J.C. Penney Explodes Higher: Buying Opportunity or Time to Run?

Source: J.C. Penney.

J.C. Penney stock has risen by more than 50% over the last week as investors are gaining confidence in the company's chance to implement a successful turnaround. The retailer is clearly making material progress, but the industry is quite challenging and J.C. Penney is still an unprofitable company carrying substantial financial risk. So is this a buying opportunity or a time to run?

The good news
Excluding the 53rd week in 2012, total sales during the quarter ended on Feb. 1 increased by 1.6%. Comparable-store sales grew by 2% annually during the quarter, and J.C. Penney delivered a 3.1% increase in comparable-store sales during the key holiday period of November and December. Sales are stabilizing and that's a big improvement for the company.

Gross margin came in at 28.4% during the quarter, a material increase of 460 basis points versus the same quarter in the previous year, in spite of the fact that J.C. Penney discontinued several brands during the period.

The company generated positive free cash flow of $246 million, and J.C. Penney ended the year with total available liquidity in excess of $2 billion, so its financial position is also showing signs of progress and stabilization.

J.C. Penney is still in the red when considering adjusted net income, but the company seems to be moving in the right direction in terms of growing sales and improving profitability.

Furthermore, forward guidance was quite optimistic; management is expecting comparable-store sales to increase by between 3% and 5% during the first quarter of 2014 and by mid-single digits during the full year. In addition, the company is forecasting gross margin to "improve significantly" versus 2013.

Industry context
Dillard's reported a similar increase of 2% in comparable-store sales during the 13 weeks ended in Feb. 1, while total merchandise sales increased 1% when adjusting for the extra week in 2012. Gross margin from retail operations declined by 180 basis points to 32.8% of sales, and adjusted net income fell by 6.3% to $2.69 per share.

Dillard's did not provide forward sales guidance, but margin pressure is clearly indicating the company is implementing big discounts in order to sustain sales in a harsh competitive environment.

Sears reported a worrisome decline of $1.7 billion in sales during the quarter ended on Feb. 1, to $10.6 billion versus $12.3 billion in the same period of the prior year. Domestic comparable-store sales fell 6.4% during the quarter, comprised of decreases of 5.1% at Kmart and 7.8% at Sears Domestic. Things have been quite dismal for Sears in recent years, and there is no turnaround in sight, judging by its recent financial performance.

Macy's is a very different story, though. The company has been materially outperforming competitors over the last several years, and the latest earnings report was no exception. The company reported an increase of 2.3% in comparable sales, including departments licensed to third parties, during the 13 weeks ended on Feb. 1.

Gross margin came in at a strong 40.6% during the quarter, and adjusted net income per share increased by 13% versus the same period in the prior year. Macy's management is expecting an increase of between 2.5% and 3% in comparable sales during the first quarter of fiscal 2014.

CEO Mike Ullman is clearly doing a sound job after retaking the reins in April 2013, and he sounds optimistic about the prospects of a sustained turnaround in the coming years: "With the most challenging and expensive parts of the turnaround behind us, we will focus on improving gross margin, managing expense and steadily growing our sales in 2014."

If the company does in fact deliver according to management's guidance, performance could be roughly in line with that of Dillard's, doing materially better than Sears but not as well as Macy's.

Under such a scenario, this should alleviate investors' concerns regarding financial risk at J.C. Penney. In addition, stabilizing sales performance could set the stage for improving profit margins in the long term, so J.C. Penney has a lot of room to run from current levels if the company continues moving in the right direction.

On the other hand, turnarounds are seldom easy, and the retail industry is a notoriously challenging business. Management does not have a lot of room for error considering the company's heavy debt burden, lack of profitability, and the harsh economic conditions affecting the industry.

Bottom line
J.C. Penney is clearly making material improvements, but the company is not out of the woods by any means. The good news is that the stock still offers substantial upside potential from current levels if management continues executing as expected. But make no mistake: J.C. Penney still represents a very risky proposition for investors.

A better proposition for investors
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The article J.C. Penney Explodes Higher: Buying Opportunity or Time to Run? originally appeared on Fool.com.

Andrés Cardenal has no position in any stocks mentioned. The Motley Fool owns shares of Dillard's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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