Conclusion: A low quality quarter from JCP might actually add support to those in the Ackman camp. Importantly, this quarter did little to change our mind that JCP is still facing fundamental challenges near and longer term.
From a fundamental perspective, JCP’s 3Q results did little to change our view on being short the shares. The quarter was driven by two key factors, a slight miss on original topline plans offset by a measurable and unexpected level of SG&A savings. Clearly not the quality quarter management and anti-activist investors were looking for. But, with the company under the watchful eye of Ackmanism, the worse the business and its prospects become, the more challenging it becomes for management to fight the company’s largest shareholder.
Overall there were a couple of key takeaways coming out of the quarter:
- Inventories remain higher than they should be given the current run rate of sales. On a 0.2% increase in 3Q revenues, inventories ended the quarter up 6.2%. Weak outerwear sales at the end of October are partially to blame for part of the inventory build, but we still see some risk here if expected same stores of 3-4% over 4Q fail to materialize. Either way, JCP remains the only player in the moderate department store space running inventories meaningfully ahead of sales growth.
- Expense savings saved the quarter on a slightly weaker than planned comp. SG&A dollars were expected to grow 2% but actually came in down 3.8%. While this flexibility is noteworthy on a short-term basis, it did result in a $50 million after-tax swing in earnings (all things being equal) or about $0.21 per share. Absent similar cost cuts, which we believe are counter to actually improving the JCP customer experience, there is minimal longer-term opportunity to continue to manage expenses down on an absolute basis. Furthermore, the addition of the “growth brands division” will likely put pressure on the expense line as infrastructure, personnel, and marketing will require incremental investment.
- Management’s announcement that the company has formed a “growth brands division” to pursue new concepts and additional growth vehicles is not exactly what capital preservationists and those looking for enhanced shareholder value are looking for. The fact is JC Penney is not a growth company, nor are there any successful examples of a department store operator incubating, managing, and growing a successful specialty concept. As reported in the Wall Street Journal yesterday and confirmed today, JCP will be developing an off-mall, big and tall concept as well as focusing on a younger consumer with an eye towards e-commerce growth. Even more interesting is that these initiatives fall under the company’s 5 year plan to add $5 billion in incremental revenues but yet there was no mention of such plans when the original plan was unveiled in the Spring. Bottom line, off-mall full line stores haven’t really moved the needle for the enterprise and it’s unlikely a specialty concept will either.
- The issue of rising cotton and sourcing costs is nothing new but management noted that they are now encountering some factories which are not accepting orders due to input cost uncertainty. While these orders primarily center around goods to be manufactured for Fall ’11 delivery, the data point is noteworthy. If this becomes a more widespread stalemate between manufacturers and suppliers, there will likely be capacity constraints come next year. For now, this is something to watch.