Are Investors Being Rational About J.C. Penney?

By Stephen D. Simpson, CFA | May 18, 2012 AAA

There are more than a few similarities between Wall Street and a spoiled toddler. Not only do both expect someone else to clean up their messes, but when they want something they want it NOW. Accordingly, I can't say I'm all that surprised to see the widespread negative reaction to J.C. Penney's (NYSE:JCP) first quarter results. While these results were disappointing and do highlight the amount of work the new management team has to do, the fact is that major business restructurings and repositionings don't happen overnight.

Investopedia Broker Guides: Enhance your trading with the tools from today's top online brokers.

Terrible Sales Drive a Bad Quarter
J.C. Penney's new CEO Ron Johnson is trying to wean its shoppers away from the sale or promotion-heavy policies of the past, and that process is carrying some huge costs. Sales fell 20% this quarter, with a nearly 19% drop in same-store sales. This drop was fueled by many factors but, mainly a decline in traffic.

SEE: The History And Future Of Sears

With the terrible sales, it was not a big surprise that gross margin also came in at a disappointing level. Gross margin dropped almost three points to 37.6%, and the company's year-ago operating profit turned into a loss. Perhaps worse still, management made it clear that larger markdowns would be necessary to clear inventory - pointing towards an uglier margin in the near future.

Rome Wasn't Built in a Day
I am not going to pretend that J.C. Penney's results weren't disappointing, nor that the 19% drop in same-store sales isn't scary. But I also think a little perspective is in order here. Exactly what did shareholders think Ron Johnson was going to do in six months?

First of all, this is still a tough retail environment. Yes, American Eagle (NYSE:AEO) and Chico's (NYSE:CHS) have shown some signs of life, but even the much-loved Kohl's (NYSE:KSS) showed barely any same-store sales growth in its last quarter (up 0.2%).

SEE: Analyzing Retail Stocks

Second, J.C. Penney has been in a decline for years. I'm still not sold on the idea that there's still a great long-term future for mall anchor-stores like J.C. Penney, Macy's (NYSE:M) or Dillard's (NYSE:DDS), but even if there is, it's a tough market in which to launch a turnaround. J.C. Penney backed itself into a corner by training its customer to expect sales and markdowns (40% of 2011 transactions were sales-related), and there's going to be a painful shakeout process as the company shifts its strategy.

At the same time, I think management is making some logical long-term moves. Not only is management cutting promotions, but also looking to wring costs out of the supply chain. CEO Johnson has assembled a good team (including a new CFO, COO and President), and moves like the strategic alliance with Martha Stewart Living Omnimedia (NYSE:MSO) and the acquisition of the Liz Claiborne brands should help J.C. Penney reestablish worthwhile proprietary brands.

The Bottom Line
Although I think the Street's reaction to J.C. Penney's results has been a little ridiculous, that doesn't mean I'm a fan of the stock today. I think there's still a reasonable chance that J.C. Penney can fix its problems, but I don't see much upside - even a "fixed" J.C. Penney is not likely to see revenue growth much above the mid-single digits, nor an especially robust-free cash flow margin. Moreover, I believe the ongoing expansion of "cheap chic" alternatives like H&M is only going to add more pressure to the situation.

SEE: The 4 R's Of Investing In Retail

Below book value I'd probably take a look at these shares, but the valuation is well above that point today. Accordingly, while I disagree strongly that the first quarter results prove Johnson's turnaround is a failure, I don't see any particular reason to own these shares right now.

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

Related Analysis
  1. Markets End Week On Positive Note As Investors Are Encouraged By Central Bank Developments ...
    Stock Analysis

    Markets End Week On Positive Note As Investors Are Encouraged By Central Bank Developments ...

  2. Charts To Watch As Fed Raises Rates
    Chart Advisor

    Charts To Watch As Fed Raises Rates

  3. Is Natural Gas About to Tank?
    Chart Advisor

    Is Natural Gas About to Tank?

  4. This ETF Offers Easy Access To Big Pharma
    Chart Advisor

    This ETF Offers Easy Access To Big Pharma

  5. A Huge Development On The Horizon For Unlimited Energy
    Investing

    A Huge Development On The Horizon For Unlimited Energy

Trading Center