J.C. Penney Needs New Management

Last week J.C. Penney Company, Inc. (JCP) lost 28% because of a weaker than expected quarterly report and investor's loss of confidence in Penney's management. The entire retail sector was hit as consumers did not seem to switch from stores that were closed to those that were still open, which had been hoped for by many bullish retail store investors. If Amazon.com, Inc. (AMZN) starts to aggressively market their basic store-branded credit card to consumers with low credit scores who are now holders of traditional retail store cards, traditional brick and mortar stores may have even fewer loyal customers.

Second Quarter Results And Conference Call

J.C. Penney reported 2Q ($0.20) per share using GAAP and using an adjusted basis they had a ($0.09) per share, which compares to the analyst's average expectation of ($0.05). Net sales increased 1.5%, but comparable store sales declined 1.3% for the quarter. During the conference call (transcript), management blamed the liquidation of inventories by 127 stores closed during the quarter for the loss that was worse than expected. Investors hoping that JCP was finally stabilizing after years of horrific losses (See below) may be concerned by these recent results.

Annual EPS (GAAP)

1st half 2017 2016 2015 2014 2013 2012

($0.78) $0.00 ($1.68) ($2.35) ($5.57) ($4.49)

The tone of the voices of some of the analysts during the conference call (audio recording) indicated that they were skeptical about management's guidance that non-GAAP adjusted EPS was still unchanged at $0.40-$0.65 for the year. Since they lost $0.03 in the first half, they would need to make $0.43-$0.68 in the second half to meet these projections. Management claims that 2Q results and inventory liquidation were just one-time events and should not be used as an indication for the second half. The market's reaction indicates that investors are skeptical and that management has a credibility problem.

During their conference call management announced a redirection focus for women's apparel away from traditional to focus instead on casual/contemporary apparel, especially activewear. I was shocked when I heard that they were going to focus more on activewear because activewear is often much cheaper online than in stores.

In addition, the variety is much greater online. It is an extremely difficult area to be competitive. Management just keeps jumping around from one new focus area to another. "Let's try this" - it fails. OK, "Let's try this other idea" - it also fails. Clearly, whoever is in charge of planning and consumer market research needs to be replaced.

Debt Reduction

During their conference call, management bragged about reducing long-term debt by $300 million during 2Q. The cash used to reduce the debt was not cash generated by cash flow from operations, but by asset liquidation. They received $90 million from the sale of a California distribution center last fall, they sold their corporate headquarters for $353 million recently, and they received millions from liquidating inventories when they closed stores.

This is hardly something to brag about. It indicates financial weakness - not strength. Instead of having $300 million of note liabilities, they now have a liability for a long-term lease for their corporate headquarters and lower assets.

Even with less long-term debt, there still is $13.08 in debt per share compared to the recent stock price of $3.93 or 3.3x. That indicates extreme financial leverage and it does not even include long-term lease liabilities.

On June 20, J.C. Penney announced that they negotiated an extension of their $2.35 billion secured revolving credit facility to 2022 from 2019. While it is a positive, it does not really indicate strong financial strength because the credit facility is fully secured with limited risk of getting less than full recovery in the event JCP files for Ch.11 bankruptcy before 2022.

CFO Steps Down

The July 10 announcement that their CFO, Edward Record, was "stepping down" raised a yellow flag. When a CFO of a financially weak company unexpectedly leaves, investors often are worried that the person knows things are going to get worse and it is time to move on to possible better career opportunities.

Management must have expected a negative reaction to Record's departure because they issued a very rosy comment on 2Q operations, "The timing of his departure coincides with a demonstrated sales performance improvement in the second quarter, and we continue to expect to report significantly improved top-line results this quarter versus the first quarter."

Many investors now think that they were deceived by management because while 2Q sales were in fact higher, 2Q losses, however, were much greater than expected. This is just another reason for investors to distrust J.C. Penney management and why the stock price was killed last week.

Store-Branded Credit Cards

One of the reasons many customers have stayed with brick and mortar stores instead of buying from Amazon is that they can use their store-branded credit cards and are not able to use them on Amazon. The store cards often have credit standards that are lower than regular credit cards. There are some potential changes in these cards that could have a negative impact on JCP.

Amazon does have an Amazon.com store card but it has been promoting the Amazon Prime store card and Amazon Prime Visa card. If Amazon aggressively promotes the lower-end Amazon.com store card with promotions most retail have used to get consumers to sign up for their store cards, Amazon could draw a larger portion of those consumers with low credit scores who have been using store cards at brick and mortar stores.

