How Many Reasons Do You Really Need?
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
How many reasons do you really need to avoid a dying retailer? I've written about J. C. Penney (NYSE: JCP) before, and with each passing earnings report, the story gets worse. In a prior post, I questioned the company's ability to change the public's perception of the brand. While I admire CEO Ron Johnson's management capabilities, his success with Apple is a different world away from trying to turn J. C. Penney around. I could give investors more, but based on the company's last earnings report, I can point to five different reasons to avoid the shares.
According to famed investor Peter Lynch, one of the most fundamental ways to measure a retailer is to look at their comparable store sales. He said that you want to see their comps increasing, because this would indicate that shoppers are buying more from existing stores. In J.C. Penney's case, their comps are some of the worst I have ever seen. In the current quarter, comparable store sales were down 26.1%. To be blunt, I've been following the market for now 20 years, and I don't ever remember seeing a retailer survive after posting 20%+ declines in comps. It would be one thing if this were an isolated incident, or if the company was making an apples to oranges comparison. However, neither is the case. Let me put it this way, no matter how you slice it, J.C. Penney sold 26.1% less in their existing stores than last year. If the decrease in sales was just from less customers, that means that more than one out of every five customers isn't visiting the stores. If you think of it in terms of dollars, this means if last year the store sold $1 million, this year the store sold $739,000. No matter how you look at the numbers, it's ugly out there.
Less Sales At Lower Prices? Huh?
One of the scariest things about the huge decline in comps is the fact that the company is seeing this decline with a big decline in gross margin as well. Imagine a business that sells significantly less, even when they lower prices, and you are beginning to get the idea. J.C. Penney's gross margin dropped from 37.4% last year to 32.5% this year. Just for some perspective, of their competitors Macy's (NYSE: M), Kohl's (NYSE: KSS), and Target (NYSE: TGT), only Target has a lower gross margin. Macy's and Kohl's are able to carry margins of better than 38% and 39%, and Target at 31.67% came very close to matching J.C. Penney.
Considering that Target sells much lower margin items like food, cleaning supplies, and more, the problem is clearly not with price. If price were the main issue, J.C. Penney's sales decline would slow as prices declined, however the opposite is happening. Shoppers that are used to big sales at J.C. Penney seem to be confused by the company's pricing strategy, and the lack of big sales may actually be hurting more than helping.
Can't Cut Expenses Fast Enough
One of the hardest things about a retailer that is struggling is, the company can't adjust their expense structure to match lower sales. If you look at J.C. Penney's selling, general, and administrative expenses (SG&A) you can see a disturbing trend. A year ago, SG&A represented 31.8% of sales, in the last nine months this grew to 36.2%, and in the current quarter, this line item rose again to 37.1%. The cause isn't hard to imagine, when your sales shrink by 20% or more, you can't exactly send 20% of your staff away to cut expenses immediately.
Less Sales, Lower Margin, Higher Expenses = Negative Free Cash Flow
When a company sees 26.6% less overall sales, reports a loss, and still opens a few new stores, it's not hard to imagine that their free cash flow would take a hit. In the current quarter, J.C. Penney reported negative adjusted free cash flow of about $331 million. Though the company sold $279 million in “non-core assets” this still means the company brought in less than it spent. In fact, even before capital expenditures, the company only generated about $10 million in adjusted operating cash flow. When you sell over $2.9 billion in merchandise and only generate $10 million in operating cash flow, the numbers don't get much worse.
I usually use free cash flow per dollar of sales to compare companies. However, since J. C. Penney has no free cash flow, I'll be generous and use operating cash flow instead for their number. In the current quarter, the company generated $0.003 of operating cash flow per dollar of sales. By comparison, Macy's generated $0.04 of free cash flow per dollar of sales, while Kohl's generated nearly $0.05 and even Target generated $0.03. When without capital expenditures, J.C. Penney can't even produce what their competition generates with capital expenditures, you know the company is in trouble.
Huge Capital Expenditures And Negative Free Cash Flow = Less Cash On The Balance Sheet
I'm sorry, but there are some decisions that just don't make a lot of sense. Count J.C. Penney opening 4 new stores and relocating 3 as one of these “no sense” decisions. I understand that the company wants to reinvent itself. I understand that Ron Johnson's shop-in-a-shop design is his idea of how to turn things around. There is one problem, when your sales are dying on the vine, you don't have money to burn. J.C. Penney has 51.61% less cash and cash equivalents compared to last year. The company's debt-to-equity ratio is worse than last year as well at 0.82 compared to 0.62 last year. Granted, their competition has higher debt-to-equity ratios with 1.23 at Macy's and 0.89 at Target, but neither of these companies is seeing huge declines in sales. Kohl's has a stronger balance sheet, with a debt-to-equity ratio of 0.73, and though the company isn't doing as well as it could, they aren't racing to the bottom like J.C. Penney is. With a weaker balance sheet, less cash, and huge sales headwinds, J.C. Penney's turnaround story just went from doubtful to critical.
How many companies would still have investors attention with numbers like J.C. Penney if Ron Johnson wasn't so well known? Why would customers go to old outdated stores to buy clothes and accessories when they can go to updated stores, and places like Target where they can buy groceries and clothes in one trip? These are questions without good answers. Given the huge job necessary to turn J.C. Penney around, I don't recommend any investor own this stock unless you are willing to take a flyer on a long-shot.
There are much better values in retail. Macy's is a well managed retailer with an over 2% yield that is expected to grow EPS by more than 12.6% in the next few years. Target pays an even better yield at 2.4% and is expected to grow by about 11.7%. Even Kohl's, which has been struggling lately to regain its growth status, offers a better deal with a 3% yield, and a 7.5% growth rate.
If Ron Johnson had come to J.C. Penney five years ago, the company would have been a long shot. Given the current numbers, investors are being given more than enough reasons to sell. I've given you five good reasons above, how many more do you really need?
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