When department store chain J.C. Penney (NYSE: JCP) reported its latest results last month, the headline of its press release read "JCPenney Reports a 1.5 Percent Increase in Total Net Sales for the Second Quarter." That sounds good on the surface -- J.C. Penney and all department stores have been struggling with weak sales for years.
But comparable sales, a measure of sales only counting stores that were around a year ago, slumped 1.3%. The total number of stores also declined, dropping to 1,011 at the end of the quarter, down from 1,014 at the same time last year. Where did this sales growth come from?
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J.C. Penney announced earlier this year plans to close over 100 stores. The stores were shut down in August, after the end of the second quarter, but the liquidation process played out during the second quarter. The proceeds from these liquidation sales, which were excluded from the comparable sales figures, were more than enough to produce revenue growth.
What's the problem?
These liquidation sales weren't a surprise. The plan to close stores and liquidate merchandise was announced months ago. The issue was how J.C. Penney spun its results. The company made sure the first thing investors read was that sales increased by 1.5% year over year. CEO Marvin Ellison, in J.C. Penney's earnings press release, touted the sales growth: "We are pleased to deliver a top line sales increase of 1.5% and quarterly sequential improvement of 220 basis points in our comp sales performance in go forward stores."
But that sales growth was a fluke, the result of a one-off liquidation event that the company shouldn't really be "pleased" about. Nowhere in J.C. Penney's earnings press release does the company explicitly tie its sales growth to these liquidation sales. You'd need to venture into the 10-Q to see that closed stores contributed $79 million of additional revenue during the quarter, more than offsetting a $35 million decline in revenue from the remaining stores.
The tune changed when the discussion turned to costs and earnings. Cost of goods sold jumped as a percentage of revenue. Why? "This increase was primarily driven by the liquidation of inventory in closing stores." Gross margin and earnings per share slumped. The reason? "During the second quarter, we liquidated inventory in 127 of our closing stores which had a negative impact on gross margin and EPS. These events were isolated to the second quarter."
Unfortunately for investors, sales growth will also be isolated to the second quarter.
A pattern is emerging
J.C. Penney reaffirmed its full-year earnings guidance despite the drop in second-quarter earnings. The company expects to produce adjusted earnings per share between $0.40 and $0.65 this year. The key word is "adjusted." This guidance is another example of J.C. Penney's selective treatment of one-time events.
Companies are free to define adjusted earnings however they like. It falls to investors to decide how meaningful these numbers are. In J.C. Penney's case, the answer is not at all. The company's adjusted earnings exclude restructuring costs related to store closings and other changes. During the first half of 2017, J.C. Penney booked $243 million of restructuring costs.
Excluding one-time restructuring costs isn't uncommon. But it's what J.C. Penney doesn't exclude that makes its guidance meaningless. The company booked a $111 million net gain from the sale of a distribution facility earlier this year. This amount, treated as a reduction in operating expenses, is conveniently not backed out from the adjusted earnings calculation. The bulk of J.C. Penney's adjusted earnings this year will come from one-off asset sales, not from the operation of the business.
I'm not very optimistic that J.C. Penney can turn itself around, given the upheaval going on in the retail industry. But the tendency of management to manufacture good news when there isn't any and to play games with adjusted numbers are reasons enough to avoid the stock.
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