J.C. Penney's turnaround grinds to a halt

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A comeback for beleaguered department store J.C. Penney(NYSE: JCP) was always a long shot. Since sales collapsed in 2012 due to disastrous changes made as part of an effort to revitalize the brand, the company has slowly crawled back from the abyss. Comparable sales returned to growth, gross margin recovered, and losses began to shrink.

But the only way J.C. Penney was ever going to return to meaningful profitability was a years-long streak of exceptional sales growth. A 0.8% decline in comparable sales during the third quarter of 2016 showed that this would be easier said than done. That decline was no fluke: Comparable sales during the nine-week holiday period also slumped 0.8%, despite retailers overall putting in the strongest performance in years.

J.C. Penney's turnaround has hit a wall. CEO Marvin Ellison expects the holiday quarter to produce the fourth consecutive quarter of positive operating profit, but interest payments have more than wiped out that profit. Sales growth remains the only path to sustainable profitability, and that path is now a whole lot more uncertain.

A weak player in a terrible industry

Department store sales have now slumped for 11 years in a row, according to data from the Commerce Department. A 5.6% decline in 2016 was the biggest decline since the financial crisis. Based on this data, it should be no surprise that J.C. Penney, along with every other major department store chain, is suffering from weak sales.

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Growing the top line in this environment will require the company to win market share from competitors like Kohl's, Macy's, and Sears. Sears is in far worse shape than J.C. Penney, and significant store closings from Sears and Macy's could boost results at J.C. Penney. But the benefit will likely be short-lived as shoppers continue to shift away from department stores, either to discount chains, more specialized retailers, or online competitors.

J.C. Penney has made some meaningful moves under Ellison, including the company's return to the appliance market. Five hundred of its stores sold appliances at the end of the third quarter, which helped partially offset weakness in apparel sales. The ongoing demise of Sears may also help the company gain appliance market share, but again, the benefit may only be temporary. The company will still be competing with the likes of Home Depot, Lowe's, and Best Buy, and winning market share won't be easy.

J.C. Penney still expects to produce $1 billion of EBITDA in 2016, despite weak holiday sales. On its own, this number doesn't mean much. Net income will still be negative, and adjusted net income, which backs out restructuring and other costs, may be negative as well. J.C. Penney guided for positive adjusted net income for the year in its third quarter report, but it failed to reiterate that guidance in its holiday sales release.

Buffett was right

A rags-to-riches success story looks far more unlikely given the company's holiday results. Turning around a retailer in general is extremely difficult, and slumping department store sales will only make things harder for J.C. Penney. Warren Buffett, describing the challenges facing Sears way back in 2005, hit the nail on the head:

Costco is working on a 10% to 11% gross margin that is better than the Walmart's and Sam's. In comparison, department stores have 35% gross margins. It's tough to compete against the best deal for customers. Department stores will keep their old customers that have a habit of shopping there, but they won't pick up new ones.

This quote applies to J.C. Penney today. The company desperately needs to win new customers, but it also needs to produce gross margins in the mid-30% range. Competing with companies like Wal-Mart, Costco, and now Amazon, all of which operate with far lower margins, may simply be impossible.

J.C. Penney has no competitive advantage. Its brand, while well-known, means nothing to most consumers. Its business model requires it to produce a gross margin that guarantees that its prices are higher than its non-department store competitors. With the company now struggling to grow sales, I see no reason to bet on a comeback.

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