J.C. Penney (JCP) reported an increasingly worrisome sales performance last week as the company put forth its Q1 2017 results.  Like Macy’s (M) and Kohl’s (KSS) before J.C. Penney, same-store-sales and total net sales fell YOY and missed analysts’ estimates.  Analysts had expected J.C. Penney to report a SSS comp of -.7% for the quarter, but the retailer grossly missed that target with SSS falling a dramatic 3.5% during the quarter. 

As an expert retail and consumer packaged goods analyst, I’ve chronicled my many retail analytics on specific retail names for Seeking Alpha and TalkMarkets. Since 2015, I’ve been broadly negative on the retail sector as a whole and as the shift to e-commerce consumption has increased more rapidly.  From Bed Bath & Beyond (BBBY), Macy’s and Target (TGT) down the line to Dillard’s (DDS) and J.C. Penney, these have been issued Sell ratings by and large and since 2015 in some cases. In 2016 and post reporting Q2 2016 results, J.C. Penney was reduced from Hold to Sell.  

In 2017, I reiterated my Sell rating even though shares of JCP were trading somewhat higher than when I initially issued the Sell rating in 2016.  I have further examined the potential of the retailer with regards to its past and present initiatives. I will be the first to admit that many of the initiatives put forth by the company in the way of home services, appliances, furniture, as well as beauty and apparel, are in the retailer’s best interest.  But more broadly, what investors have to consider is the value to place on such initiatives and a timeline for which the initiatives can produce a return on invested capital. It is for these mentioned considerations that I understood in 2016, the share price of JCP would decline even in the face of the offered improvements to retail operations.  Time was not on the investor’s side as the continued shift toward online shopping and away from brick & mortar storefronts would impact J.C. Penney revenues and same-store-sales. 

Since issuing a Sell rating, shares of JCP are down more than 55% and trading at all-time lows. It is from this point that investors will more readily benefit from considering the potential of the company going forward.  Sales are everything to a retailer as they determine the long-term potential of profits that can exhibit peaks and troughs intermittently. J.C. Penney is offering that the moves the company is making today will supplant their profit outlook for the future.  Having said that, the history of the retail world has been littered with like business models that have attempted, to some degree, what J.C. Penny is attempting.   Despite the many product and service implementations the retailer is putting forth, the underlying theme of the go-forward strategy for J.C. Penney is akin to that of Macy’s.  It’s the shrink to grow strategy that Macy’s is struggling to successfully implement and one that I warned a great many investors and analysts about in 2016.  Macy’s restructuring of the business included reducing its retail square footage by closing a set amount of stores. I warned investors that the “shrink to grow” strategy is riddled with problematic implementation and an overwhelming history of its failure. It was only a few days after issuing an analytical piece that sell-side analysts and investors were emailing me directly.

What many believed would offset the problems with the shrink to grow strategy was that of the potential to offload real estate through strategic sales.  Unfortunately and again, such a strategy has been attempted in the past and only to the detriment of the retailer implementing the strategy. Shrink to grow doesn’t work, nor has it ever in the big-box-retail business segment and regardless of the consumer trends of the time. As such, if we are to recapture the topic and business focus of J.C. Penney, their go-forward strategy breeds skepticism. 

The appropriate mix of storefronts and e-commerce business is a difficult one to produce.  This is especially the case when such a small percentage of retail sales are done online. Despite the overwhelming headlines that focus on e-commerce retail sales, the reality is that e-commerce accounts for less than 10% of total retail sales as reported by the United States Census Bureau. The problem for traditional brick & mortar retailers, however, is one of peak brick & mortar retail sales having largely been captured and as such every online sale impacts the brick & mortar retailer’s sales. In other words, for most every sale moved online, brick & mortar retailers are negatively impacted.  And therein lies the conundrum for retailers like J.C. Penney.

Shrinking storefronts doesn’t necessarily correlate to growing total sales even as you compete in the digital sales arena. This is the case especially for the likes of J.C. Penney who is competing online at a lesser pace and scale than its peers and more obviously, the leading online retailers. By closing storefronts, 138 in total as offered thus far by J.C. Penney, the retailer is giving up on the potential to achieve sales where 90%+ of retail sales are occurring in favor of online sales and where less than 10% of retail sales are proliferating. That’s an extremely difficult dynamic to succeed with, even as it favors the trend in where consumption is taking place, and an even tougher business decision for investors to accept. The gap between where J.C. Penney achieves online sales scale and where they’ve given up the greater retail sales can be one that takes many years.  Focusing on profitable stores and e-commerce while eliminating unprofitable stores can be an intermediate solution to profit and debt issues, but sales are what retailers are bound and valued against. It’s one of the main reasons Amazon (AMZN) achieves ever-increasing valuations in lieu of profits.

