J.C. Penney: Pre-Gaming Q2 2016 Earnings

| About: J.C. Penney (JCP)

Summary

July was weaker than expected for apparel retailers, although apparel retailers appeared to do better than expected for Q2 as a whole compared to the low expectations.

I maintain my expectation for 2%+ to 3%+ Q2 comparable store sales for J.C. Penney, and that its full-year guidance will be maintained.

However, there is probably more downside risk than upside opportunity right now, especially with full-year guidance.

Meeting full-year guidance is significantly dependent on the effect of various initiatives, such as appliance sales, window treatments expansion and the Center Core refresh.

As those will have most of their impact starting in the second half, any potential upward revision to guidance probably wouldn't happen until Q3.

J.C. Penney (NYSE:JCP) is due to report Q2 2016 earnings on August 12. While I still believe its Q2 comparable store sales growth should be better than Q1 at around 2%+ to 3%+, the sluggish apparel sales in July mean the company would have to do very well relatively to the overall market to deliver above that range.

I do expect J.C. Penney to maintain its full-year guidance, as it should have a strong second half due to the rollout and expansion of various initiatives partway through Q2. However, much is dependent on the success of those initiatives. J.C. Penney has test data for those initiatives already, so it probably has a solid idea of the expected results. However, there may be some variability in results as the initiatives are expanded to a larger percentage of the store base.

July Apparel Sales Appear Weaker Than Expected

After May and June's same-store apparel sales exceeded analyst expectations, July appears to have fallen approximately 2% short of analyst expectations. This is primarily due to Gap (NYSE:GPS) reporting -4% comparable store sales in July versus expectations for a -0.3% decline, while performance at other apparel retailers was mixed.

Overall though, Gap did exceed expectations for the quarter by around 1.8%, driven by a strong June. The apparel retailers included in Thomson Reuters' monthly same-store sales results appear to have exceeded expectations for Q2 by around 1.3%, although the final number hasn't been released yet. The Gap appears to account for around 55% of the index's weighting, so it has a disproportionate effect on the overall results.

What this means is J.C. Penney's Q2 2016 revenues are likely to be solid, but not particularly exciting. The retail apparel climate was better than expected during the quarter, but expectations were low to begin with, and there remains a cautious outlook for the second half of the year. I am maintaining my expectation for 2%+ to 3%+ comparable store sales during the quarter.

Effect On Full-Year Guidance

A 2%+ to 3%+ comparable store sales result for Q2 2016 would put J.C. Penney at approximately +1% for the first half of 2016 using the midpoint of the Q2 estimate. The first half represents around 45% of the company's annual sales, so that would result in J.C. Penney needing to do 4.6%+ comps during the back half of the year to reach 3%+ for the full year. Hitting 4%+ for the full year would require 6.4%+ comps over the back half of the year.

It may seem challenging to reach 4.6%+ comps during the back half of the year due to the retail climate, but J.C. Penney is going to benefit from items like the appliance sales rollout, the Center Core refresh and window treatment offering expansion. These are initiatives that are being introduced in Q2 or expanded during the quarter. Since the full benefit of these initiatives will be felt in the back half of the year, I expect J.C. Penney to maintain its sales guidance for the full year unless its Q2 sales fell significantly short of my expectations. However, given the loading of sales growth into the back half of the year, it seems unlikely that the company will raise full-year sales guidance yet. If there is any revision to sales guidance, it would likely be towards a lower range.

Notes On Gross Margin

One area to keep a watch on is gross margin expectations. I previously calculated that J.C. Penney should be able to reach 36-38% gross margin in the long run, and have typically used 37% or 37.5% gross margin in my modeling. Some of J.C. Penney's expected future sales growth is coming from new categories or expanded offerings for current categories, and the category gross margin percentages could differ from the company's overall gross margin percentage.

Appliances are estimated to have approximately half the gross margin percentage of J.C. Penney's average. While appliances will contribute positively to its overall gross margin dollars, strong appliance sales will lower the company's gross margin percentage. For example, if appliances end up being 1.5% of total sales (approximately $200 million per year), it would reduce J.C. Penney's gross margin percentage from 37% to 36.7%. If appliances reached 3% of total sales ($400 million per year), J.C. Penney's gross margin percentage would go from 37% to 36.4%. The company may accept even lower gross margins on appliances initially as it establishes the business and competes with the likes of Sears (NASDAQ:SHLD). This is a typical strategy for a new entrant, but may affect short-term numbers.

As for window treatments, the company has identified this as a potential $200 million opportunity. I haven't found typical gross margin percentages for window treatments in the US yet, although data from other countries indicates gross margins for window treatments are probably near J.C. Penney's average.

Conclusion

A weaker-than-expected conclusion to Q2 for apparel retailers results in some downside risk to my earlier expectations for J.C. Penney. Overall, the quarter was better than expected for apparel retailers, and I am maintaining my expectations for 2%+ to 3%+ comps for the quarter. However, the news does indicate the up and down situation with apparel retail right now, and likely means that J.C. Penney will need a very strong second half to meet its guidance. The company's initial plans appear to have included a lot of backloaded second-half growth as it rolls out various initiatives, so I currently expect it to maintain its full-year guidance. If there is any guidance revision for sales in Q2, though, it will probably be downward, since any upward revisions would need more data from the initiative rollouts first. I am cautiously long on J.C. Penney, as its risk/reward situation was better a few weeks ago when it was trading nearly $1 lower and before the lackluster July apparel sales report came out.

Disclosure: I am/we are long 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.