Why JC Penney is worse off than you think

If you thought first-quarter earnings were bad, wait until you get a load of this.

By Minyanville Jun 11, 2012 5:30PM
JC Penney's (JCP) fundamental position is worse -- and the challenges facing it more dire -- than many investors thought.

A year ago, the struggling retailer hired Ron Johnson, the former head of Apple's (AAPL) retail stores, as its CEO. In addition to his credits at Apple, which included the creation of the stores' open layouts, Johnson had been at Target (TGT) and played a role in the makeover of its stores, which included high-profile, highly publicized designer partnerships.

On the day Johnson was named Penney's CEO, the stock climbed just over $5 to $35.37 a share. At the end of January this year, JC Penney announced it was shifting to an "everyday low pricing" (EDLP) model, eliminating discounts for in-season merchandise, which would be marked down from the start, similar to the way Target operated. The announcement coincided with the start of the company's fiscal year. By mid-February, the stock had climbed to a high of $43.18.

I could not understand the stock price run-up to the $40s. There were obviously huge problems in educating customers about the new pricing system. Many retail analysts shared my skepticism. I figured the euphoria would fade in time and the stock would come back to a level that represented a possible buying opportunity.

In mid-May, when the company announced its first-quarter results, it was obvious that it was in an even weaker position than most investors, including me, believed. Same-store sales were down nearly 19% in the quarter. Gross margin shrank to 37.5% from 40.5% the previous year, and the company announced it was canceling its dividend of 20 cents a share.

When the results were announced, the stock fell 20% to $26.75, the largest drop on the Nasdaq since July 1980 and the largest drop recorded by the S&P 500.

The first-quarter GAAP earnings per share was a loss of 75 cents. Two-thirds of the loss was attributed to restructuring and management transition charges and the remaining one-third to a change in non-cash qualified pension expense

Store traffic was down 10%. Worse, customers were spending less per trip, and some were not making any purchases at all.

Selling, general, and administrative (or SG&A) dollars were down 9% since last year. Sounds bad -- and is bad -- but changes like these in pricing strategy are few and far between, so there is little precedent regarding what to expect. 

What caught the market by surprise was the elimination of the dividend. That might better have been done earlier when the new pricing strategy was announced. And the company did burn about $600 million in cash this quarter.

In all, management has a hard road to travel to make the new strategy work, even though management reaffirmed its $2.16 adjusted EPS outlook for this year and asserted a $5 EPS by 2015. Executives believe they will be able to cut inventories from 17 weeks to 13 weeks, which would free up $500 million. They also said that they were speeding up the realization of expense savings generally. 

At this point I do not think there are many who still believe the $5 EPS number for 2015. That figure was based on reaching $300 in sales per square foot (historically JC Penney has been in the $135 to $150 area), or the 13% EBIT (or earnings before net interest and tax) margin. Only one store, Nordstrom (JWN), ever achieved such a high EBIT for one year among department store companies in recent memory.

While there still is a chance that JC Penney will be a buy at some point in the next year or two, the expectation will be more soberly based. 

But none of that, I think, is the really bad news. 

Here's where it gets worse
This is where I'm going to drop the proverbial dime. I have see something very ugly.

One sharp sell-sider did an analysis showing that JC Penney's past quarter's sales loss in apparel, accessories and footwear went almost entirely to Wal-Mart (WMT) (35%), Target (30%), Sears (SHLD) (25%) and Costco (COST) (10%).

If the losses had gone predominantly to Kohl's (KSS), Macy's (M) and other department stores, with Sears following those, the losses might have been still considered sector-wide and thus easier to win back. The expectation is that if a Sears bankruptcy happened in the next few years, that would be a plus for Penney.

What the analysis showed was that Penney's customers skipped a normal "step" in the trade-down process. It proved that Penney's customers were not only price-sensitive but so economically pressured that they wouldn't or couldn't switch to another department store but would immediately make the bigger trade-down to discount stores.

This was not a development I, or probably Penney's management, believed would be the case during the attempt to change the company's pricing structure. 

Given the across-the-board consumer retrenchment that is still going on, I believe lost sales to discount stores will tend to be a "one-way ratchet" similar to the situation in consumer packaged goods where buyers who trade down from name brands to private labels seldom reverse themselves.

Valuation-wise, I had assigned JC Penney a 7% risk discount for a long time. The 7% risk discount applied to JC Penney’s $25 price and an adjusted EPS of $2.16 for this year and (a very shaky) $2.50 EPS for next year would imply a 1.5% infinite EPS growth rate. 

