J.C. Penney: Still Looking For A Bottom?

Jul.12.12 | About: J.C. Penney (JCP)

It's been a while since I last wrote about J.C. Penney (JCP), so I thought to take the occasion of a new 52-week low near $20 in Wednesday trading to offer an update. In my last article, I noted that there was no particular reason to believe that the slight improvement in March and April sales relative to February implied customer acceptance of the new pricing model. I also argued that cost cuts alone could not solve J.C. Penney's problem, because revenue (and gross margin dollars) has been shrinking even more rapidly.

These arguments appear to be supported by the early data. A major factor in J.C. Penney's awful performance this week has been a new research report by Credit Suisse analyst Michael Exstein. Exstein wrote that Q2 sales could be even weaker than the 20% drop posted in Q1. This is corroborated by the abrupt departure last month of J.C. Penney President Michael Francis. Francis was lured away from Target (TGT) less than a year ago by CEO Ron Johnson and had been in charge of marketing for J.C. Penney. While management tried to portray an upbeat tone at its live post-earnings presentation in May, it seems unlikely that Francis would have been pushed out if sales results had been improving through the spring.

J.C. Penney management now faces an unenviable situation where they are dealing with a tougher-than-expected reorganization in a weak macroeconomic environment. Most of J.C. Penney's competitors in the moderate price department store category have been hitting turbulence recently. Macy's (M) disclosed that its same-store sales were up 1.2% in June, which was the weakest result the company has posted in a long time. Macy's management blamed the poor result on a "stagnant" economy. Meanwhile, Kohl's (KSS) reported a 4.2% drop in same-store sales for the June period, and discount chain Target saw a 2.1% gain, which was below that company's expectations.

Broad-based weakness in the sector will put further pressure on J.C. Penney's attempts to maintain pricing integrity through its three-tiered price structure. Macy's and Kohl's in particular will continue to use promotions and coupons in an attempt to boost sales. Since I expect J.C. Penney to stay the course with regard to pricing, the company will continue to lose sales to its more aggressive rivals over the next few months.

In spite of my negative outlook with regard to near-term sales, I think that J.C. Penney shares are becoming interesting (if not entirely attractive) at current levels. At $20/share, J.C. Penney shares finally sit below my target price of $22 and only about 10% above book value. On the other hand, with the shares having lost more than half of their value in less than six months there is a serious danger of trying to catch a falling knife. (Essentially, I think that current investors are just hoping that Q2 results aren't quite as bad as expectations.) While I do not think the company is headed for bankruptcy in the near future, a second disappointment in Q2 could drive shares below book value. Furthermore, as the company continues to get hit with credit rating downgrades, there is a risk that the company will have to raise capital to fund the "transformation" by issuing new shares (and diluting current shareholders).

Therefore, if you are interested in this turnaround story, my recommendation is to wait for tangible signs of improvement in the Q2 or Q3 earnings results. There will be plenty of upside in the event of a successful turnaround, and so waiting does not mean missing out on all of the potential gains. There are two main developments to watch over the next couple of quarters. First, the company plans to roll out the first 10 new shops in August. As J.C. Penney continues to add new shops and improve its merchandise assortments, sales should stabilize, and hopefully begin to grow again. If the company can convince customers (and this is a big "if") that its merchandise is superior in quality to Target and Kohl's and offers better value than higher-end stores like Macy's and Nordstrom (JWN), then J.C. Penney may be able to wean shoppers off of discounts. So it is important to see how the new shops are faring based on management commentary, and more importantly, whether Q3 sales (which will include the initial batch of shops) show noticeable improvement over the first half.

Meanwhile, the company is nearing the end of its cost-cutting, at least for now. J.C. Penney recently announced another 350 layoffs at the home office, in order to simplify processes and reduce the firm's layers of management. That should bring Q3 expenses in line with the long-term model. Therefore, it will be important to see if the current level of cost-cutting is sufficient to move J.C. Penney into the black for Q3.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.