J.C. Penney: A Look At Gross Margin Expectations

| About: J.C. Penney (JCP)

Summary

Department stores include different items in cost of sales, so gross margin may not be entirely comparable across companies.

J.C. Penney can likely reach 36% to 38% gross margin long-term.

However, even at that gross margin level, J.C. Penney needs to improve growth rates from guidance to reduce net debt levels from 2013 to 2015.

This article intends to address J.C. Penney's (NYSE:JCP) gross margin situation, including what can reasonably be expected for future gross margin and how J.C. Penney compares to Macy's (NYSE:M). I think there are two mistakes that can be made here. One is to look back and note that J.C. Penney once had over 39% gross margin, that Macy's currently has 40% gross margin, and then believe that J.C. Penney should be able to achieve 39% gross margin fairly easily. The other mistake is to look at J.C. Penney's gross margin over the last couple years and assume that it cannot eventually make it back to at least the mid-30s for gross margin.

Comparison With Macy's

Macy's has been brought up as an example of a department store that gets over 40% gross margin, even with a strong omnichannel offering. However, it is up to each department store company to determine what items get put into SG&A and which items affect cost of sales. J.C. Penney includes such items as warehousing, buying and brand development costs, and merchandise distribution center expenses in cost of sales, while Macy's puts that into SG&A. The Davis Database mentions that warehousing expenses (see page 50) average 1.8% of sales. This number will obviously vary by company, but it appears that the average does not vary drastically according to company size. Add the other costs (such as buying), and it is probably reasonable to assume that the difference in what is included in cost of goods sold would make J.C. Penney's gross margin about 1.5% to 2.0% less than Macy's.

Between 2006 and 2010, Macy's averaged gross margins that were 1.5% higher than J.C. Penney's. This appears to suggest that Macy's and J.C. Penney previously had similar merchandise margins, and the difference in gross margin is mostly due to accounting differences.

Year

J.C. Penney's Gross Margin

Macy's Gross Margin

2006

39.3%

39.9%

2007

38.6%

40.4%

2008

37.4%

39.7%

2009

39.4%

40.5%

2010

39.2%

40.7%

2011

36.0%

40.4%

2012

31.3%

40.3%

2013

29.4%

40.1%

Click to enlarge

What This Means For J.C. Penney's Gross Margin Potential

J.C. Penney is currently playing catch-up in terms of online sales. Macy's had approximately 11.5% of its sales come from online sales in 2012, while J.C. Penney was at approximately 10% in Q4 2013. Online sales and omnichannel initiatives do have a negative effect on gross margin due to free shipping, as noted by the comments from Macy's and Kohl's. Kohl's has broken out the effect of free shipping on margins as around 8% to 11%.

The below table shows the effect on gross margin if J.C. Penney has 13.5% of its sales come from e-commerce in 2015 and 21% in 2019. In 2019, the effect on gross margin will be -0.8%, based on 21% online sales with gross margins that are 8% lower than in-store. The base gross margin is calibrated to 11.5% online sales to match Macy's 2012 mix.

Online % of Sales

Effect on GM @-10%

Effect on GM @-8%

2015

13.5%

-0.2%

-0.2%

2019

21.0%

-1.0%

-0.8%

Click to enlarge

Therefore, I would suggest that the appropriate starting point for calculating J.C. Penney's gross margin potential in 2015 would be to take Macy's 2012 gross margin of 40.3%, subtract 1.5% for the accounting differences, and then subtract an additional 0.2% for increased online sales (13.5% for J.C. Penney in 2015 vs. 11.5% for Macy's in 2012). This brings us to 38.6% gross margin for J.C. Penney, dropping to around 37.8% to 38.0% by 2019.

There are a couple other adjustments that need to be made. Some of the warehousing costs (staffing levels) can be scaled according to sales levels. Other components, such as rent and utilities for warehouses and distribution centers do not scale downward as easily, and represent a larger percentage of sales if J.C. Penney is a $13 billion company instead of a $17 billion company. This effect is probably 0.2%.

Shrinkage is also an item that may not fully scale downward with sales levels. Typical shrinkage levels are 1.4% of sales. J.C. Penney was much higher than this recently, but it has taken steps to reduce the very high shrinkage levels it experienced in Q3 2013. However, though sales fell by more than 30% from 2010, it seems doubtful that the level of employee theft, shoplifting, administrative error and vendor fraud (the four main components of shrinkage) fell by the same amount. This affects gross margin by an additional 0.2% if shrinkage (in dollars) fell by 2/3rds the rate that sales did.