But given the elimination of the dividend in the first quarter, the fact that almost all of the near-term earnings growth will come from expense savings and, for me, the likelihood of very high market share losses to come in the pricing transition, an 8% risk discount is more appropriate.

Applying an 8% risk discount to these earnings and a $25 price implies a 4% five-year EPS growth rate, something an average department store is likely to achieve.  Therefore JC Penney stock is, at best, efficiently valued at $25. The stock closed Monday down nearly 5% to $24.

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104Comments
Jun 11, 2012 8:50PM
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Get rid of Ellen and the other perverts with the Father's Day ad with 2 "Gay" fathers and real people might shop there again.  JC Penney is not the right segment for the queers - they shop more ritzy stores and normal people are turned off with the latest spokespersons!
Jun 11, 2012 8:42PM
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They should have kept their coupons and sales promotions.  They certainly got more people into their stores.
Jun 11, 2012 8:10PM
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 They spend so much on advertising now I'd rather see " lower" ever day prices if that is their goal than more books in my mailbox.  I have gone in there three times and have left without buying a thing.

 

 

Jun 11, 2012 10:44PM
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We liked the "old" JCP a lot and shopped there (actually bought things almost every trip!) frequently.   We liked the sales, the coupons, the brands, even the way the clothes and racks/signs were arranged.  Since the change we have been in a JCP only once and then only to look.  We have gone over to Kohls almost exclusevly, but are not completely happy with that.  If JCP were to go back to the old format, we would go back to them in a hearbeat!  What a tragedy, for the customers, the company, and the JCP employees. 
Jun 11, 2012 9:26PM
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Back in the 70's you couldn't beat Penney's for quality.  No one held a candle to the value in shoes, clothing and anything you needed for your home...furniture, decor, ANYTHING!  And the selections were stupendous!  It was my first stop and usually my only.  Now I pass by without even looking in the window when I'm at the mall.  Quality has been slipping for years, and selection stinks.  Now these ridiculous ads, and generic looking store displays are a real turn off. The whole store now has a junk store feel to it since they've went to the new pricing.   Go back to what it was when it was when Mr. Penney himself ran things and watch it take off again.  If not, you may as well close it up. 
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This explains it!  Last September, 2011 I bought some (nice) quality ladies' clothing and lingerie at JCPenney's in the MidAtlantic and then left for the winter.  When I returned in the late spring 2012 from Florida and returned to the same JCPenney's store I was horrified at the crappy quality of the inventory in the store.  I spent about two hours roaming the store in various departments and there was truly not one item that I considered of quality worth buying.  By contrast, the prior Septmber I'd stocked up and bought at least 25 items of the higher quality, or "former" inventory level.  Before leaving the store I stopped to chat with one of the longtime employees and commented to her, "Wow the Chinese must be keeping all the good stuff for themselves and just sending the crap over here now.  What happened to the good stuff?  What is all this silly pricing about - it looks and feels just like a Target or a K-Mart in here now."  The sales clerk just smiled wanly and said I was not the first to say this.  Now I get it; the idiot CEO from Target has now come to trash JC Penneys - and he has succeeded.  It's a shame.
Jun 11, 2012 8:54PM
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Not sure what Penney's is trying to achieve here.  The public no longer perceives Penney's to be a good value and the abscence of sale advertising hurts the store even more.  We still buy there, but not as much.  Kohls has jumped way ahead of them.  Screw WalMart- their clothes are cheap Chinese garbage and too low to go for us.

Jun 11, 2012 8:55PM
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I haven't stepped foot in a Penney's, since they started those ridiculous screaming commercials, and the artsy, show nothing I would ever buy, ads.  Ron Johnson, do the right thing.  Google Japanese hari kari swords.
Jun 11, 2012 10:09PM
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I used to buy all of my family's clothes, shoes and home furnishing items there.  I bought towels at Penneys last year. They shrank, the fabric pulled and the hems came out.  I don't shop there anymore.

The quality is gone and the selection stinks. 

Jun 12, 2012 8:47AM
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I worked there part time for 4 years. When they announced the new pricing structure not one employee that i talked to, including managers, thought that this would have a snow balls chance in hell of working. Although we all tried to buy into the idea, we just did not believe in it. You just can't take your core customers who have been trained for years by coupons and big sales and tell them, now you are getting the best price/value. I think Ron Johnson is all wet, but he got a huge bonus, somewhere in the $52 million $$ neighborhood. He will be ok financially, but all the long time JCP employees are getting the shaft in this deal. Many long term employees have been let go. Pay plans have been changed, never to the benefit of the employee. Ron Johnson took a company that needed updating and made the worst decision he possibly could have. I truely doubt the company will survive this change. Mr Johnson should have to forfit his giant bonus, suck it up, admit he made a huge mistake and go back to the pricing structure that made this company successfull. Change the look, not the pricing. Don't turn your back on your core customer.

