Although J.C. Penney (JCP) delivered a solid earnings report in Q2 2014 (with particularly strong improvement in gross margin), there are several items that have made me more confident in the idea that J.C. Penney has only modest upside at best.
Gross margin improvement was strong during Q2 2014, but it is still unclear what level J.C. Penney can recover to. In-store traffic on the other hand remains quite weak, with continued reports of negative traffic versus easy comps. Internet sales growth has slowed significantly and is not growing enough to offset the negative traffic numbers.
J.C. Penney has made strong improvements in conversion rate and average transaction size, making rapid progress in returning those numbers towards historical levels. However, the traffic numbers indicate that J.C. Penney is having significant difficulty getting former customers to return (or that current customers are leaving at a higher rate than former customers are coming back). The case for J.C. Penney having long-term upside is predicated on getting above $14.2 billion or so in revenue. Currently the stock is pricing in a reasonable chance of that happening. However, there is a very limited chance of that happening without positive traffic numbers. Even with positive traffic numbers that revenue target is not guaranteed, but it depends on a combination of how positive the traffic numbers are, what gross margin ends up as, and whether conversion rates and average transaction size can fully recover too.
On Gross Margin
J.C. Penney delivered an excellent performance with respect to gross margins in Q2 2014. The 36.0% gross margin in the quarter translates into an approximate annual run rate of 36.6% based on historical gross margin changes from quarter to quarter. This is a marked improvement over the 31.0% annual run rate suggested by Q1 2014's results. However, gross margin guidance for Q3 2014 suggests that the annual run rate could fall to as low as 35%.
Quarterly gross margin compared to fiscal year averages
Q1 | Q2 | Q3 | Q4 | |
Vs. FY | +2.1% | -0.6% | +1.1% | -1.9% |
J.C. Penney's strong gross margin performance during Q2 2014 does give it some extra value, with EBITDA ending up about $67 million higher than I expected based on gross margin improvement alone. This translates into an extra $0.22 per share in value. However, the gross margin improvement so far and the guidance given for Q3 2014 doesn't answer the question of where J.C. Penney's gross margin will end up in the long-run.
Most analysts have believed that J.C. Penney can restore gross margin to somewhere in the 37% to 39% range eventually. My articles from 2013 even assumed at least a 37% gross margin rate long-term. J.C. Penney's value is partially dependent on where it can get to within the 37% to 39% range, and there has been not much indication of where it will end up yet, with the Q2 2014 results and guidance for Q3 2014 providing no more clarity on this issue.
Traffic, Traffic, Traffic
The most glaring weakness with J.C. Penney's turnaround is in-store traffic. Sixteen months after Ron Johnson left, traffic continues to be negative year-over-year. Basically, in-store traffic is lower now than at any time during Ron Johnson's leadership. The various eyewitness accounts of how busy J.C. Penney stores were during the last couple quarters have been proven to paint a very inaccurate picture of J.C. Penney's actual traffic.
It is true that in-store traffic is not a problem unique to J.C. Penney. Retail in general has been struggling with significant declines in foot traffic, with shopper traffic falling by 5% or more in every month (except for April 2014) during the last two years. However, J.C. Penney does not seem to be tremendously outperforming its competitors with regard to foot traffic. The one positive traffic month this year that it posted so far (April) is also the one positive traffic month that retail in general has posted too, and appears highly influenced by the Easter shift. This is a sign that its lost customers are not flocking back, at least not fast enough to offset general traffic losses.
From what I can tell, traffic was down about 15% between 2011 to 2013. It may be down up to 20% now. With a 20% traffic loss, even if conversion rates and average transaction size return to historical levels, J.C. Penney will max out at around $13.5 billion to $14 billion in sales. There is a distinct possibility that J.C. Penney will continue to lose traffic too, as it fights against negative trends for retail overall.
Internet Sales
With the decline in retail traffic, there is an expectation that Internet sales will pick up some of the slack. However, for J.C. Penney Internet sales growth appears to be decelerating, going from 25.7% growth in Q1 2014 to 16.7% growth in Q2 2014. Internet sales remain 21% below 2010 levels, which is quite weak given the growth in Internet sales among department store competitors over those four years.
J.C. Penney Internet Sales
$ Million | Q1 | Q2 | Q3 | Q4 |
2009 | NA | 305 | 350 | 464 |
2010 | 353 | 317 | 361 | 495 |
2011 | 376 | 326 | 341 | 480 |
2012 | 271 | 220 | 214 | 315 |
2013 | 217 | 215 | 266 | 381 |
2014 | 273 | 249 |
Based on a comparison of the change in Q3 sales vs. Q2 sales from 2009 and 2010, Q3 2014 Internet sales are estimated to be approximately $290 million, which would represent a further deceleration to under 10% growth year-over-year.
Conclusion
We have a situation where J.C. Penney continues to lose traffic from the lows of the Ron Johnson era. Internet sales growth is also slowing significantly, and is unable to make up the lost in-store traffic. While gross margin has improved significantly, there is still uncertainty about where in the 37% to 39% range J.C. Penney can get gross margin to in the long-term.
On the positive side, J.C. Penney is making strong gains in conversion rates and average transaction value. However, with traffic approximately 20% below 2011 levels and potentially still declining, even getting conversion rates and average transaction value back to historical levels will only result in a J.C. Penney with $13.5 billion to $14 billion in revenue at most. At $14 billion in revenue, it requires some rather extreme assumptions for other inputs to justify a stock price much above $10. On the other hand, fighting against the negative retail traffic trends (and with J.C. Penney's relatively weak position in Internet sales) could lead to revenue topping out below $13.5 billion.