Having said all of that and exampling the well-predicted outcome for shares of JCP, BBBY, M and TGT over the last 12 months, I believe J.C. Penney is doing the right thing for shareholders today.  J.C. Penney’s choices are limited. The balance sheet is disadvantaged when compared to its peers and by CEO Marvin Ellison’s own admission; the retailer is trying to catch up to its peers. Besides the objective aimed at shrinking to grow, the company aims to diversify its retailing strategy with a mix of services, experiences and general product sales. 

Sephora has been a bright spot in an otherwise challenging retailing environment for J.C. Penney. The sales of beauty products from the segment continue to comp positively year-after-year and quarter-after-quarter.  Having said that, investors should understand two things:   J.C. Penney will be expanding this business in terms of total store-within-a-store concept as well as square footage and two,  Sephora is still not incremental enough to offset J.C. Penney’s larger sales segment, apparel.

Moreover, if we take the collection of initiatives and/or strategies and add their potential value and assign a generous 10% CAGR over the next 5 year period, they still won’t offset declines from J.C. Penney’s apparel business if in fact that business segment continues to decline.  Apparel is the biggest retail segment for J.C. Penney, for better or worse. J.C. Penney is continuing to address the challenges to its apparel business, but for each challenge addressed it simply can’t eliminate the fact that all retailers are facing the same challenges and all are attempting to address them in unison. In other words, the challenge is unlikely to ever end, but result in submissions, like that known as a shrink to grow strategy. 

The bottom line truly is and as evidenced throughout history:  The challenge of today will be met with an equal or greater challenge tomorrow and for that, size matters. Just ask Wal-Mart (WMT).  To refer to the size and balance sheet disadvantage noted earlier, J.C. Penney doesn’t have the ability to buy a Jet.com business now does it? And this is all before mentioning the staggering on-line growth in Amazon’s apparel sales.

The ecommerce giant is about to tap into one of America's biggest clothing trends by launching its own athleisure brand, making it a competitor to Lululemon, Gap's Athleta, Under Armour, Nike, and other top sportswear brands. 

The move will also make Amazon a bigger threat to department stores like Macy's, Nordstrom, and JCPenney, which have been battling years of declining shopper traffic to malls.  

And this reality from Amazon, besieging traditional department stores and brands, needs to be considered.  When J.C. Penney’s CEO offers a refined focus on casual and sportswear assortment for customers, Amazon is doing the same thing, possibly at a lesser price point and with equal to or greater convenience.  After all it is hard to compete with free shipping when Amazon Prime subscriptions are factored into the equation.  Even as J.C. Penney works on lowering its shipping costs the end-game for a consumer is quite simple, free shipping on similar or exact products is going to be the choice for a vast majority of consumers. It’s purely logic. The long-term value for the initiatives surrounding J.C. Penney’s apparel and online sales is limited, has a ceiling for sure.  So for now, J.C. Penney is doing the right thing, but when juxtaposed with the dominating forces that already proliferate in these arenas it is no wonder J.C. Penney is shrinking, but to grow sales long-term defies the logic exampled and chronicled throughout history.  As it pertains to J.C. Penney’s apparel sales, here is what the CEO offered on the Q1 2017 Conference Call:

Marvin R. Ellison - J. C. Penney Co., Inc.

For the quarter, overall apparel performed worse than the company comp. I think that's probably the best way to illustrate the overall performance. And candidly, as we look at our sales plan and our guidance of down 1% to plus 1%, apparel is obviously planned down. So we have no great optimism that we're going to swing apparel to positive comps overall. There are categories in apparel, active being one, dresses and some components of contemporary and casual that we are expecting to see positive comps in. But overall, we have apparel planned down appropriately.

Even by the CEO’s own admission again, regardless of what the company has planned to improve the apparel business, positive comps will not be found solely based on these improvements.  The apparel business in the Q1 2017 period actually finished lower than the total sales comp.  Simply put, it will take more to turn the total comp around.

J.C. Penney will show some improvement undoubtedly and despite the negative tone put forth thus far and within.  But like J.C. Penney’s past, 2-year stack comp sales of greater than 4% from 2014-2015, investors would be wise to understand that there is a law of low numbers just as there is a law of large numbers.  It was quite easy to outperform sales coming out of a dismal 2012-2013 period and where it can be easily exampled as to the demolition of sales from Ron Johnson, the former J.C. Penney CEO.  But after jumping over a very low bar in those dismal years, it has proven that as numbers grew from 2014-2016, the laws of large numbers become too much an obstacle to overcome with the business model and consumer trends.  So with J.C. Penney underperforming their sales projections for 4 straight quarters, the company is once again establishing a low bar for which to jump over.  Again more simply put, it will be difficult to define in the coming quarters as to whether the low comps from 2016 will be the drivers of assumed improvement or the improvements to the business model.  Such confusion in metrics and the timing of the potential improvements tend to be sell signals for investors, as the risks associated with understanding the cadence of metric performance become muddled. 

