Can J.C. Penney Find Its Footing?

It has been a bad year for J.C. Penney , with a declining customer base, board member departures, and a sharply falling stock price. J.C. Penney recently altered its deal with Martha Stewart Living Omnimedia, the subject of pending litigation with Macy's , though the move didn't dissuade its larger competitor to drop its lawsuit. 

On the bright side, J.C. Penney has returned to basics by dumping former CEO Ron Johnson's branded shop-within-a-shop strategy in favor of its historical promotional strategy built around private-label brands. So, is there potential upside for investors?

What's the value?
J.C. Penney remains a meaningful part of the value-priced department store segment, generating more than $12 billion in sales during its latest fiscal year through a national base of more than 1,100 stores. The company derives most of its sales from men's and women's apparel, accounting for 44% of the total, with a stable of recognized private-label brands that include St. John's Bay and Stafford. However, its home category was a potential avenue for future growth, hence the importance of the deal with Martha Stewart Living.

In the first six months of fiscal year 2013, J.C. Penney has continued to post poor results. A 14.2% decline in revenue was primarily caused by weak comparable-store sales.  The high level of clearance merchandise in the company's sales tally has also led to a weak gross margin and an inability to cover its overhead, straining its cash resources. 

As a result of J.C. Penney's financial profile deterioration, management had no choice but to do a highly dilutive stock offering in September to shore up its stakeholders' confidence level. The transaction raised net proceeds of roughly $785 million.

Looking for a more durable play
J.C. Penney's sales trend has noticeably improved lately. Management disclosed a 4% year-over-year drop for September 2013 led by the apparel, jewelry, and women's accessories categories. However, the company's strategy misstep has left it in a deep hole. It needed to use increasing amounts of debt and equity in order to fund its operations and capital expenditures. As such, investors might want to stick with J.C. Penney's better-positioned competitors, like Macy's and Kohl's.

While Macy's hasn't been growing its physical store network lately, it has focused on making its existing stores more productive by shifting product mix responsibility to the local management level and by incorporating in-store technology capabilities. In addition, the company has been adding to its base of stores that can provide fulfillment for online orders, which should total 500 stores by the end of the year.  The initiatives are designed to enhance the organization's overall efficiency and to deliver on management's long-term goal of a 14% EBITDA margin.

In fiscal year 2013, Macy's has managed to post slight top-line growth. Revenue was up 1.6% led by the handbag, active apparel, and furniture categories.  More important, its operating profitability ticked marginally higher. This was aided by a solid gross margin and double-digit growth in its credit operations. The result has been strong operating cash flow of $664 million during the period. This allows Macy's to easily fund its capital expenditures and return funds to stockholders through share repurchases.

Meanwhile, Kohl's has also eked out a top-line gain in fiscal year 2013. Revenue was up 0.5% despite a slight decline in comparable-store sales. The company has a more middle-class customer base than Macy's, which results in lower price points and related gross margin. However, it shares a commitment to efficient operations, with open store layouts and a similar initiative that provides the capability for its stores to fulfill online orders. Operating profitability dipped slightly during the current period. However, Kohl's continues to generate substantial excess cash flow that it is likewise returning to stockholders through share repurchases.

The bottom line
For retailers, balance sheet strength is vitally important given the general need to fund significant quantities of inventory via trade credit.  While J.C. Penney improved its position through its equity offering, the jury is still out on whether the company can win back its former customer base and return to profitability, a necessary ingredient in its turnaround plan. As such, investors should probably leave the bottom-fishing to the speculators and focus on its competitors that continue to make investments to drive efficiency and higher shareholder value.

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