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Summary

  • Strong growth gives J.C. Penney significant momentum for a while. Likely no negative catalysts for a few months.
  • Growth was partially driven by higher than expected levels of clearance, trading margin for top line.
  • When growth slows, it will result in a focus on valuation that is unfavorable for J.C. Penney.
  • Key question to determine is when slowing growth will occur and what level of deceleration will shift focus to valuation.

J.C. Penney (NYSE:JCP) reported strong top-line growth in Q1 in a period where many other department stores showed poor results. These results will likely propel J.C. Penney up further in at least the short-term, with slowing growth being the main catalyst to bring it back down to Earth. Since there are three months until the next earnings report and limited other negative catalysts for a while, there is a good case to be long for at least a short while.

Longer term I remain pessimistic about J.C. Penney, as strong top-line growth was boosted by higher than expected clearance levels. The resulting lowered gross margin contributed to EBITDA levels in line with (actually very slightly below) my model. The conference call also confirmed some ideas that I had written about with regards to SG&A that would make it difficult for J.C. Penney to reach the EBITDA levels necessary to justify higher long-term valuations.

J.C. Penney will likely continue to defy conventional valuations as long as it appears to remain a strong growth story. Once the growth slows, the focus shifts to valuation, which is quite negative for J.C. Penney. The investing/trading question of the moment is how long the illusion of a potential $15+ billion J.C. Penney can continue?

Below I will attempt to answer some questions of interest.

Have the bulls won?

I would certainly say that the bulls have won for the short-term and perhaps the medium-term. I remain very skeptical about the long-term due to some items from the report that I'll mention below. Still, the bulls will likely control the narrative for much of the next three months at the very least (since J.C. Penney doesn't report monthly sales anymore).

I am actually very tempted to take a speculative long position to ride J.C. Penney's potential momentum for a while. Certainly the high short interest may fuel matters, along with the lack of negative news for several months. The challenge is to determine when to get off, as eventually slowing growth will bring valuation into sharp focus and J.C. Penney is running far, far ahead of itself in that regard.

One question for everyone to ponder is what level of slowing growth will bring valuation into focus again. At this point I'm not sure how the market will react to something like +5% same-store growth and 34% gross margin in Q2. That would represent a slight deceleration of growth vs. Q1, but also slightly improved margins. If the market is okay with that, then the bullish narrative might survive until 2015, where low-single digit comps and reaching a ceiling in gross margin improvement will put the focus on what J.C. Penney is worth as a $13 billion revenue company with $700 million or $800 million in EBITDA. I still haven't seen anyone explain how that would be worth more than $7 billion in Enterprise Value.

Are you going to stop looking in the rear-view mirror for analysis?

I get asked this question a fair bit, but my published model was quite accurate for gross margin dollars and SG&A during Q1, with the resulting EBITDA estimate of negative $55 million to negative $65 million actually being slightly more positive than J.C. Penney's actual EBITDA. The problem for bears is that J.C. Penney's growth rate makes for some eye-catching headlines (especially when many other department stores did poorly). However, this growth was largely created by heavy clearance sales that sacrificed margins for revenue. I doubt a situation where J.C. Penney delivered +2.5% growth and 34.8% gross margins would have elicited quite the same initial market reaction.

Whether you are a bear or bull, I think it is important to understand how J.C. Penney's business is actually trending, and can make decisions accordingly on how you think the market will react to that. To be honest, I find the "look at the tape, screw analysis" type of comments to be quite unhelpful. Even if you have a significantly different opinion on how the market will react to various metrics, it is never a bad idea to understand the business trends so you can make informed decisions.

How did clearance affect sales?

As noted in a recent article, I had estimated +2.0% to +3.0% growth in same-store sales for Q1, and a gross margin rate of 34.8%, resulting in gross margin between $936 million and $945 million. The gross margin rate was based on J.C. Penney's Q4 gross margin of 28.4%, adding back the 1.9% one-time hit that J.C. Penney took for discontinuing brands, and then adding the 4.0% historical change in gross margin from Q4 to Q1. I allowed another 1.0% increase for actual gross margin improvement that wasn't due to seasonal factors (reducing shrinkage, reducing clearance levels, increasing private label, etc...) and subtracted 0.5% for clearance/liquidation due specifically to the store closings.

Same-store sales growth (%)

+ 2%

+ 3%

+ 2.5%

Revenue ($ Million)

$2,690

$2,716

$2,703

Gross Margin (%)

34.8%

34.8%

34.8%

Gross Margin ($ Million)

$936

$945

$941

Q1 ended up with higher sales, lower gross margin percentages and lower gross margins in terms of dollars though. As noted during the conference call, clearance reached up to double historical percentages at times and had negative margins to boot. Here's how extra clearance could boost sales while reducing gross margin dollars.

 

Base

Extra Clearance

Total

Revenue ($ Million)

$2,703

$98

$2,801

Gross Margin (%)

34.8%

-13.0%

33.1%

Gross Margin ($ Million)

$941

-$13

$928

Although J.C. Penney did not give details about exact clearance levels and clearance margins, it seems that much of J.C. Penney's growth during the quarter was generated by higher than anticipated clearance levels that were good for the top line and clearing out old inventory, but negative for gross margin.

How is SG&A going to evolve?

I'll note that J.C. Penney's Q1 conference call confirmed that my prior article about SG&A was at the very least mostly accurate.

The key points about SG&A from that article were that Q4 2013's SG&A was an anomaly, that bonuses would affect 2014's SG&A if J.C. Penney met or exceeded guidance, and that merit increases would affect future SG&A starting in 2015.

Here's the relevant table from that article:

SG&A

   

($ Million)

2014

2015

2016

Misses Guidance

$3,950

$3,925

$3,900

Meets Guidance

$4,025

$4,100

$4,150

Exceeds Guidance

$4,075

$4,175

$4,250

As Q4 is typically around 10% higher than other quarters in SG&A, there were some suggestions that Q4's SG&A drop indicated that future SG&A would be more in the $3.7 billion, $3.8 billion range.

Ed Record mentioned the following during the conference call, which would suggest SG&A more in the $4.0 to $4.1 billion range depending on whether J.C. Penney met guidance (resulting in bonus payout).

"We expect -- we are basically a billion this year. We expect that to be roughly our run rate. There may actually be a little slight uptick in fall this year as we hopefully will be paying some incentive comp and some other things that were not in the history."

Do I now think that people can tell how well J.C. Penney did from going to the stores?

No. I will agree that people skilled in sampling can get valid results. However, Q1's results actually confirm the idea that the store visits that most investors conduct (going to a handful of stores and observing traffic levels and checkout activity) are very inaccurate in determining sales and traffic levels. J.C. Penney had positive year-over-year traffic in April, but negative year-over-year traffic in February and March. In-store sales increased by approximately 4% to 5% in the quarter, with the remaining increase in comparable store sales driven by online sales growth. Those results are positive for J.C. Penney, but are also hardly indicative of the busy atmosphere that was posted about a lot.

Conclusion

J.C. Penney's strong top-line growth plus a probable lack of negative catalysts over the next while may continue to propel it upward. However, the key question is when to get off. The ride will likely continue as long as the potential for a $15+ billion revenue J.C. Penney appears possible. J.C. Penney sacrificed margins for top-line growth in Q1 and kept that idea alive. Eventually I believe it will become apparent that a $13 billion J.C. Penney is much more likely and then valuation will come into sharp focus, with negative implications for share price value.

Source: J.C. Penney: Have The Bulls Won?

Additional disclosure: I may decide to initiate a long position in JCP for shorter-term purposes, although I remain negative on JCP long-term.