Last month, I wrote that J.C. Penney (JCP) shares were beginning to look interesting at the $20 level. However, I also cautioned that we had yet to see any tangible signs of a turnaround. Since that point in time, J.C. Penney has rallied to $24.75 as of Friday's close: roughly 30% above last month's 52-week low at $19.06. This 30% gain comes in spite of a second consecutive awful quarter from J.C. Penney. J.C. Penney CEO Ron Johnson has once again projected an upbeat tone, in spite of his company's underperformance. Newly-minted CFO Ken Hannah has been similarly optimistic. This has led some observers to conclude that the worst is over, and therefore that investors should consider buying J.C. Penney stock.
However, I am more inclined to think that management is simply in denial. This is nothing new: I was extremely skeptical earlier this year when management laid out its $2.16 non-GAAP/$1.59 GAAP earnings guidance for the current fiscal year. Sure enough, in the first quarter earnings release, management pulled down the GAAP guidance but reaffirmed the non-GAAP target. Then, in the second quarter earnings release, management canceled the non-GAAP portion of the guidance. In short, by now Ron Johnson has forfeited the benefit of the doubt he initially received due to his successful tenures at Apple (AAPL) and Target (TGT).
On one level, I applaud what Johnson is trying to do at J.C. Penney. It's pretty clear that the previous management team's heavily promotional strategy was leading J.C. Penney to a slow death and was therefore unsustainable. On the other hand, I am not confident that the company can survive its current shock treatment. Sales have dropped by over 20% so far this year (see the earnings release links above) leading to significant losses. As former J.C. Penney CEO Allen Questrom recently opined, it was very imprudent to completely change the pricing strategy and redesign stores without first testing the changes in a few markets. In light of this year's sales slump, bulls have to hope that relief is right around the corner.
In the most recent earnings presentation, Ron Johnson provided some hopeful tidbits. For August, the company retooled its marketing techniques, focusing more on particular products than on the more abstract shopping experience. (This seems like a smart move.) Furthermore, the new in-store "shops" are rolling out, and management highlighted significant increases in sales and margins for the new Levi's shops. Bulls believe that the rollout of shops over the next several years will drive dramatic sales gains for J.C. Penney. Over time, having a strong assortment of brands and good merchandising will yield benefits. But looking at individual brand sales trends is rather myopic. J.C. Penney is in the midst of streamlining its merchandise offerings, meaning that many brands are being eliminated. Much larger sales gains in the new shops will be needed to compensate for declines from discontinued brands.
Lastly, J.C. Penney has been offering free children's haircuts to drive traffic. This has led to some moderate improvement in traffic relative to the first half of the year. On the other hand, offering the free haircuts entails a clear upfront personnel expense for J.C. Penney. In spite of the traffic improvements, early August sales only improved by 2 percentage points compared to the dismal spring sales numbers. This trend seems bound to result in yet another quarterly loss for Q3.
Unfortunately, after two embarrassing guidance misses this year, J.C. Penney announced a third long-shot target in the second quarter earnings release. Now, the company projects that it will have at least $1 billion of cash on the balance sheet at year-end. Given that the company plans to pay down $230 million of debt and invest well over $500 million in CapEx in the second half, this requires roughly $900 million of positive operating cash flow in the back half. It will be nearly impossible to meet this target.
This highlights the danger of relying on guidance from a management team in denial. Ron Johnson and company clearly expect significant improvement in the seasonally strong Q4. Analysts seem to agree, forecasting an 11% decline in sales on average (which looks good compared to the 21.3% decline year to date). A strong Q4 could indeed salvage J.C. Penney's year. However, I expect the company to face brutal competition from Target, Macy's (M), Kohl's (KSS) and other similar competitors during the holiday season. In the current economic climate, most mass retailers understand that consumers are looking for extreme bargains. J.C. Penney is relying on luring customers in with holiday activities in "the Square" in lieu of the Black Friday fever seen at its competitors.
I strongly doubt that the J.C. Penney strategy of "everyday value" will work well in the heavily promotional holiday period. Customers will do their shopping at the stores offering great Black Friday markdowns first, and will only make it to J.C. Penney after finishing the bulk of their holiday shopping. Therefore, the company will likely see a sales decline well above the 11% that analysts are currently predicting. A worse than expected sales decline could perpetuate the company's excess inventory problem and continue to depress margins (resulting in further losses).
As an investor, there is no reason to own shares of J.C. Penney at the current price, until management proves that it can deliver on its promises. So far this year, that has not happened. Furthermore, if shares continue to rise without clear signs of progress at J.C. Penney, the company will become a tempting short opportunity again.