Last week, I wrote that investors should continue to avoid J.C. Penney (JCP), despite the significant drop in the company's share price. In this follow-up piece, I will explain in more detail why J.C. Penney shareholders are likely to experience continued disappointment over the next few quarters. The primary reason is that, in spite of the awful Q1 result, investor expectations are still (on average) too high.
To be clear, Ron Johnson's turnaround strategy for J.C. Penney makes sense from a business perspective. Simplifying the company's pricing strategy is likely to improve margins over the long-term while allowing massive process simplification (leading to cost savings). Meanwhile, bringing a better merchandise assortment into the stores will allow the product (rather than the promotion) to drive customer traffic. But even though I think this overall vision is sound, that does not mean that the company can achieve all of these benefits in a short period of time. This was put sharply in a Deutsche Bank analyst note on Wednesday, which noted that changing a retailer's image is difficult, if not impossible. Wal-Mart (WMT) has been dealing with this issue for several years now and more or less gave up on its attempt to move up-market.
All that said, the biggest red flag regarding J.C. Penney is management's (and investors') focus on cost cuts rather than profitability. The big positive news in the earnings report was that the company would exceed $900 million in annual cost cuts, and would get there by the end of the current fiscal year, instead of the end of 2013. To be sure, that is good news: but cutting costs alone won't get J.C. Penney back in the black. For instance, in Q1, SG&A expenses declined by $121 million, but because of the 20% sales decline, SG&A increased as a percentage of sales from 32.5% to 36.8%. The company's business plan presupposes SG&A expenses below 30% of sales, which just shows how far in the wrong direction J.C. Penney went last quarter.
To look at it another way, suppose J.C. Penney manages to take out $1 billion in annual costs, and splits that evenly over each quarter. Even if J.C. Penney's SG&A costs had declined by $250 million in Q1 (to $1.031 billion), that still would have represented a slight year over year increase in percentage terms, to 32.7% of sales.
Yet some analysts, like Citigroup's Deborah Weinswig, seem to be enthralled by the scale of cost cuts. Weinswig stated after J.C. Penney's earnings that the transformation was still on track in spite of the big loss. Apparently, having her pre-earnings prediction of a short squeeze decisively refuted did not deter her from issuing further bullish predictions.
The point of all this is that cost cuts won't grow earnings unless sales stabilize. On that subject, hedge fund manager Bill Ackman (Penney's largest shareholder, and a board member) apparently expects sales growth to resume in August, when the first new shops will be built and the first new products will come into the stores (see slide 41). The analyst community seems to agree. Bizarrely, while the average revenue estimates for the next two quarters are down mid-teens and high single digits, respectively, the revenue figure for the full year implies flat revenue in Q4!
While J.C. Penney will have a better assortment in the stores by then, and a few new shops operating (both good things), this overlooks the heavily promotional nature of the holiday season. Competitors Macy's (M) and Kohl's (KSS) are still committed to strategies that emphasize promotions, and so they are likely to severely undercut J.C. Penney on price during the critical holiday period.
If those retailers have major Black Friday sales and J.C. Penney has no special event, shoppers will go get their "deals" while they can, and might never make it to J.C. Penney. Thus, the Deutsche Bank note cited above recognizes the risk that sales trends could actually get worse in Q4.
Furthermore, management and a number of commentators have latched on to the fact that comp store sales declined 21% in February, but improved by 300 basis points in March and April (leading to a 19% comp figure for the full quarter). However, these people seem to have forgotten that J.C. Penney posted a comp store sales increase of 6.4% last February. By contrast, the comp figure for the full Q1 2011 was 3.8%.
In other words, J.C. Penney faced a much easier comparable figure for March and April this year than for February. This more than explains the increase in same store sales trends. Thus, there is no reason to believe that the company has made any meaningful progress at winning shoppers back so far. The rollout of new merchandise and the shops in August will begin that process, but it will be a long slog, and revenue/earnings will not improve nearly as quickly as J.C. Penney bulls expect.
Thus, there is still significant downside to J.C. Penney shares. However, I think the disappointment won't really set in until after the Q3 earnings report, since Q2 expectations are fairly low now. The real blow will be in Q4, where I see downside to projected sales of as much as $1 billion (though a $600-$800 million year over year decline seems more likely) and resulting profit downside of more than $1 per share. Depending on the share price later this summer or in the fall, I will consider re-opening my short position. My 1-year price target is $22.
P.S. For a laugh, see the final slide of Ackman's presentation, referenced above, where he discusses potential valuations for J.C. Penney... if the company somehow manages to double (or more) its sales.