Jun 11, 2012 9:56PM
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J.C. Penyaa....a little fun there...used to be my taylor, my clothier, etc., now , it is not.  They've outslicked themselves into beleiving that if you jack up a price on an item, call it a sale by selling that item for 25% off, people will fall for it. Baiting? Switching?  Where I come from, they call it stealing.  Don't get me started about the quality issue....they don't even even have a quality advertising scheme going now. It's an institution that time has been run over by the truth of quality, the trust of the public and is feeling it's own demise....Perhaps when they start closing stores ( And I hate to see all those people losing jobs ) the real sales will begin.  Sad.  Sad.  Sad.
Jun 12, 2012 8:18AM
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Isn't this the same company that has left it's founder's original ideas and morals for greed. Isn't this the same company that had (2) women do a mother's day commercial and (2) men do a father's day commercial when the rest of us knew that those (2) women could never be mothers without a man and the (2) men could never be fathers without a woman. Wow. Better start factoring in the boycott of moral Americans when you want to know how LOW the stock will go.
Jun 12, 2012 9:57AM
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I have always liked Penneys and I don't mind the new changes.  I do wonder about the wisdom of thier advertising.  The other day I got one of thier sales ads and it was printed like a book on heavy glossy paper, several pages long.  I glanced through it and then threw it away, feeling a bit guilty because that's pretty expensive print.  I have also noticed the lack of knowlegeable sales help.  But the thing that bugs me the most in Penneys, as well as other stores, is that their clothes are geared almost exclusively toward young people.  I'm 58 and not ready to dress like an old lady, but at the same time I don't feel comfortable in low cut shirts and shorts up to my ****.  The more mature section looks like stuff my grandma wore.  I'm not heavy and I still love to wear jeans and t-shirts...when I can find ones that covers my boobs and butt.  For work I need a dressy casual look that, again, covers me up.   I'm not finding my look at Penney's anymore.
Jun 12, 2012 8:27AM
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Good riddance......Same sex Father's Day. What were they thinking? 
Jun 12, 2012 8:18AM
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Easy fix for JCP!  Go back to coupons, that's what consummers understand.

JCP & Apple are not the same.

Jun 12, 2012 12:40AM
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First and formost the quality of their products really is inferior, not a thing in the store that is made in America either.  The Gay trend has not helped them either.  Gays make up a minority of maybe 2% in our country, and there are still 50% of the people that think this is wrong. 
Jun 12, 2012 7:30AM
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Economic times as we are experiencing today, the shopper is left with a few choices in which to spend their dollar. I believe that most retailers have had it too good for too long.The base JCP consumer was driven by "sale events" They became accustomed to discounts and Sat 9-noon markdowns.That's the American way. If they don't change back soon, I see an ugly ending to what onnce was an "American institution"
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J.C.PENNY'S IS DEFINITELY NOT WHAT IT USE TO BE. PUT THE CATALOGS BACK IN THE MAIL,

YOU MIGHT GET MY MONEY IF YOU DO,AND BRING IN SOME NAME BRAND CLOTHES,HAVE YOUR COUPONS PUT BACK IN PLACE..HECK I COULD RUN THE STORE BETTER THAN YOUR CURRENT CEO. I HAPPEN TO KNOW WHAT WE YOUNG,MIDDLE AGE AND SENIORS LIKE TO WEAR,AND I KNOW HOW THEY THEY LIKE TO DECORATE THEIR HOMES...ITS NO WONDER YOUR STOCK HAS FALLEN AND PEOPLE COME INTO THE STORE AND THEY ACTUALLY LEAVE WITH OUT BUYING ONE THING....SO THERE YOU GOT IT FROM THE HORSES MOUTH...................

Jun 12, 2012 8:32AM
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JCP supports the Gay population and  supports the gaying of our culture. Let's see how much the gays will support this failing business.

 All decisions have consequences.

Jun 11, 2012 11:54PM
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They messed it up with the change. I used to buy almost everything from them,,but the quality is gone. I bought 3 pairs of pants recently and had to take all 3 to the tailor before I could wear them.The stuff is cheap,the advertising stinks and they have no stock. Everytime I go into the store I have to order anything I want from the catalogue. When I complained I was told to be patient. While I'm being patient I'm shopping somewheree else. Also, get rid of the gay spokswoman.

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