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After J.C. Penney's (JCP) disappointing earnings last month, I wrote that the stock was untouchable. I closed my short position and advised investors to stay away because I felt there were serious upside and downside risks going forward. Since hitting a 52-week low at $15.69 on November 16, the stock has rallied more than 30%, closing at $20.80 on Thursday. While J.C. Penney's promotional actions in the current quarter suggest that the company is adapting (a good thing), there has been no improvement in the company's results to justify the recent rally. I am therefore considering re-opening my short position, and will probably do so if the stock continues to move higher in the next week or two.

Small Strategy Shifts

Under CEO Ron Johnson, J.C. Penney unveiled a radical new strategy at the beginning of 2012. Over a 4 year period, the company is dividing its large-format stores into a collection of 100 shops. More immediately, J.C. Penney did away with most promotions and coupons, in an attempt to improve margins and maintain a more consistent flow of store traffic. However, this strategy backfired in the first few quarters, as sales dropped by more than 20%. In Q3, J.C. Penney began bringing back some promotional activities. Management finally recognized that it is impossible to compete with heavily promotional retailers like Macy's (M) and Kohl's (KSS) without offering some promotions of your own, to entice customers to come into the stores.

This quarter, J.C. Penney has been expanding on the new semi-promotional model. Last weekend, the company ran a "Friends & Family" 20% off event. As a recent note from Deutsche Bank points out, "The [Friends and Family] event is the latest of a series of promotions (i.e. 30% Off Select Outerwear, $10 Gift from CEO Ron Johnson, Free Family Portraits, Free Haircuts, etc.) that have been issued by the company over the past few months to drive traffic." Many analysts (including those from Deutsche Bank, J.P. Morgan, and Oppenheimer) appear to be relatively encouraged by this new flexibility. While Deutsche Bank has a $17 price target on the stock, the firm actually called J.C. Penney a short term buy based on recent news.

Underlying Weakness Remains

The problem for J.C. Penney investors is that the company's recent strategy changes have been reactive rather than proactive. After the initial promotional events in October (a $10 "gift" from Ron Johnson to customers, and a 30% off clearance merchandise event), I suggested that the return to more promotions could be an indicator of poor sales trends. Sure enough, sales were even worse in Q3 than in the previous two quarters, down more than 26%. In the Q3 earnings presentation, Johnson stated that the company would run its "only sale of the year" on Black Friday. With J.C. Penney holding another sale just two weeks later, in the form of the Friends & Family event, it seems extremely likely that sales are continuing to underperform. If management had intended last month to hold a second sale-type event, Johnson would have mentioned that in the Q3 earnings presentation. In all likelihood, weak traffic in the intervening weeks forced J.C. Penney to add another promotional event.

I am thus inclined to agree with other retail analysts who have suggested that J.C. Penney's sales this quarter could be down 25-30% (excluding the impact of a 14th week). While the Wall Street consensus is already pricing in a 22% sales decline, there is still meaningful downside to Q4 sales and earnings estimates. Just two months ago, analysts expected J.C. Penney to turn a profit this year (on an adjusted, non-GAAP basis). Now Wall Street is looking for a loss in the hundreds of millions of dollars.

J.C. Penney Has Dug a Deep Hole

J.C. Penney bulls point to strong sales trends within the few "shops" that have opened this year. They argue that as more shops roll out, J.C. Penney's performance will improve dramatically. While there is some truth to this, J.C. Penney has dug itself into a deep hole this year. With annual sales likely to total $13 billion (or slightly above) this year, the company will need significant sales increases going forward just to get back to breakeven. After cutting nearly $1 billion in costs from the FY11 budget (offset somewhat by higher depreciation and pension expense), J.C. Penney will have approximately $5 billion in annual operating and interest expenses next year. With sales flat at $13 billion, J.C. Penney would need a gross margin of 38.5% to break even; with 4% growth to $13.5 billion, it would need a 37% gross margin, and with 8% growth to $14 billion, it would still need 36% gross margins. By contrast, year-to-date gross margins have been only 34.5%, and Q4 is typically has the lowest gross margins of the year.

The bottom line is that J.C. Penney would need to boost sales and gross margins next year to get back to breakeven; cost cuts alone will not do the trick. It may be able to accomplish one of those tasks, but not both. Retailers will face a bevy of challenges next year, including higher taxes on consumers (the 2% payroll tax reduction is almost certain to go away), a shorter holiday selling season (due to the calendar shift of Black Friday from Nov. 23 to Nov. 29), and the loss of the 53rd week compared to the 2012 fiscal year. J.C. Penney specifically will face the continuing disruption of having its stores under construction as up to 30 new shops are built out. Lastly, management still has not figured out how to bring people into the stores on a regular basis without offering margin-sapping discounts.

If, as I expect, J.C. Penney is unable to reach breakeven next year, the company may be forced to raise capital in order to fund its "transformation". Last quarter, cash and investments fell to only $500 million, and the company's aggressive investment plans will require as much as $1 billion in capital expenditures next year. J.C. Penney will not generate more than $500 million in free cash flow next year as a result of its unprofitability. Furthermore, the company's credit rating has been downgraded numerous times this year, which will make it hard to raise debt on acceptable terms, and I view it as unlikely that the company would fund capital expenditures through its credit line. The company could thus be forced to sell additional stock, diluting existing shareholders.

Conclusion: Sell the Hype

I believe that J.C. Penney's recent rally has been driven by factors unrelated to the company's fundamental performance. The stock has very high short interest (over 40% of the float as of November 30). Just as Apple (AAPL) has been punished in recent weeks due to tax-related selling, I think J.C. Penney may have benefited from tax-related short covering. Shorts sitting on big gains from J.C. Penney's awful year may be closing positions to book profits before the end of the year. Compounding that, the stock's rapid gains triggered a short squeeze; over the past six trading sessions, the stock has gained nearly 20%.

This trading pattern could continue for another week or two. However, by January 1 at the latest, tax driven short covering will have ended and shorts may be looking to re-enter. I therefore recommending selling into strength over the next few weeks. Investors who are inclined to short the stock could also begin scaling into a short position if the stock moves higher before the end of the year. When J.C. Penney reports Q4 results in February, I expect another disappointment for longs, which should drive the stock back down towards 52-week lows.

Source: J.C. Penney Jumps: Buy The Rally Or Sell The Hype?