Will J.C. Penney Benefit From Upheaval at Toys "R" Us?

Struggling department-store chain J.C. Penney (NYSE: JCP) has received plenty of attention for its 2016 move back into the appliance business. This strategy was purposely designed to capitalize on the downward spiral at Sears Holdings, an even more troubled competitor.

A less heralded decision to open dedicated toy shops across the J.C. Penney store fleet could also prove profitable, because of another retailer's struggles. Toys "R" Us is on track to close a huge number of stores this year. While discounters such as Target (NYSE: TGT) will probably capture the largest share of lost revenue from Toys "R" Us, J.C. Penney could also get a meaningful sales lift if Toys "R" Us shrinks dramatically in 2018.

J.C. Penney tries out toys

In the past few years, J.C. Penney has tried to branch out into new merchandise categories in an effort to get customers to visit more, and spend more, despite the declines in overall mall traffic. As part of this broader strategy, the company tested toy shops in some stores during the 2016 holiday season. Last July, it announced that it would roll out the toy sections to all of its stores in time for the 2017 back-to-school season.

J.C. Penney's toy shops are located next to its existing Disney-branded shops in the children's department, with the obvious goal of boosting cross-selling. J.C. Penney is working with most of the top toy manufacturers -- including Lego, Mattel, Hasbro, and Playmobil -- giving it a broad selection of items.

So far, management seems happy with the performance of the toy shops, but details are scant. J.C. Penney may provide more information during the company's fourth-quarter earnings call later this week.

Good timing

Soon after J.C. Penney decided to move into the toy business, the iconic toy retailer Toys "R" Us filed for bankruptcy protection. While Toys "R" Us originally planned to keep its store fleet intact during the bankruptcy process, weak results during the holiday season forced it to change its tune.

Toys "R" Us has already begun the process of closing about 170 U.S. stores. It could soon move to shutter another 200, according to a recent Wall Street Journal report. That would slash the company's domestic store count to around 500, from 881 as of late 2017. There's even a risk that the company could be forced to liquidate, if it loses the support of its suppliers.

Traditional competitors for Toys "R" Us, including discount retailers such as Target, are aiming to gain market share in toys as their rival tries to regroup. Target also has a big opportunity in baby gear, one of its best-performing categories, as Toys "R" Us' store closure plans include some of its Babies "R" Us locations.

J.C. Penney should also be able to scoop up some of the business Toys "R" Us is losing. While its in-store toy shops are fairly small, the retailer has significantly expanded its online inventory to provide a wide selection of toys. It has adopted a similar approach in the baby category. Most importantly, J.C. Penney has a built-in customer base, as it does more than $1 billion of annual sales in children's apparel. It just needs to get the customers who are already coming to its stores to buy toys there as well.

Another important opportunity

To be clear, J.C. Penney doesn't have the same heft in the toys and baby categories as Target or Walmart. However, its annual revenue is barely more than one-sixth that of Target. As a result, getting just $100 million of incremental revenue would be a big win for J.C. Penney, whereas it wouldn't mean much for either of the discounters.

Toys "R" Us generated $11.5 billion of revenue in its most recent fiscal year. While some of that came from the company's international operations, the closure of more than 40% of its domestic stores would still put billions of dollars of sales up for grabs. J.C. Penney only needs to pick up a small percentage of that sales volume to achieve a meaningful revenue and earnings boost in 2018 and beyond.

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Adam Levine-Weinberg owns shares of J.C. Penney. The Motley Fool owns shares of and recommends Hasbro and Walt Disney. The Motley Fool is short shares of Mattel. The Motley Fool has a disclosure policy.