Short Opportunity: J.C. Penney Is Losing Its Luster

Mar.11.12 | About: J.C. Penney (JCP)

As they say, what goes up must come down (although Apple (NASDAQ:AAPL) might be an exception to the rule). In late January and early February, shares of J.C. Penney (NYSE:JCP) surged by more than 20% on the back of a bullish financial forecast from the company based on substantial cost-cutting plans. This was part of a broader "transformation" of the brand. J.C. Penney, under new CEO Ron Johnson, is doing away with most sales and coupons, and breaking up stores into roughly 100 mini-shops.

In the days after J.C. Penney's financial presentation, analysts were falling over themselves to raise their earnings estimates and price targets. Then reality struck: on February 24th, the company reported an ugly fourth quarter, culminating in a 41 cents/share GAAP loss on weak sales and dreadful margins. This underperformance was entirely predictable: in early December I predicted gross margins would fall to 34% (adjusted gross margin came in at 34.0%) on sales of $5.42 billion (the final tally was $5.425 billion) and adjusted earnings would be roughly 52 cents (the actual figure was slightly higher due to some markdowns being classified as non-recurring).

However, the most damaging material was in the pre-recorded "conference call". CEO Ron Johnson commented that February sales were "trending below last year", particularly on days when the company had major promotions last year. He declined to give even a rough estimate of how large the decline has been, but analysts are now assuming the worst, forecasting an 8% drop in quarterly sales. Meanwhile, analyst EPS estimates, which had spiked to roughly 50 cents total for 1H12 in early February, have since declined to just 2 cents each for Q1 and Q2. As a result, J.C. Penney shares now trade more than 10% below their February high.

One analyst, Michelle Clark of Morgan Stanley, recently stated that most of Penney's competitors are gaining market share, as longtime J.C. Penney customers are put off (or just confused) by the new pricing strategy. Likely beneficiaries, according to Clark, include Macy's (NYSE:M), Gap (NYSE:GPS), Target (NYSE:TGT), and TJX (NYSE:TJX). I agree that there is a substantial market opportunity for each of these companies. Each can provide either better (sale) price points, higher quality merchandise, or both.

This is not to say that J.C. Penney is doomed; however, I expect things to get worse before they get better. Currently, analysts expect sales to decline by $540 million year over year in the first half of the year, but to increase by $80 million year over year in the second half. While that scenario is possible, because the company faces easier comps in the second half of the year, it is still aggressive. While management hopes that customers will "understand" the new pricing scheme by this fall, the back to school and holiday seasons tend to be the most promotional times of the year. If holiday shoppers spend their whole budget on "doorbusters" at Target, Wal-Mart (NYSE:WMT), and Macy's, it won't matter that J.C. Penney's "month-long values" are priced "fair and square". J.C. Penney's sales declines could be as bad or worse in the second half of the year as they are in the first.

J.C. Penney may be a turnaround story, but it's not one that investors should buy into until there is concrete evidence of success. For the time being, there is still a considerable short opportunity here.

Disclosure: I am short JCP.