Now let’s look at some specific metric performance from J.C. Penney’s Q1 2017 results as well as the company’s unrevised outlook for FY17:

• Net sales of $2.7 billion in the first quarter of 2017 compared to $2.8 billion last year.  Comparable store sales were (3.5) % for the quarter.
• Gross margin was 36.3 % of sales, an increase of 10 basis points compared to the first quarter last year. 
• Net loss was $180 million, or ($0.58) per share. 
• Adjusted net income improved $116 million, or $0.38 per share, to $0.06 per share for the first quarter this year compared to a net loss of $97 million, or ($0.32) per share, last year.  Adjusted net income for the first quarter of 2017 and 2016 includes the sale of operating assets, which totaled $117 million and $8 million, respectively. 
• The Company completed the sale of its Buena Park distribution facility in March for a net sales price of approximately $131 million and recorded a net gain of approximately $111 million in the first quarter associated with the sale of this facility. 
• During the quarter, the Company utilized available cash on hand to retire $220 million of outstanding bonds that matured in April.

Outlook

The Company reaffirmed its 2017 full year guidance.  As a reminder, fiscal 2017 is a 53-week year, which has been incorporated into the full year guidance, with the exception of comparable store sales, which are calculated on comparable 52-week basis.  The following guidance also includes the expected impact of the Company's previously announced store closures.  The fiscal 2017 full year guidance is reaffirmed as follows: 

• Comparable store sales: expected to be -1% to +1%;
• Gross margin: expected to be up 20 to 40 basis points versus 2016;
• SG&A dollars: expected to be down 1 to 2% versus 2016;
• Adjusted earnings per share1: expected to be $0.40 to $0.65.  

It was a rough quarter for J.C. Penney as the retailer continues to implement its various strategies. With the sale of assets, the company managed to beat net income expectations but the total loss widened for the company in quite a dramatic fashion. It’s really difficult to rationalize the sale of such distribution assets in a time when the economy is growing and knowing that assets are desired by lenders for collateral in times of need. 

So once again, when we look at the big picture, go-forward strategy offered by J.C. Penney we are forced to question the outlook during times of economic strife in the United States. Don’t get me wrong, I laud the company’s debt reduction and dedication for committing to the practice, but it seems short-sighted and lacking for future planning. Certainly debt restructuring will streamline the path to greater profitability near-term, but it doesn’t fix the ills of the revenue generating business. This is critical during a time when retailers are valued, in all “absolutivity”, on the strength of their sales/revenues. So when investors reviewed the net income beat and were surprised at the stock reaction, they should be anything but shocked.  Without sales there simply are no profits long-term and the greater population of investors are with the consideration of long-term sales, not short-term profit band-aids that prove to be little more than fleeting fixes.

I certainly don’t enjoy watching the shareholder carnage surrounding JCP shares and I would have to assume that is why Appaloosa disposed of their position in shares of JCP prior to the latest quarterly results. More importantly, is there a better option for shareholders of record than to simply hold shares and hope for the better?  Of course there is and that is why I maintain a Sell rating in part. As it were with my analysis and general coverage of Macy’s in 2016-present, I offered an opportunity for Macy’s shareholders to recognize a better investment opportunity.  

Only a few weeks prior to articulating my thoughts on Macy's did I publish my long-term position in ProShares Ultra VIX Short-Term Futures ETF (UVXY), dating back to 2012.  I informed investors to the value and wealth-generating proposition offered through participation in UVXY from the short side. In terms of risk and as the UVXY is designed to fall in price and seek new lows over time; the predictive outcome for shares of UVXY and participating investors/traders has been greatly beneficial. In terms of risk for participating in shares of M over this same period and against the backdrop of considerable restructuring plans as well as the malaise over traditional brick and mortar retailers, the risk was considerably higher than UVXY. We will get to the actual YTD results produced by these two investment vehicles momentarily.

Based on the quote and article above and from last year’s offered opportunity that persists in perpetuity, UVXY shorts have continued to outperform M shares.  Heck, such an investment has outperformed the vast majority of investment vehicles in the marketplace with an average rate of return above 90% since the commencement of trading in 2011.  Investing can be quite the educational experience when we open ourselves up to such an education.

The Final Takeaway

JCP shares are likely not going to see any meaningful or sustainable share price appreciation over the next several months. The stock is presently uninvestable for many institutional investors, as it has found a valuation below $5 per share. The barrier that creates for an accredited investor class is not surmountable. The stock is thus deemed a battleground stock.  J.C. Penney will remain a “show me” business and the stock will be more appreciably participated with for trading purposes as opposed to investing purposes.

I would be of the opinion, that with economic conditions and consumption trends improving QoQ, J.C. Penney will find improving metric performance from sales initiatives. However, it is unlikely that sales will achieve the high-end of the current Company forecast. The many sales initiatives currently in place largely lack marketing practice and rely heavily on in-store presentation and social media word of mouth. This may prove to be a lesser strategy that relies on peer retail closings and will find a benefit in 2018, rather than 2017. It is probable that J.C. Penney can increase its market share from such peer closings over the next 2-3 years and in conjunction with its sales and service initiatives. The value of market share gains may be muted by core business segment declines, which remains to be seen and provide investors with a balance of puts and takes to consider.