The Prospect Of Survival Is No Reason To Own Best Buy Or J.C. Penney

Includes: BBY, JCP
by: Valuentum


Shares of JC Penney and Best Buy are currently engaging in a classic “dead cat bounce”.

The competitive environment of the retail industry is nothing short of intense. Both firms are not out of the woods.

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Shares of J.C. Penney (NYSE:JCP) and Best Buy (NYSE:BBY) are currently engaging in a classic "dead cat bounce" with the equity prices of both firms experiencing appreciation after reporting their respective fourth-quarter results recently. J.C. Penney is trading at nearly $9 per share, down from about $70 per share in 2007, while Best Buy is hovering at about $26 per share, down from more than $40 per share, a level achieved only a few months ago. We continue to believe both companies are far from healthy.

What's the news that has J.C. Penney's shares spiking to nearly $9 and change? The firm reported a loss per share of $0.68 in its fourth-quarter report, released February 26, beating estimates that had expected even worse. Management's commentary was encouraging stating that the company reported positive same store sales in the fourth quarter and registered its first quarterly sales gain since the second quarter of 2011. Holiday sales, however, advanced only 3.1% in November/December, which isn't that blockbuster of a recovery following significantly depressed sales levels in the year-ago period.

We know many want us to sound the 'all clear' on J.C. Penney, but the competitive environment of the retail industry is nothing short of intense. During the quarter, J.C. Penney generated positive free cash flow of $246 million and even posted an improved gross margin (up 460 basis points from last year), but we have to be realistic…one quarter a true recovery does not make. The firm ended the year with total available liquidity in excess of $2 billion (and this is good news), but we still have to see how the company performs through the course of 2014 to get a feel for overall annual free cash flow burn. J.C. Penney probably put up one of the best quarters any company could while still losing $0.68 per share. For all of 2013, the company reported an adjusted operating loss of $1.24 billion.

Looking ahead, J.C. Penney issued guidance for 2014. Comparable sales are expected to increase in the mid-single-digits, its gross margin is expected to improve significantly relative to 2013, and it is expected to hold the line with respect to liquidity. Though we were encouraged by the outlook, J.C. Penney remains a speculative bet on its operating survival, which must happen for its equity to be worth anything. At more than $7 per share, investors are not only buying the company's survival but a return to sustainable operating profitability - not just in 2014 but into perpetuity. This may happen, but that doesn't mean that the stock is a good bet at this juncture on a risk-adjusted basis. We view J.C. Penney as a trading vehicle until more sustainable performance is registered.

Another troubled retailer, Best Buy reported fourth-quarter results February 27. Shares of Best Buy were hammered when it reported holiday revenue results January 16, and the slight recovery as a result of the fourth-quarter performance is hardly worth writing home about. But unlike J.C. Penney's results, Best Buy did post a profit of $1.24 per share on a non-GAAP diluted basis. Comparable store sales still dropped 1.2% in the quarter, and competition from online powerhouse Amazon (NASDAQ:AMZN) and other electronic retailers will almost certainly intensify in coming years. Best Buy's non-GAAP operating margin in the 52-week year ended February 1, 2014, was a meager 2.8%, not unlike that of other retailers, but still representative of just how slim of operating error the company truly has. In all fairness, however, by the company's estimates, return on invested capital didn't deteriorate much from last year, and while the 9.1% mark it posted this year is below our estimate of the firm's cost of capital, it is not terrible. Still, Best Buy's fundamental prospects are far from bright. Declining retail traffic and intense promotions offset by cost-cutting initiatives is low-quality performance, no matter how one looks at it. Best Buy's commentary:

As we said in our holiday sales release, the fourth quarter was an environment of declining retail traffic, intense promotion, fewer holiday shopping days and severe weather. In the face of these unusual circumstances, our strategy to be price competitive and provide an improved customer experience resulted in market share gains in a weaker-than-expected consumer electronics market.

While we cannot be satisfied with the fourth quarter operating income rate decline of 120 basis points, the decline included the expected approximate 100-basis point negative impact associated with our mobile warranty and new credit card agreement economics that we called out in our Q3 FY14 earnings release. Thus we were able to materially offset the price investments we have been making with substantial cost savings and other operational improvements.

Valuentum's Take

J.C. Penney and Best Buy are fighting an uphill battle. The odds are long against them, unless they continue to make the necessary strides to remain relevant. Many investors remember the demise of the once-mighty Montgomery Ward, and while J.C. Penney's survival through the most recent holiday season indicates to us that it will be around for another year, the long-term (or even the intermediate term) is not guaranteed. As for Best Buy, to say that its long-term is guaranteed is similar to saying the now-defunct Circuit City will be around forever. Business models do change, and the respective management teams are working hard to right their ships (or in J.C. Penney's case, stop the bleeding), but survival is not guaranteed. Long-term investors should look elsewhere than J.C. Penney and Best Buy, which to us, represent speculative, trading vehicles. Our best ideas are included in the actively-managed portfolios.

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.