales fell 14.3% on top of a 20.3% decline in the first half of 2012. Comparisons will get tougher starting next quarter, making it harder for J.C. Penney to post sales growth -- even with all of its new initiatives.
The same competitors that took share from J.C. Penney over the last seven years or so are likely to continue expanding at its expense. The most noteworthy competitor is TJX (NYSE:TJX), which operates the T.J. Maxx, Marshalls, and HomeGoods chains in the U.S.
In 2007, when J.C. Penney's sales peaked at $19.9 billion, TJX's U.S. chains posted sales of $14.1 billion. Last year, TJX's U.S. sales reached $20.9 billion. In other words, it grew nearly 50% in a span of six years that included the Great Recession!
TJX's off-price model allows it to offer fashionable, high-quality merchandise at prices that J.C. Penney and its peers can't match. It also has more convenient locations outside of traditional malls. That's an incredible value proposition for customers, which is why TJX has generated such robust growth. Moreover, TJX's growth is not over.
In the long run, TJX believes it can operate 3,000 T.J. Maxx and Marshalls stores in the U.S., up from 2,021 at the beginning of this year. It also sees an opportunity to nearly double the HomeGoods store base from 450 to 825. Consumer spending is not growing that quickly -- this growth entails TJX taking share from traditional department stores like J.C. Penney.
TJX isn't the only growing off-price retailer, either. Ross Stores plans to roughly double its store base in the long run, reaching 2,500 locations. Nordstrom has grown its Rack off-price division from 50 stores in 2007 to 162 today, with plans to reach 230 stores by the end of 2016.
These low-cost retailers will continue to disrupt midprice department stores like J.C. Penney and Sears Holdings for the foreseeable future. Indeed, they have taken virtually all of the business lost by both Sears and J.C. Penney in the last 7 years. Neither department store chain has profited from the other's struggles.
Struggling to break even
J.C. Penney will confront these strategic challenges from a weak position. It posted an adjusted loss of $581 million in the first half of 2014, and analysts expect it to lose money in the second half of the year as well. The company's finances look somewhat better on a cash flow basis, but it still needs mid single-digit annual sales growth in the next few years to produce positive free cash flow.
Meeting these goals will be an incredibly tough task for incoming J.C. Penney CEO Marvin Ellison. He must continue to rebuild J.C. Penney's brand image while fending off competitors, particularly in the off-price segment.
However, while Ellison has the skills to execute on the strategic plans laid out by the current management team, he doesn't have a fashion background. This could be problematic insofar as fashion leadership has been one of the key levers used by off-price stores to gain market share.
Meanwhile, J.C. Penney is struggling with a $5.3 billion debt load that requires more than $400 million in annual interest payments. (That's more than 3% of J.C. Penney's revenue.) The company can't afford even a small setback at this point.
Unfortunately, competitive pressures may prevent J.C. Penney from making the market share gains its leaders are hoping for in the next few years. If that happens, the company will probably need to file for bankruptcy in order to reduce this debt load to a more manageable level. Until J.C. Penney gets back on a firm financial footing, investors should stay away.