J.C. Penney's gross margin potential is therefore estimated around 38.2% in 2015, decreasing to around 37.5% by 2019 if it keeps a good handle on inventory and avoids heavy clearance sales.

The unknown factor in all this though is how much J.C. Penney is willing to sacrifice margins to regain customers. I've been using 37.5% as an estimate for J.C. Penney's gross margin in 2015 onward on the assumption that it sacrifices margins somewhat to grow, more so in the near future. A J.C. Penney stuck in the $12 billion revenue range is in significant trouble long term, so promotional activity is likely to be higher than normal for a while. I think one can make a decent argument for anywhere from 36% to 38% gross margin long term, though, with the high end declining to 37.5% by the end of the decade.

Why Can J.C. Penney Mostly Restore Margins?

I do believe that the majority of J.C. Penney's margin problems are fixable. The restoration of private label balance and reducing the huge shrinkage problem are a couple items that will help gross margin. Eventually J.C. Penney will also clear out the remainder of the legacy inventory that has been languishing on shelves and racks for years. Beyond that, it really comes down to strong inventory controls and a balancing act between trying to drive growth and maintain margins.

J.C. Penney can likely get gross margins back up to the 36% to 38% range that I mentioned earlier long term. However, I am more skeptical that it can get gross margins back to the higher end of that range and achieve strong growth at the same time.

Gross Margin Seasonality

Here's a look at J.C. Penney's gross margin by quarter from 2006 to 2010. Typically, Q1 has been the quarter with the highest gross margin, being above-average in every year, and having the highest gross margin for a quarter in three of the five years. Q3 typically has the second-highest gross margin, followed by Q2 and Q4.

Q1

Q2

Q3

Q4

FY

2006

40.8%

37.3%

41.5%

38.0%

39.3%

2007

41.5%

38.1%

39.7%

36.2%

38.6%

2008

40.0%

37.5%

38.5%

34.6%

37.4%

2009

40.5%

38.5%

40.6%

38.2%

39.4%

2010

41.5%

39.4%

39.0%

37.6%

39.2%

Average

40.9%

38.2%

39.9%

36.9%

38.8%

Click to enlarge

Another way to look at it is that Q1 averages a gross margin that is 2.1% higher than the full year, Q2 averages 0.6% less than the full year, Q3 averages 1.1% higher than the full year, and Q4 averages 1.9% lower than the full year.

Q1

Q2

Q3

Q4

Vs. FY

+2.1%

-0.6%

+1.1%

-1.9%

Click to enlarge

Therefore, Q4 2013's 30.3% gross margin (after factoring out the 1.9% impact from discontinuing brands) would translate into a full-year run rate of approximately 32.2%.

I'm currently modeling a 1% increase in the gross margin run rate per quarter, although Q1 is discounted by 0.5% due to the clearance sales at the 33 closing stores and the slightly higher-than-planned inventory at the end of Q4 2013. Therefore, it is modeled as 32.2% (Q4 run rate), +1.0% for quarterly margin improvement, -0.5% for clearance, +2.1% for Q1 seasonality = 34.8% gross margin.

Below are the expectations for the various quarters in 2014, assuming a 1% quarterly rate of gross margin improvement.

Q1 2014

Q2 2014

Q3 2014

Q4 2014

FY 2014

34.8%

33.6%

36.3%

34.3%

34.7%

Click to enlarge

Effect On EBITDA

A 34.7% gross margin, combined with guidance for +5% growth in comparable store sales in 2014 will result in an EBITDA of approximately $200 million to $250 million in 2014. Gross margin of 37.5% in 2015, combined with +3.5% growth will result in EBITDA of approximately $650 million to $700 million in 2015. These results would be significantly better than the past two years, but at the same time, would likely leave J.C. Penney with higher net debt at the end of 2015 compared to the end of 2013.

Conclusion

A return to 39% or greater gross margin seems unlikely for J.C. Penney. Macy's achieves 40% gross margin due to accounting differences, while increasing e-commerce sales and some fixed cost factors will push J.C. Penney's margins down slightly from 2010 levels. Gross margins in the 36% to 38% range appear achievable long term, with where J.C. Penney falls in that range determined by how much margins are sacrificed to help growth. The growth trajectory suggested by guidance does indicate that J.C. Penney's net debt position will likely not improve over the next couple years, even if it achieves these gross margins.

Disclosure: I am short JCP. 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.