JCP store credit card is issued by Synchrony Bank (SYF), a former subsidiary of GE Capital, that has a very high interest rate of 26.99%. Synchrony and J.C. Penney are major business partners with JCP accounting for 10-17% of their business. Because of Synchrony's sharp increase in net charge-offs in 2Q to 5.42% from 4.51% in same period last year, a modest tightening of credit standards by either offering lower credit limits or denying some new accounts, could be on the horizon.

Another reason that Synchrony may need to raise credit standards is the recent changes by the Consumer Financial Protection Bureau that make it more difficult to recover on delinquent accounts by imposing new restrictions on abusive tactics used by collection agencies.

During a meeting with analysts last year, the company stated that 40% of their customers have J.C. Penney cards and that 80% of their revenue growth lately has come from those cardholders. (Note: management did not specifically say it came from using the JCP card.) While the change in credit standards may not have a dramatic impact on JCP revenue, even a modest 2-3% decline in sales impacts the bottom line.

Retail Store Closures

With the massive number of store closures over the last few months by various retailers including Sears Holdings Corp. (SHLD) and Macy's Inc. (M), many retail stock investors were hoping that consumers would switch from the closed stores and shop at brick and mortar stores that are still open. They were greatly disappointed with 2Q retail store results.

In the past, management has asserted J.C. Penney will gain from other retail store closures as Mr. Ellison stated in August 2016, "When a Sears closes in a mall that we're in, it's a net positive for J.C. Penney. Our sales increase. In some of the most recent Macy's closures in malls in which we occupy, it's been a net positive." Mr. Ellison's statement raised JCP shareholders' hopes, but they were crushed with 2Q same store declining 1.3%, which does not indicate a robust customer switch from closed Sears and Macy's stores to JCP stores.

Store credit cards could explain part of the reason why consumers did not switch from a store that closed to a competitor store still open. They cannot use a store card to buy at other stores. Even with enticing offers to sign up for a store credit card at another retailer, some consumers may be reluctant to get another card. Many understand that just applying for another card is a negative when determining their current credit score or they may worry they will be turned down for a new card due to a recent missing/late payment.

Vendor Issue

Vendors seem to be tightening their contract terms because the merchandise accounts payable to merchandise inventory ratio dropped to 0.342 in the 2Q from 0.367 in 2Q 2016. Since JCP had massive inventory liquidation in the 2Q due to the closure of 127 stores, this ratio should have increased. Clearly, therefore, there seems to be a vendor issue. Vendors must be requiring stricter contract terms.

Since vendors won a major victory in a July 10 Third Circuit Court ruling regarding when goods are 'received', one might have thought that J.C. Penney vendors would even be willing to relax their contract terms. Under this ruling goods are 'received' when the company buying them has actual physical possession and not when they are shipped even if it was 'free-on-board'.

This was a critical decision because under Section 503(b)(9) of the Bankruptcy Code, goods 'received' within 20 days prior to filing for bankruptcy are considered administrative claims instead of just unsecured creditor claims that have much lower priority for recovery. Therefore, those vendors that ship a long distance have less worry. While this case does not have much immediate impact on JCP, it could in the near future.

Management And Male Shoppers

I am not sure that J.C. Penney management understands consumers. They are trying to expand their appliance sales, but they do not seem to understand the appliance buyers. After a husband and wife look at appliances in a store they often separate and agree to meet x minutes later at the front door. The wife has many shopping choices in a JCP store, but the husband has very little.

His total shopping experience is not positive while looking at appliances. J.C. Penney has become just a 'woman's' store and many men do not want to even shop there. During their recent conference call they never mentioned men. Their total focus was on women. Men may be willing to check JCP appliances on their website, but they would prefer to go into a Home Depot, Inc. (HD) store instead of a JCP store.

Their announcement of adding the brand Frigidaire may be a positive, but if they cannot attract male customers into the stores it will be difficult for the appliance expansion plans to be successful. In JCP stores that I visited the last few months, I saw very little consumer traffic in the appliance areas.

Conclusion

The negatives facing J.C. Penney seem to have increased since I wrote an article last May recommending selling JCP. Their CFO left, inventories required greater than expected discounts to liquidate, credit standards on their very important JCP credit card could be raised hurting sales, customers do not seem to be switching from closed retail stores to ones still open, and J.C. Penney management has created a credibility problem.

Many of the problems/issues raised in this article were caused by poor management and unless they get new management ASAP, J.C. Penney faces a bleak future. Given their extreme financial leverage and an uncertain future, I rate JCP a strong sell even at these depressed levels.

Disclosure: I am/we are short SHLD.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I do not have any position in JCP at the time I submitted this article but I may short JCP and/or write naked JCP call options within the next 72 hours