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Shares of J.C. Penney (NYSE:JCP) witnessed a roller-coaster trading session on Tuesday after the company released its second quarter results, and continued to decline on Wednesday.

While returning CEO Ullman might have stabilized the business and laid out the foundations for further improvements, shares are not an obvious buy at the moment. Even if the company can successfully make it through these rough times without severe dilution, the current valuation already reflects a lot of good news for the future ahead.

I remain on the sidelines.

Second Quarter Results

J.C. Penney generated second quarter revenues of $2.66 billion, down 11.9% on the year before. The entire decline in sales is attributed to an 11.9% decline in comparable sales. Revenues fell short of consensus estimates of $2.77 billion as analysts expected same-store sales to fall by just 8.3%.

Net losses widened from $147 million last year to $586 million over the past quarter, as losses rose to $2.66 per share. The losses included quite a few incidental charges. Excluding all the one-time charges, losses per share came in at $1.18 per share, a bit larger than consensus estimates of $1.06 per share.

CEO Mike Ullman commented on the developments over the quarter:

"Since I returned to J.C. Penney four months ago, we have moved quickly to stabilize our business - both financially and operationally - and we have made meaningful progress in important areas of the business. There are no quick fixes to correct the errors of the past. That said, we have identified the challenges, put solid plans in place to address them and have experienced and capable people in key roles to do so."

Failed Strategy

The fall in revenues is attributed to prior poor merchandise and promotional strategies, which resulted in much larger markdowns and clearance levels, and are a direct result of former CEO Johnson's strategic vision.

While the current trends are still extremely disappointing, same-store sales improved by 470 basis points from the first quarter, and have shown improvement during each month of the period. On top of the poor sales developments, gross margins compressed another 360 basis points to 29.6% of total sales. Lower sales and higher clearance efforts were to blame. At the same time, selling, general & administrative expense rose by 380 basis points to 38.5% of total sales, resulting in an operating loss of 14.8% of total revenues, compared to 6.1% a year earlier.

Reported losses of $2.66 per share included a range of incidental charges, which in total depressed earnings by $1.48 per share. J.C. Penney recorded a $0.99 charge related to tax valuation allowances, a $0.52 charge on an early debt retirement tender offer, $0.21 in restructuring charges. The only benefit came from a sale of non-operating assets, which boosted earnings per share by $0.28.

Valuation

J.C. Penney ended the quarter with $1.53 billion in cash and equivalents. The company operates with $5.77 billion in total debt, for a net debt position of $4.24 billion. Revenues for the first six months of the year came in at $5.30 billion, down 14.2% on the year before. Net losses tripled to $934 million in the meantime. At this pace, J.C. Penney is on track to generate annual revenues of $11 to $12 billion, while the company will report a large full year loss.

Trading around $14 per share the business is merely valued at $3.1 billion, or roughly 0.25 times annual revenues.

Some Historical Perspective

Between 2003 and 2007, shares of J.C. Penny tripled from merely $20 to $80 per share as the boom in consumption boosted prospects for the entire economy, including retailers.

Shares fell to lows of $15 during the crisis in 2009, but unlike other major retailers J.C. Penney kept struggling, working with an outdated business model.

In the years following, shares traded in a $20-$40 trading range until the failed strategy executed by Johnson, who was put forward by hedge fund manager Bill Ackman, resulted in consumer defections. The strategy, which was too aggressive in hindsight, has led to enormous losses over the past year as costs rose while sales plunged.

Shares fell from $40 at the start of 2012 to fresh lows around $12 per share in recent weeks. After the earnings report, shares are currently exchanging hands at $14 per share.

Between the calendar years of 2009 and 2012, J.C. Penny has seen its revenues fall by little over a quarter to $13.0 billion. Very modest profits in 2009 and 2010 have been reversed into a billion dollar loss last year, to be followed by an ever greater loss this year.

Ackman Out

Last week Bill Ackman of Pershing Square Capital Management gave up his seat on the board of directors after a public fight. Ackman pushed for a replacement of both CEO Ullman and Chairman Engibous, while the rest of the board supported both executives.

Ackman gained approval to sell his 17.7% stake, or some 39 million shares in J.C. Penney. Ackman joined the board in February of 2011 when shares were still trading in the mid-$30s, and pushed for the hire of former CEO Johnson, which turned out to be a disaster.

Investment Thesis

J.C. Penney is in a terrible position at the moment, yet some light points are emerging.

First of all, the pace of the decline of comparable store sales is slowing down, and J.C. Penney saw incremental improvements in each of the months over the past quarter. The company sees encouraging signs for the back-to-school season, and expects incremental improvements on a sequential basis to continue throughout the year. Online sales fell just 2.2% over the past quarter compared to a 30% drop in the first quarter. Another comforting factor is that the company expects to end the year with $1.5 billion in liquidity without tapping outside financing.

Yet the company is also seeing challenging economic conditions, also mentioned by Wal-Mart (NYSE:WMT) and Macy's (NYSE:M) in their earnings reports, among others. Therefore J.C. Penney is reorganizing its home department unit, which sold upscale goods under Johnson, and instead is returning to towels, cooking gear and other more profitable categories for the average household.

Returning CEO Mike Ullman has "stabilized" the business, which is comforting to investors, as ousted CEO Ron Johnson made the wrong strategic choices in a much too "violent" transformation plan. Ullman quickly generated cash to avoid cash flow or liquidity fears by drawing upon an $850 million revolving credit line and negotiating a $2.25 billion 6% loan. Ullman furthermore went back to "basics" by re-introducing the loved coupons, sales events and basic merchandise offerings to increase J.C. Penney's appeal for middle-income and middle-aged shoppers.

While it seems likely J.C. Penney can make it through the storm, especially given the liquidity and incremental improvements in the second half of the year, this does not automatically mean that shares are a buy. In a rosy scenario, the company could generate annual revenues of $15 billion again in two years' time or so, while reporting earnings of $250-$500 million. However, based on the company's high debt load, the current $3 billion valuation and the road of uncertainty ahead, this does not seem like a golden opportunity to me.

As valuation ratios based on sales are not indicating an extreme discount, I remain on the sidelines.

Source: J.C. Penney - No Screaming Buy, Even If The Company Will Survive