J.C. Penney's Turnaround Remains on Shaky Ground

J.C. Penney's (NYSE: JCP) stock plunged after the company reported weak second-quarter results last month, and shares are down about 36% so far this year. Comments by the struggling retailer's leadership team during its earnings call did little to assuage investors' fears regarding a rough road ahead. Read on to see why J.C. Penney's stock remains fraught with risk.

Competitors' woes may provide only short-lived gains

Toys R Us' bankruptcy is providing J.C. Penney with a chance to gain share in the $20 billion U.S. toy market. But an even better opportunity may lie in baby-related items. As my colleague Rich Duprey notes, the Babies R Us chain and baby gear within its toy stores made up more than a third of Toys R Us' domestic revenue.

J.C. Penney is attempting to seize this opportunity by rolling out baby-focused shops at 500 of its stores, many of which are located near recently closed Babies R Us stores. "The baby care business is expected to reach over $13 billion by 2021 and we are seizing this opportunity to pursue available market share and aggressively go after the baby customer with these new shops," senior VP James Starke said in a press release.

Yet while these new baby shops may provide a temporary sales boost, their long-term success is not assured. J.C. Penney has enacted a similar strategy with appliances in an attempt to win sales that are being lost by Sears Holdings, as the distressed retailer continues to shutter stores. But although appliances provided a short-term pop in revenue in previous quarters, appliance sales were actually lower in the second quarter than in the year-ago period. So while toys and baby-related sales will likely help in the quarters ahead, they may not have as large of a long-term impact as J.C. Penney's investors are hoping for.

Bloated inventory and declining margins are denting profits

J.C. Penney's sales were softer than management expected in the second quarter, forcing the company to offer discounts to clear out excess seasonal inventory. That dented profitability, with J.C. Penney's gross margin falling 1.6 percentage points year over year to 33.7%.

More worrisome is that, as my colleague Adam Levine-Weinberg notes, this downturn continues a multiyear trend of margin erosion for J.C. Penney. Worse still, management expects gross margin to continue to fall in the quarters ahead.

Davis said that J.C. Penney is investing in data analytics and consumer insights capabilities in order to better identify and adapt to shifting consumer trends. The company hopes that these investments -- combined with its inventory reduction initiatives -- will help sales and margins rebound in the near future. But merchandise selection and inventory management lie at the very core of retail, and J.C. Penney's failures in these vital areas paint a pessimistic picture of its ability to compete and win in an increasingly competitive retail environment.

Bankruptcy isn't imminent ... but remains a possible outcome

J.C. Penney has enough cash and lending capacity to fund its operations for the all-important holiday selling season. And with positive free cash flow, the struggling retailer should be able to ward off bankruptcy for the foreseeable future. That said, things could change -- quickly.

J.C. Penney is being strangled by more than $4 billion in debt. It will be difficult for the company to free itself of this heavy burden, particularly if sales remain sluggish and margins remain under pressure. Interest expense in the second quarter alone was $79 million.

Moreover, J.C. Penney is producing tepid results during a time when consumer confidence and spending are strong. Should the economy enter a rough patch, the retailer's problems could get a lot worse -- and faster than many bulls currently expect. As such, investors may be best served by staying well clear of J.C. Penney's high-risk stock.

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Joe Tenebruso has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.