3 Things Skeptics Don't Understand About J.C. Penney's Turnaround

By Markets Fool.com

In the first two months of 2016, shares of J.C. Penney surged from less than $7 to nearly $12 as investors started to believe in the company's turnaround. However, in the past few weeks, J.C. Penney stock has given up nearly all of these gains as many analysts and investors have panicked about widespread sales declines across the retail industry.

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J.C. Penney year-to-date stock performance. Data by YCharts.

However, despite the tough sales climate for department stores, J.C. Penney's turnaround still appears to be on track. Let's take a look at three key ways that many analysts and investors are underestimating J.C. Penney's prospects.

J.C. Penney can outperform peers

Earlier this month, the New York Post published a rather alarming account of "emergency measures" taken by J.C. Penney to meet an "expense challenge" caused by slow sales.

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J.C. Penney's comparable-store sales did decline last quarter but only by 0.4%. That didn't stop J.C. Penney from increasing its earnings before interest, taxes, depreciation, and amortization by 63%, to $176 million. Moreover, the company maintained its full-year guidance for 3%-4% comp sales growth.

By contrast, Macy's reported an ugly 5.6% comparable-store sales decline in Q1. Macy's proceeded to slash its guidance and now expects a 3%-4% decline in comp sales for the full year.

It's clear that department stores and mall-based retailers are struggling, but J.C. Penney is dramatically outperforming rivals like Macy's. Every major retailer expects sales trends to improve as the year progresses. If that happens, J.C. Penney's sales should return to growth.

Some analysts instead fear that J.C. Penney's sales will inevitably converge to the poor trends seen at Macy's and other department stores. However, even if apparel sales trends remain sluggish, J.C. Penney is pursuing growth in other categories, particularly home. The home department fared the worst when J.C. Penney's sales cratered during 2012 and 2013. The company now aims to grow home department sales by $750 million in the next couple of years.

J.C. Penney is working to boost sales in its home department.

One example of this focus is J.C. Penney's decision to begin large appliances in more than 500 stores. But it's also expanding its window treatments business and testing new partnerships with Empire Today and Ashley Furniture to sell flooring and furniture, respectively.

Lower-margin categories won't hurt profitability

J.C. Penney's aggressive move into the appliance business has given rise to another concern: that low-margin appliance sales will weigh on J.C. Penney's profitability.

It's true that J.C. Penney expects gross margins in the appliance business to be lower than the company average. However, J.C. Penney found that the new appliance sections in its pilot stores generated 10 times the sales of the products they displaced on the selling floor.

A section generating $10 million of sales at a 20% gross margin will produce five times as much gross profit as a section with $1 million of sales at a 40% gross margin. Thus, unless adding these appliance sections drives up operating expenses dramatically -- which doesn't appear to be the case -- they will bolster J.C. Penney's profit margin as well as its revenue.

The debt load is manageable and declining

A third concern among some investors is J.C. Penney's debt load. The company ended 2015 with $4.8 billion of debt, compared to $900 million of cash on hand.

That's more debt than would be ideal. Still, J.C. Penney had $5.6 billion of debt at the end of 2013. The fact that it has been able to reduce its debt load when it was less profitable than it is today bodes well for its future debt reduction efforts.

J.C. Penney plans to pay down another $400 million-$500 million of debt this year, using its free cash flow as well as the proceeds from the planned sale-leaseback of its home office. By the end of 2017, J.C. Penney expects to have cut its net debt to $3.1 billion.

As free cash flow rises in the years ahead, J.C. Penney will be able to continue strengthening its balance sheet. This will make the company's stock less risky, which should improve its valuation. It will also have a direct positive impact on earnings by reducing J.C. Penney's interest expense, which has exceeded $400 million in each of the last two years.

Still on track

Despite its slight sales decline last quarter, J.C. Penney's turnaround remains on track. Sales trends rebounded near the end of Q1 and remained strong in the first two weeks of Q2, which suggests that J.C. Penney's management isn't being unrealistic by maintaining its guidance.

J.C. Penney is in the early stages of a transformation almost as dramatic as the one it attempted four years ago. The difference is that under new CEO Marvin Ellison, everything is being tested rigorously before being implemented.

That gives J.C. Penney very good odds of successfully reinventing itself this time around. With the stock down by a third since early March, I am strongly considering adding to my holdings of J.C. Penney.

The article 3 Things Skeptics Don't Understand About J.C. Penney's Turnaround originally appeared on Fool.com.

Adam Levine-Weinberg owns shares of J.C. Penney Company, Inc. and Macy's, Inc. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.