This Company Could Be in Trouble Financially, Be Careful

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J.C. Penney (NYSE: JCP) reported an extremely disappointing quarter with the performance metrics pointing to a rather abrupt decline in sales and earnings. The financial press has been talking about the continuous decline of J.C. Penney and whether the business can remain solvent. I have to air on the side of caution with this company. After all, anything can happen in retail.

The earnings run down plus some corporate history

The company, in its first-quarter 2013 earnings report, posted a 16.4% decline in revenue. Management hoped to offset some of those losses by cutting back on the cost of its business operation. For example, the company reported a 7.3% decline in cost of goods sold. The cost cutting could not offset the sudden decline in revenue.

The company adopted a strategy whereby luxury would be emphasized. This meant hiking up the prices of its products. How did customers respond? Consumers stopped buying at J.C. Penney. It did not matter that the company remodeled stores and made them look better. What mattered to customers was the price they had to pay for their products. This can be reflected in the 16.4% year-over-year decline in sales followed by the 50% increase in the total short-term liabilities.

The increase in short-term liabilities indicates two things. Firstly, the company initially accumulated a large amount of inventory on credit, tried selling it at an expensive price, but then marked it down immediately realizing that it could no longer sell products at a higher premium. Secondly, the increase in short-term liabilities also implies that the company is unable to sell inventory on credit. By not being able to sell inventory on credit, the company accumulated additional inventory or cash liabilities.

The company reported a decline in merchandise inventory. Inventory declined from $3.1 billion to $2.8 billion from the year ago period. The company had to sell its inventory at a loss, which contributed to its overall increase in short-term liabilities without an increase in sales.

The company reported a 113.5% decline in net income. The decline in net income implies that the company was not able to manage its operations very effectively. It had to mark down the value of its inventory, sales declined, and the cost-cutting measures were not enough to offset the decline in sales. In other words, Penney's is in a lot of trouble financially.

What J.C. Penney might do

J.C. Penney could potentially turn around its business operations if it were to better manage its inventory, close unprofitable stores, and focus on a re-branding strategy that isn't nearly as expensive as retro-fitting every store. If the company does this (which it most likely will), it could be a turnaround story. Penney's will have to go back to selling its products at a very low profit margin and rely heavily upon volumes and the winter shopping season to bring its stock back into the good graces of shareholders.

Investors should wait until the fourth quarter of 2013 to buy the stock. By then, consumer sentiment indicators will give us a better idea of whether or not J.C. Penney will be able to recognize profits in the fourth quarter due to inflated demand for non-durable goods. Generally speaking, clothing retailers tend to out-perform in the fourth quarter as investors buy into these companies in anticipation of better fourth-quarter earnings. Investors should also wait to see if J.C. Penney can do a better job of managing its operations during the back-to-school shopping season. 

Time to consider alternatives

When I look at retail companies, I look for companies that operate within a specifically defined niche. Smaller retail stores that are more vertically structured like Abercrombie & Fitch (NYSE: ANF) have outperformed peers. These companies offer a compelling investment thesis compared to others in the space.

Abercrombie & Fitch has a well-defined target along with an easily identifiable growth strategy. The company continues to expand its operations by continuing to open stores in international markets, which help to keep the business diversified while adhering to its “near-luxury” product strategy. Analysts anticipate the company to grow its earnings 20.30% in 2013. 

Limited Brands (NYSE: LTD), which owns Victoria’s Secret and Bath & Body Works, is expanding its store foot print across the world. The company has been able to build a strong following for its products by offering consumers a pleasant buying experience, all at a reasonable price. The company, like every other fashion retailer, relies heavily on the holiday season to generate volume-driven sales and margins.

Analysts anticipate the company to grow earnings by 11% on average over the next five years. The company also offers an enticing dividend at a 2.32% yield.

Conclusion

J.C. Penney is in a very tough position financially. When strictly focusing on the financial aspects of the business, it is hard to determine whether or not the company can spark a turnaround in its financial position.That being the case, investors could look for investment alternatives like Abercrombie & Fitch or Limited Brands as they are more predictable.

J.C. Penney’s stock cratered under Ron Johnson’s leadership, but could new CEO Mike Ullman present the opportunity investors have been waiting for? If you're wondering whether J.C. Penney is a buy today, you're invited to claim a copy of The Motley Fool's must-read report on the company. Learn everything you need to know about JCP's turnaround -- or lack thereof. Simply click here now for instant access.


Alexander Cho has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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