J.C. Penney Turns Back The Clock

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About: J.C. Penney Company Inc. (JCP)
by: Elephant Analytics
Summary

J.C. Penney is not going to sell major appliances anymore.

This will likely result in a 1% to 2% decrease in sales and a 50 to 75 basis point increase in gross margins, at least in the near-term.

The move could be EBITDA positive if the space is effectively used to improve apparel and soft home sales.

Sears appears set to continue operations for a while longer.

This will spread out the boost to J.C. Penney from Sears' closures over multiple years, making the impact on comps less noticeable.

In one of its first major moves under new CEO Jill Soltau, J.C. Penney (JCP) is discontinuing the sale of major appliances and limited furniture sales to online and Puerto Rican stores. It believes that removing appliances will help improve the shopping experience and allow for additional focus on higher-margin apparel and soft home furnishings sales.

This undoes one of Marvin Ellison's key initiatives, which contributed to sales growth initially (albeit with a negative impact on gross margin percentage), but had stalled out in the last couple of quarters.

This move may have an incrementally positive effect on EBITDA if the space is used well to improve apparel sales. I remain cautious about the value of J.C. Penney's stock due to the difficulty of turning around department stores, but believe that it may have potential as a speculative buy. The common stock's value depends on J.C. Penney making significant changes, which would increase both the chances of a turnaround and a quick failure. That higher-risk scenario is better for the common stock, though, than a scenario where J.C. Penney mostly stays the course and just tries to stay afloat.

Appliance Sales At J.C. Penney

I had previously estimated that major appliances accounted for approximately 3% of J.C. Penney's sales, while taking up around 1.5% of J.C. Penney's square footage (around 1.4 million square feet). This meant that appliances probably contributed a roughly average amount of gross margin per square foot after accounting for their much lower than average merchandise margins.

That was after Q1 2018, though, when appliance sales were still growing quickly (with +15% comps). In Q2 and Q3 2018, appliances comps were negative, which would probably push the gross margin for appliances a bit below company average.

The impact of removing appliances (and furniture) from J.C. Penney will depend on how the replacement apparel products and soft home furnishings do. In general, J.C. Penney's sales are likely to decrease slightly (1% to 2%), while its gross margins may increase by around 50 to 75 basis points. The overall impact on J.C. Penney's EBITDA may be roughly neutral from removing appliances, although it could be positive if it can make good use of the store space. These sales and gross margin impact calculations are based on J.C. Penney getting near store average sales per square foot in the former appliance sections. The 1.5% of J.C. Penney's square footage formerly devoted to appliances would now contribute somewhere near 1.5% of total revenues, versus 3% before. With major appliances having gross margins that are 50+% lower than apparel, this results in the estimate that company wide gross margins would decline by 50 to 75 basis points.

The decision to stop selling appliances shows that Soltau is capable of making significant moves. We have yet to see further details of her plans for J.C. Penney, but J.C. Penney seems likely to operate a fair bit differently under Soltau compared to Ellison.

Return Of The Chief Merchant

J.C. Penney is also continuing to put a renewed emphasis on merchandising (including Soltau's hire). It eliminated the Chief Merchant position in 2017, which was considered to be one of the most powerful positions in a retail company. However, that move doesn't appear to have panned out, with J.C. Penney forced to take extensive markdowns to clear out inventory during 2018.

J.C. Penney is now searching for a Chief Merchant for the restored position as well as attempting to fill out its senior management team. Restoring the position seems to be favorable to keeping J.C. Penney's inventory situation in better shape, which will help boost its gross margins due to fewer markdowns.

Sears Lingers On

It also appears that Sears will continue to operate for a while longer with Judge Drain approving Eddie Lampert's bid to buy most of Sears' assets. This means that the benefit to J.C. Penney's comparable store sales from Sears's demise may not be all that noticeable since it will likely be spread out over multiple years. A closure of all the Sears/Kmart stores at the same time could provide a several percent boost to J.C. Penney's comps, but the effect of closing Sears over two to three years would result in an estimated boost of less than a percent to J.C. Penney's comps each year. The details behind those calculations are in this previous report on J.C. Penney.

Sears is reportedly keeping around 425 stores open for now. I expect the store closures to continue since the restructuring isn't going to solve Sears' issues with the extreme lack of retail productivity. The restructuring does give Lampert some time to sell off and close Sears' stores in a more orderly fashion, though.

Conclusion

Jill Soltau is undoing some of the moves of her predecessor at J.C. Penney, by ending the sale of appliances and adding back the position of Chief Merchant. Stopping appliance sales will likely reduce J.C. Penney's sales by 1% to 2% while increasing its gross margins by 50 to 75 basis points. At the better end of those ranges, that could improve J.C. Penney's EBITDA by up to $45 million if the additional space is used well. The impact on EBITDA is likely to be more incremental than $45 million though.

The news that Sears will live on for a while longer is probably a slight negative for J.C. Penney, although it mostly just means that the benefits from Sears closing down will be spread out over multiple years. Sears still doesn't have a long-term future as a retailer, and will likely continue to close large numbers of stores.

I still have a position in KTP, which mostly is a bet that J.C. Penney will at least survive for a while longer. I may take a speculative long position in JCP at some point as more details about Jill Soltau's plans come out. Generally, significant changes will be beneficial for J.C. Penney's common stock since its value depends on a turnaround. More change increases the risk of a quicker failure, but also the chances of a turnaround. The downside scenario for the common stock is the same anyway, whether J.C. Penney fails in two years or five, so an increased risk of a quicker failure isn't really an issue for the stock at current levels.

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.

Additional disclosure: Long JCP via KTP