4 Signs This Retailer Is at the End of its Rope

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

“This doesn’t end well,” is a phrase I’ve heard uttered several times by sports broadcasters, usually as a fighter has his opponent on the ropes. This phrase seems to apply perfectly to the current situation at J.C. Penney (NYSE: JCP). The retailer has problems, and to be quite blunt, the company’s issues aren’t fixable in just a quarter or two. Shoppers have been leaving Penney in droves, and things aren’t likely to get better. Management needs to realize the company should be in survival mode, and yet that’s not happening either. The bottom line is, this doesn’t end well for employees or stockholders.

What Happened?

Honestly the biggest problem facing J.C. Penney today is that the company is being forgotten. The old days of choosing between J.C. Penney at one end of the mall and Sears at the other are gone. When companies like Kohl’s (NYSE: KSS), Target (NYSE: TGT), and Wal-Mart (NYSE: WMT) began opening standalone stores it was the beginning of the end.

Peter Lynch once said that the best measure of any retailer is their same-store sales. He suggested that it wasn’t a big deal to see a drop in same-store sales if the economy was bad or if the weather was unusual. However, when a retailer underperforms its peers on a consistent basis, you know there are bigger issues.

The biggest issue facing J.C. Penney is their struggle when it comes to same-store sales. While the past several months were no great sales bonanza for most retailers, J.C. Penney clearly was the worst of the bunch, reporting a 16.6% drop in same-store sales. Of the company’s peers, Target actually performed the best with a same-store sales decline of just 0.60%. By comparison, Wal-Mart and Kohl’s saw same-store sales declines of 1.4% and 1.9% respectively.

I Thought Everyday Low Prices Were the Solution

It’s amazing to me that a retailer can change to everyday low prices and investors believe this is the solution to the company’s problems. What’s equally amazing is, when the company goes back to promotional pricing and sales, investors believe this is the solution to the company’s issues.

The truth of the matter is that J.C. Penney is suffering primarily because shoppers have found other alternatives that offer similar or better quality, and better selection. This brings us to the second problem facing the chain: their gross margin is falling off a cliff. Last year, J.C. Penney commanded a gross margin of over 37%, which is similar to other large mall-based retailers. This year, the company’s gross margin dropped to 30.8%, which is only slightly better than Target's gross margin of 30.7%.

While it’s true that J.C. Penney’s gross margin is better than Wal-Mart's at 24.66%, the latter has been focused on taking grocery market share, which is a historically thin margin business. Kohl’s, on the other hand, still carries a gross margin of over 36% and seems to have taken J.C. Penney’s place, with higher normal prices and regular sales.

The double-edged sword of J.C. Penney’s gross margin dropping is, they are unable to spread their fixed expenses across as large of a revenue base. This has caused the company’s SG&A to jump to nearly 41% of revenue. If this crazy level of expenditures isn’t a solid third reason to avoid the shares, I don’t know what is. To get an idea of just how far out of whack this is, consider that between Kohl’s, Target, and Wal-Mart, the average SG&A percentage is just under 21%.

You Do Realize You’re Losing Money, Right?

The fourth and most troubling reason to avoid J.C. Penney at the current time has to do with their cash flow and capital expenditures. In the last year, the company’s core operating cash flow (net income + depreciation) declined by over 400%.

By comparison, Kohl’s reported operating cash flow growth of 1.69%, and excluding Canadian expansion costs, Target reported cash flow growth of 0.86%. With Wal-Mart reporting a 2.32% increase in operating cash flow, we can clearly see that J.C. Penney is not only lagging their peers, but the situation looks extremely serious.

As if the decline in operating cash flow wasn’t bad enough, management decided that doubling their capital expenditures versus last year somehow made sense. The company is losing sales left and right, their gross margin is declining severely, and management at the top has just changed. Spending twice as much on capital expenditures appears to show a severe lack of judgment.

The bottom line is, investors in J.C. Penney should seriously consider abandoning ship. Any of their peers seem to offer a better value at the present time. Whether investors choose Kohl’s, Target, or Wal-Mart, each company offers a yield of at least 2%, which is something J.C. Penney cannot claim. In addition, these companies are all expected to grow earnings per share by at least 8% over the next few years, whereas most analysts see J.C. Penney reporting a significant decline going forward. As I said at the beginning, J.C. Penney reminds me of a fighter on the ropes, and this doesn’t end well for investors.

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.


Chad Henage owns shares of Target. 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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