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J.C. Penney Earnings Preview: Any Signs of a Turnaround?

Adam Levine-Weinberg, The Motley Fool

Three months ago, J.C. Penney (NYSE: JCP) reported disappointing results for the first quarter of its 2018 fiscal year. Shortly after the earnings report, the struggling department store chain suffered another blow, as CEO Marvin Ellison decided to leave to take the top job at Lowe's.

That said, bad weather contributed to J.C. Penney's weak first-quarter performance. Weather wasn't an issue in the second quarter. Furthermore, strong U.S. retail sales trends and big market share growth opportunities should have helped J.C. Penney accelerate its sales growth last quarter. Thus, the company's upcoming earnings report (due out on Thursday morning) will be a key test of whether J.C. Penney can get back on track under its interim leadership team.

Back to being a laggard

J.C. Penney surprised many onlookers by achieving a strong 4.5% comp sales increase in fiscal 2015, far outpacing rivals like Kohl's (NYSE: KSS), which reported a meager 0.7% comp sales gain that year. Entering 2016, management expected J.C. Penney's momentum to continue. The company's initial guidance for fiscal 2016 called for 3% to 4% comp sales growth.

The exterior of a J.C. Penney store

J.C. Penney posted strong sales growth in 2015. Image source: J.C. Penney.

Instead, J.C. Penney posted flat comp sales in fiscal 2016. However, that was still better than most of its main competitors. More troublingly, comp sales inched up just 0.1% in 2017, while Kohl's saw comp sales rise 1.5% -- largely due to a stellar 6.3% comp sales gain in the fourth quarter. The underperformance continued in the first quarter of 2018, as comp sales rose just 0.2% at J.C. Penney, compared to a 3.6% increase at Kohl's.

Adding to J.C. Penney's woes, gross margin has declined significantly since 2016. A sales shift toward lower-margin goods (particularly appliances), store closures, and inventory management miscues have all contributed to this margin weakness. As a result, J.C. Penney has fallen short of its earnings targets recently.

Last quarter may have been better

Despite posting weak comp sales growth in Q1, J.C. Penney maintained its full-year guidance for comp sales to increase by as much as 2%. However, investors are understandably skeptical that the retailer's sales trend will improve in line with this forecast.

Yet there are some reasons for optimism. First, management noted on the first-quarter earnings call that comp sales growth was above the high end of the full-year guidance range during the first two weeks of May. This supports the idea that bad weather was a key factor holding back sales in the first quarter.

A rendering of a new J.C. Penney store

Image source: J.C. Penney.

Second, the U.S. Census Bureau reported strong retail sales growth in May and June. Sales at department stores increased 1.8% year over year in May and were flat in June. That may not sound impressive, but with customers fleeing weaker retailers like Sears Holdings and Bon-Ton Stores (which is going out of business this month), other department stores like J.C. Penney and Kohl's must have achieved correspondingly larger sales gains.

Third, J.C. Penney may have gotten a substantial boost from its appliance departments last quarter. In the first quarter, appliance comp sales rose 15%, which represented a significant slowdown relative to the prior quarter. However, the second quarter is seasonally a much stronger period for appliance sales. Meanwhile, Sears has continued closing stores at a rapid pace, putting lots of market share up for grabs.

Of course, it's possible that J.C. Penney suffered more operational missteps last quarter, negating these positive factors. But with J.C. Penney stock sitting near a multidecade low, it seems like investors' expectations are already very modest.

How is the balance sheet doing?

One other key question for investors is the health of J.C. Penney's balance sheet. The company ended last quarter with just $181 million of cash and equivalents -- even after borrowing $351 million from its credit facility.

Fortunately, J.C. Penney tends to generate positive free cash flow in the second quarter. Free cash flow totaled $303 million in the year-ago period, when the company benefited from a big reduction in its working capital due to closing nearly 140 stores in mid-2017.

J.C. Penney probably didn't achieve a similar working capital improvement last quarter, although it did enter the period with some excess inventory. On the other hand, it brought in proceeds of at least $90 million from selling three corporate jets and a distribution center. The net result is that J.C. Penney may have been able to repay the bulk of the $351 million it drew on its credit line in the first quarter.

Looking ahead to the second half of 2018, J.C. Penney is poised to reap an even bigger benefit from competitors' store closures. But investors will be much more confident in the iconic department store's outlook if its business trends improved meaningfully last quarter.

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