J.C. Penney: We Don't Envy Ullman's Position

| About: J.C. Penney (JCP)

After firing controversial CEO Ron Johnson during the quarter, department store retailer J.C. Penney (NYSE:JCP) announced weak results yet again. Revenue fell 16% year-over-year to $2.6 billion, falling short of already low consensus expectations. The firm's loss was also much deeper than consensus estimates, widening to a loss of $1.31 per share on a non-GAAP basis. Free cash flow was substantially worse as the company burned through even more cash than it did in the prior-year period, posting negative free cash flow of $966 million.

The main culprit of J.C. Penney's weakness seems to have been its change in price strategy. Same-store sales declined 16.6%, which is simply unacceptable for any retailer. The firm brought back coupons, but it may have been a little too late - though the rate of decline was better than the 31.7% same-store sales dip during the fourth quarter. Johnson already ditched the unsuccessful pricing, but new (and former) CEO Mike Ullman understands couponing as well as any retail executive, so perhaps he can add some value in that respect.

Reversing the sales decline is the top priority for Ullman, in our view, so we're also encouraged to see the company bringing back some of its most popular brands, like St. John's Bay. According to Ullman, St. John's Bay was a $1 billion brand, so efforts to re-establish traffic with a strong brand reintroduction could be fruitful. Ullman also mentioned that national brands weren't experiencing the same precipitous decline in sales as private label brands, so Penney's business might not be as broken as it seems.

Interestingly, it appears Johnson will leave some legacy on the company, though a great deal of people would prefer not to remember his tenure. Ullman spoke about the shop within a shop concept, saying:

"Given the proven success of Sephora and the encouraging performance by Levi's, IZOD, Liz Claiborne, Arizona, and JCP shops, attractions are going to remain a strategic emphasis. We aren't going to set a specific number of shops; it will test and build out the ones that customers clearly want."

We've long supported the idea of the firm creating a better shopping experience, and a combination of superior shopping and pricing could certainly benefit sales.

However, driving additional sales isn't the only issue at J.C. Penney. Margins continue a downward spiral, falling 680 basis points year-over-year to 30.8%. Although we believe the firm will benefit from lower sourcing costs in the back half of the year, a gross margin in the low 30s makes profitability nearly impossible. If sales improve, margins should follow suit to a degree (as overhead is leveraged), but we still think the company needs to generate profitable sales growth (as it remains in need of cash).

SG&A isn't as much of an issue for the company, even though it increased 410 basis points year-over-year to 40.9%; it fell 7% year-over-year on an absolute basis. Johnson was meticulous about removing excess waste from the firm's cost structure, but a retailer can only run so thin. Again, sales growth will help leverage fixed costs, though we think closing unproductive stores could help boost profitability.

Although Ullman's goal looks fairly straightforward - boost sales - the path to doing so isn't as easy as it seems. The firm drove away several of its core customers during the past year and a half, and the new sales strategy could turn off any of the new consumers it acquired (even if it wasn't that many). While Penney's changed its strategy, we think customers turned to Macy's (NYSE:M), which experienced mostly positive same-store sales growth, and to the off-priced retailers like TJX (NYSE:TJX) and Ross (NASDAQ:ROST). The off-priced stores were already stealing market share, in our view, but Penney's change in pricing may have driven some of its long-time customers to a different value-oriented shopping experience. They simply may not come back. Rivals Kohl's (NYSE:KSS) and Sears (NASDAQ:SHLD) made only marginal sales gains, even though Penney's was losing nearly 25% of its sales at a given time. We're not feeling great about the lower-middle tier of department stores.

In addition to growing sales in a highly competitive environment, Ullman has to repair the firm's cash drain. Penney's already slashed its dividend last year, but high capital spending intended to remodel stores and drive sales growth hasn't brought incremental revenue. The firm recently raised some cash via a debt offering, which will help solve near-term liquidity issues, but the company desperately needs to return to profitable sales growth to ensure its survival.

Before Johnson's arrival, we believe J.C. Penney was on the slow path to irrelevancy and decline, and in the worst case scenario he would accelerate the process. Well, the worst-case scenario occurred. Ullman has his job cut out for him, but hopefully, for shareholders' sake, he can combine the positive store-in-store strategy of Johnson with more selective discounting to help drive a profitable recovery. Ultimately, we think several of Penney's stores could become data centers (alas Sears) in the years to come. We have no interest in the high-risk retailer at this time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.