In the middle of October, a UBS analyst downgraded J.C. Penney (NYSE:JCP) to sell, citing the usual lineup of concerns that bears have been spouting for the last three years. Specifically, UBS thought the department store chain's plan for the future was overly optimistic, that the retailer's product offering was too thin, and that new management wouldn't solve the business's underlying issues.
What the pessimists are overlooking is the value of the company's brand and the speed at which a bounce could revitalize J.C. Penney's core business. That's because, unlike a newly growing business, much of J.C. Penney's trouble has come from a weakened brand, not growing pains.
We've been here before
Let's look at another fashion retailer that was in a bad way after losing focus. At the beginning of 2009, Gap (NYSE:GPS) hit a low point. The company was riding a five-year decline in revenue, operating margin was up and down, and comparable sales had fallen 12% in the previous year. It looked like a horrible time to be a Gap shareholder, and the stock fell below $10.
Today, we all know Gap turned it around. Sales have risen, income is up, and the stock now trades at $37.50. While J.C. Penney's predicament can't be modeled directly on Gap's, let's see if there are any insights to be gained by looking at the two companies at their lows.
When Gap was hurting back in 2009, it was doing one thing right: spending less. Even with sales down, the company generated $980 million in annual free cash flow. While annual free cash flow is yet to be determined, J.C. Penney has also put its cash house in order. For the first time in three years, the retailer generated positive free cash flow over the last quarter. Yes, that actually happened.
Free cash flow represents two important things. First, it shows investors that the company has some operational flexibility. Gap's strong free cash generation enabled it to invest in its business when it needed to, refreshing stores, designing new lines, or buying back cheap shares. J.C. Penney can do the same.
The second important thing is that it tells us that J.C. Penney can -- despite all appearances -- manage its processes in a profitable way. Returning to the bear case, one of the biggest influences on cash management comes from management, and J.C. Penney's prudent use of cash is due largely to executives' focus and conservative approach.
Let's address the UBS analyst's speed concern next, and see how long Gap needed to return to growth. The reason we're comparing Gap and J.C. Penney is that both were dealing with a similar situation -- a well-known brand being skipped over due to previous weakness.
After Gap's fiscal 2008 failure, it took one year for things to stabilize, and one more for growth to return. Gap managed the rebound by shifting from staunching the bleeding to bringing in new business. As CEO Glenn Murphy said at the time, "In the last couple of years, there has been a lot of focus on holding on to the customers you had, but now we are redirecting marketing using new mediums and new strategies to get new customers inside of each one of our brands."
The future for J.C. Penney
J.C. Penney's expansion of its product offerings, its renovation of stores, and the shift in leadership at the top of the company are all going to give the retailer the tools its needs to follow in Gap's path. By generating positive cash flow and keeping its fiscal house in order, J.C. Penney is putting itself in a position of strength going into the end of 2014, with a chance for a quick increase in revenue in 2015.
That doesn't mean the company is without risk, though. American retail spending hasn't had the banner year analysts hoped for after a weak 2013. Employment and wage concerns persist, and that limits the amount that households are willing to spend on nonessential items -- like a new spring wardrobe. J.C. Penney needs a few things to go its way to really get up a head of steam. Even so, this company is poised for success at the expense of the bears.
Andrew Marder has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.