"Let me start off by saying that the turnaround of J.C. Penney is beginning to take hold. We're making significant strides towards restoring J.C. Penney to its rightful place in retail."
-Mike Ullman, J.C. Penney CEO, during the Q3 2013 Conference Call.
J.C. Penney (JCP) began to generate positive sales momentum in Q3 2013, which also allowed them to get off to "an encouraging start in the fourth quarter." For the first time in nearly two years, J.C. Penney reported positive comps in October, with comps rising another 10.1% in November from the previous year. The positive results were most likely helped by more competitive store hours, as well as several other initiatives I will outline in this article.
However, with such large gains, it is surprising that the nine week period from November to December (the holiday period) only saw a same store sales increase of 3.1%, as well as growth of just 2% in the quarter compared to the previous year (which we will assume was rock bottom).
There are several short term "sell" signals, including the terrible margins (compared to historical levels, but above low-20's seen just a few months ago) and tough competition. However, I believe that the phrase "short term" describes these problems accurately, as I will later showcase. Instead, I believe that sales growth and liquidity should be looked at more rigorously.
From the recently unveiled same store sales, as well as marginal year over year growth, it is clear that many of J.C. Penney's customers are coming back.
The main difference that the new management team is making is to suit their stores to the consumers, changing layouts and merchandise. The remodeling of the home department, one of the key aspect of their stores, should be completed by the Spring of 2014.
However, merchandise purchased by the old management (Ron Johnson) didn't appeal to the consumers as well as expected. This spells out one of J.C. Penney's major problems: inventory that consumer's don't want. These items continue to hurt margins (as they are severely marked down), but management expects to clear the aisles of unwanted stock beginning in 2014.
Analyst Brian Sozzi says that J.C. Penney has "one goal this holiday season - to clear though basically everything that Ron Johnson brought to the table." This would be the first step in a long term voyage to restore J.C. Penney's historical margins.
For clearance purposes, I believe that J.C. Penney will disappoint on margin (growth) during Q4, the holiday season. However, as I will outline later, I believe that margins are set to begin to improve next year.
On the other hand however, J.C. Penney's private brands, such as Worthington and St. John's Bay, as well as national brands such as Izod and Carter's are a strong appeal to consumers both online and in store. Customers are responding well to the rebranding of J.C. Penney stores, which will help the company report positive comps for Q4 2013.
Management pointed out on the conference call that margins improved sequentially throughout the months of the quarter to 29.5%, though not representing a major change in momentum.
The main change in margin will come from J.C. Penney selling old unwanted inventory (from previous management), and should "allow J.C. Penney to return to its previous margins." Along with gains to be seen from selling off old inventory, the sale of private brand merchandise is also returning to "normal" levels, which carries a 400 to 500 basis point better gross profit margin (than national brands).
The margin affect of unwanted inventory should begin to decline in 2014 (though it will not be evident in Q4). I believe that we should begin to see improving margins next year, with continuing rebranding efforts and price fixes.
The mark up of prices in some case will be extreme, as J.C. revives their idea of becoming a discount retailer. Hence, marking up inventory will allow them to discount it to healthy margin levels to consumer, who will believe they are getting a deal. I believe that this will be a turn on for consumers, and also allow JCP to increase their margins (and perhaps sales).
While J.C. Penney carries their own special brands inside their stores, including roughly 450 Sephora's, they also carry multiple national brands, including: Levi's, Nike, Carter's, Dockers, Alfred Dunner, Vanity Fair, and Izod. The assortment of inventory should continue to attract consumers.
I see online sales as one of the largest positives for J.C. Penny going forward. Sales in the quarter were up 24.5% over the previous year to $266M. Online sales in 2012 was $1.02B, which I believe to increase to over $1.25B in 2013, and $1.5B in 2014. These gains should help add to revenue in 2014 (though I am not adding them to my estimates, allowing for more potential upside).
Preparation for the future
Of the $46M in restructuring charges in the quarter, $13M was used in the rebranding of JCP, with $36M being "paid" (also received a credit) to Martha Stewart for the settlement of the ongoing suit between Macy's and the other companies.
In Q3, JCP gained $786M from a secondary sale, and loaded up on holiday inventory ($592M invested in inventory for the holiday), as well as voluntarily paying down $200M in revolving credit. I believe that this will save JCP $10M in interest next year, a very good allocation of capital in my opinion.
Capital expenditures of $161M in the quarter continue to prepare JCP for the future, as they invested in "additional Sephora inside J.C. Penney locations, Disney, and a partial paydown of the accrued and unpaid capital expenditures from last quarter."
The rate of capital expenditures will decrease to around $300M in 2014, showing the continuing stability of JCP.
All of the data above leaves me to the following guidance based on analyst sales estimates for 2014 and 30% gross margins:
|Gross Profit %||30%|
The analysis for 2014 which I outline above leaves several areas for improvement:
1) An increase in sales
2) An increase in gross margins (as I expect to see later in the year)
3) A decrease in operating expenses (which I expect to see y/y)
4) Repayment of more debt, which could lead to less interest loss
However, in 2015, I expect margins to return to normal in part due to this statement during the Q3 conference call:
"So the combination of those three across private brand, national brand, and our attractions and exclusives, that's the arithmetic that gets us back to 37% to 39% gross profit that we had for 7 to 10 years."
With just around $1B in pre-tax loss during 2014, I believe that 2015 will finally be the year that JCP becomes profitable. With 37% margins on stagnant revenue from 2014, JCP would earn more than $100M in pretax income, putting them back on the recovery track (assuming they pack back their debt with excess capital).
There are many things to like about JCP. Although I expect holiday and Q4 margins to disappoint, I believe that 2014 will be a crucial year for JCP to show that it can make a come back. With it already mounting serious competition in the tight retail industry, I believe that J.C. Penney has the fundamentals to become profitable within six quarters and unlock its book value.
Perhaps the best way to describe the future of J.C. Penney is consistency. The consistent goals, ethics, and offerings that will continue to attract consumers.
"While our immediate goal has been to get us our customer back into our stores, the ultimate goal is to deliver consistent, profitable growth over the long term. We're not there yet, but if we continue gaining traction and building momentum, we will get there. I'm confident that we have the strategies and people in place to do it."-Mike Ullman, J.C. Penney CEO