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J.C. Penney's Slump Worsens, Adding to the Pressure on Its New CEO

Adam Levine-Weinberg, The Motley Fool

During 2018, J.C. Penney (NYSE: JCP) has released a string of ugly quarterly earnings reports. Three months ago, the company cut its sales forecast, calling for flattish comp sales for the full year, compared to its original forecast for 0% to 2% growth. Margin pressure forced it to make even deeper cuts to its earnings and cash flow forecasts.

Unfortunately, J.C. Penney's results took another turn for the worse last quarter. Moreover, the company's leadership doesn't expect a quick bounce-back during the holiday period. This adds to the pressure on new CEO Jill Soltau to develop and execute a viable turnaround plan quickly.

Weak results across the board

J.C. Penney generated $2.73 billion of revenue in the third quarter, down 5.3% year over year. This was well below the average analyst estimate of $2.81 billion.

The primary driver of this steep fall in revenue was a 5.4% comparable-store sales decline. On a "shifted" basis -- which adjusts for a change in the timing of the fiscal third quarter during the calendar year -- comp sales still fell 4.5%.

The exterior of a JCPenney store

J.C. Penney posted a big comp sales decline last quarter. Image source: J.C. Penney.

J.C. Penney's efforts to address its bloated inventory caused gross margin to continue eroding. Gross margin dropped by 2.1 percentage points last quarter, to 31.9%. As a result, while the retailer was able to reduce its selling, general, and administrative costs by 4%, its adjusted net loss widened to $164 million ($0.52 per share) from $108 million in the year-ago period.

Furthermore, J.C. Penney announced that it now expects a low single-digit comp sales decline for the full year. That implies only modest improvement in its sales trend for the fourth quarter relative to last quarter. The company also withdrew its full-year earnings guidance. Moreover, Soltau acknowledged during the earnings call that business trends may get worse before they get better. But on a brighter note, J.C. Penney is still on track to post positive free cash flow this year, limiting the risk of a liquidity crunch.

There are clear fixes for some problems

J.C. Penney stock initially took a double-digit dive after the company released its dreadful earnings report on Thursday morning. The stock reversed course during the day, however, and actually ended Thursday with a double-digit gain.

JCP Price Chart

J.C. Penney Thursday stock performance. Data by YCharts.

This surprising recovery may have been driven by optimism about the potential for J.C. Penney to significantly improve its profitability through some relatively simple fixes.

Most notably, J.C. Penney revealed that its gross margin on clearance sales has been about -20% year to date, due to poor inventory management. That compares to roughly breakeven clearance margins in 2015 and 2016. Additionally, "shrink" -- the cost of merchandise that is lost or stolen -- has been significantly higher than historical levels recently.

J.C. Penney began to rationalize its inventory a few months ago, so management thinks clearance margins could return to breakeven or positive territory within a year or two. Moreover, in her first month as CEO, Soltau has prioritized reducing shrink through staffing adjustments and other changes. Getting clearance margins and shrink back to more typical levels would boost J.C. Penney's bottom line by hundreds of millions of dollars annually.

Running a better operation could thus be the difference between returning to profitability and continuing to lose money. That's important because J.C. Penney should be able to improve its inventory management and shrink rates regardless of economic conditions.

Jill Soltau still faces a tough task

While straightforward operational improvements could significantly improve J.C. Penney's bottom line, the company ultimately needs to get comp sales growing again to ensure its long-term survival. That represents a bigger challenge. Soltau, who has been on the job for just one month, hasn't had enough time to develop a strategy for driving a sales rebound.

Better inventory management should help, as it would allow J.C. Penney to react to fashion trends faster. However, Soltau also needs to solve fundamental challenges like acquiring new customers and finding the right mix of marketing and pricing to motivate existing customers to spend more with the company. And as a practical matter, Soltau will likely need to improve J.C. Penney's sales results in the context of weaker economic growth than what the U.S. is currently experiencing.

J.C. Penney certainly has opportunities to grab market share over the next couple of years as regional department store Bon-Ton liquidated over the summer and Sears Holdings might not be far behind. But investors should recognize that the struggling department store chain has yet to answer some of the biggest questions about how it will achieve a sustainable turnaround.

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Adam Levine-Weinberg owns shares of J.C. Penney. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.