Last week, I wrote that J.C. Penney (NYSE:JCP) was still a short after November sales numbers were released. Incredibly, the stock has posted gains each day since the announcement, in spite of the weaker than expected 2% decline in same store sales (and 5.9% decline in total sales). So I've decided to take a step back and offer a fuller assessment of why J.C. Penney is likely to have significant trouble on the horizon. It seems that investors are relatively confident that J.C. Penney can still achieve its Q4 earnings guidance; but if it turns out that the company misses badly, the stock is likely to fall off a cliff.
In their Q3 earnings release from November 14, J.C. Penney management offered the following guidance:
- Comparable store sales: expected to be flat to up slightly to last year;
- Total sales: expected to be approximately 250 to 300 basis points less than comparable store sales due to the impact of the Company's exit from its catalog and catalog outlet businesses;
- Gross margin rate:expected to be down modestly when compared to last year;
- SG&A expenses:expected to be well-managed and slightly below last year's levels;
- Restructuring and management transition charges:approximately $104 million;
- Average shares for EPS calculation: approximately 220 million common shares;
- Earnings per share: Including restructuring and management transition charges, earnings for the fourth quarter are expected to be in the range of $0.64 to $0.74 per share. Excluding these charges, earnings for the fourth quarter are expected to be in the range of $1.05 to $1.15 per share on a non-GAAP basis
I'll start by putting together what I take to be the approximate "management scenario" and then contrast that to a more realistic scenario for the company.
Management Scenario: Last year, J.C. Penney had total sales slightly over $5.7 billion. Assuming that comparable sales increase by 0.5% but total sales trail by 300 basis points, we get a figure of $5.6 billion in total sales. Assuming gross margin of 36.5% of sales (down 110 basis points), that implies $2.03 billion in gross margin. Operating expenses were $1.69 billion last year, but assuming a slight reduction in SG&A and savings of about $50-$60 million on the pension and real estate/other lines, OpEx could come in at $1.61 billion (excluding the restructuring/management transition charges). This leaves $420 million in operating income. Subtracting $55 million in interest expense and assuming a 35% tax rate, we get a non-GAAP net profit of $237 million or $1.08 a share, well within the guidance range.
There are two major flaws in this "management scenario". First of all, J.C. Penney will have a hard time meeting its sales target. In the above noted November sales release, the company stated that same store sales had been positive until Black Friday, but that the entire Black Friday weekend was soft in stores, partly because J.C. Penney refused to open at midnight like competitors Kohl's, Macy's, and Target. (In fairness, the midnight opening did not salvage November for Target or Kohl's; of this group, only Macy's beat consensus sales estimates and Kohl's was very weak.) However, for most retailers, Black Friday weekend sales helped offset weaker sales earlier in the month. Given the large increase in Thanksgiving weekend sales, it appears that Black Friday deals pulled some December sales forward into November. December is thus likely to show relative weakness, and J.C. Penney is probably looking at a sales drop of at least the same magnitude this month.
Secondly, J.C. Penney's gross margin targets will be virtually impossible to hit. The company entered the quarter with inventory up 3% year over year to $4.38 billion, in spite of the fact that total sales have been running about 5% lower. As another SA author noted, the company made some ominous comments about changes in pricing strategy that would impact Q4 earnings. Essentially this means that the company will have to cut prices to get rid of the excess inventory they are holding; this will substantially cut into gross margin. Assuming total sales remain 5% lower year over year ($5.42 billion), gross margin could easily drop as low as 34%! In the dismal Q4 2008 (admittedly in the depths of the recession), gross margin came in at 34.6% on sales of $5.76 billion. But the company went into that quarter with only $4.5 billion in inventory, having planned in advance for the weak consumer environment. Thus J.C. Penney inventories are less than 3% below 2008 levels, even though sales are likely to come in 6% lower. Modeling gross margins slightly below 2008 levels thus seems entirely appropriate.
Realistic Scenario: Starting from these assumptions, we get $5.42 billion in sales and 34% in gross margin as a percentage of sales. This results in $1.84 billion in gross margin. Assuming the same OpEx number of $1.61 billion, we get $230 million in operating profit. Once again subtracting $55 million in interest expense and assuming a 35% tax rate, we get a non-GAAP net profit of $114 million or 52 cents a share, less than half of management guidance. Ouch! Considering that management transition expenses are left out of this calculation, J.C. Penney is likely to make a marginal GAAP profit of 10 cents a share in what should be a very profitable quarter for retailers.
Obviously, there are areas where J.C. Penney could turn in a better performance than I have modeled here. But there are also areas where it could quite easily underperform even this realistic scenario. On balance, I think this is a fair assessment of J.C. Penney's likely earnings this quarter. Investors have not yet appreciated just how much the company's business has deteriorated this year. When they do, they will abandon the stock in droves; this is why J.C. Penney is still a very good short candidate. Accordingly, I increased my short position in the stock today.