Hedge fund manager Bill Ackman's sale of his entire stake in retailer J.C. Penney , totaling 39.1 million shares, or 18% of the company, ends a contentious period in the company's history. Ackman initiated the stake about three years ago and successfully pushed for a new CEO, former Apple executive Ron Johnson. Johnson embarked on an ambitious plan to remodel stores and introduce everyday low prices, which caused loyal customers to flee. Revenue fell off a cliff in 2012, sinking by nearly 25%.
Johnson was ousted in April of this year, replaced by former CEO Mike Ullman. Ullman now heads a company that lost nearly $1 billion in 2012 and almost $600 million in the first half of 2013. In April J.C. Penney negotiated a $1.75 billion loan with Goldman Sachs in order to shore up its balance sheet and avoid defaulting on its debts, pushing the total debt past $5 billion.
The big question is this--can J.C. Penney return to profitability before it runs out of money?
When J.C. Penney shifted from discounts and promotions to everyday low prices, the company lost much of its loyal customer base. In May, after new CEO Ullman brought back promotions, J.C. Penney launched an advertising campaign that essentially apologized for the previous changes and begged customers to come back.
The second quarter, while terrible compared to the prior year, did show some improvement sequentially. The second quarter saw comparable store sales improve by 470 basis points compared to the first quarter, and each month within the second quarter improved upon the last. In the earnings press release the company stated that it expects this trend to continue through the second half of the year.
Online sales were also encouraging. While sales were down 2.2% compared to the same period last year, sales were up compared to the first quarter, and again each month of the quarter improved upon the last. July sales were up over 14% compared to July of last year, a remarkable improvement.
Time is of the essence
Although sales trends are starting to improve, J.C. Penney is on a strict timetable governed by its balance sheet. At the end of the second quarter the company had $1.5 billion in cash and cash equivalents, along with $5.7 billion in debt.
In 2012 J.C. Penney lost about $1 billion, and 2013 is on pace to be worse. Hopefully the new strategy and strong back-to-school and holiday seasons will improve the picture a bit, but I think it's safe to say that losses will be at least $1 billion this year. At this rate J.C. Penney will run out of cash in about a year and a half. The increased debt level is also a problem. J.C. Penney is on pace to spend about $400 million per year on interest, making a return to profitability more challenging.
J.C. Penney needs to increase sales, plain and simple. Cost cutting cannot solve this problem, and the company needs to work hard to get customers back into stores. The progress so far is encouraging, but it's unclear whether it will be enough. If the company had five years to pull this off I would be fairly optimistic. But that's not the case. There's still a chance that the company can right itself, but it's a bit of a long-shot.
Don't forget about the competition
Winning back business will be difficult for J.C. Penney. Kohl's , a company that I've written about before, has been consistently profitable over the last decade, with operating margins only falling below 10% in 2008 and 2012. The most recent quarter saw modest 2% revenue growth, and while earnings declined slightly on a per share basis, earnings actually increased.
An article posted on Forbes from April of this year examined how customers' perceptions of J.C. Penney and Kohl's had changed since the beginning of 2012. Consumers were asked whether they had a positive or negative view of both brands. The trend is not encouraging for J.C. Penney, which was viewed more positively at the beginning of 2012. Consumers' perception of J.C. Penney fell as Ron Johnson's efforts continued. By April of 2013, Kohl's was viewed far more positively than J.C. Penney.
Kohl's main advantage is its ability to keep costs low. In 2012 J.C. Penney spent 41% of its revenue on operating expenses, compared to Kohl's 26%. Kohl's spends less on operating expenses in absolute terms than J.C. Penney, even though Kohl's had nearly 50% higher revenue in 2012. Kohl's ability to run a lean company is what sets it apart from J.C. Penney.
Macy's is a bit more upscale than J.C. Penney and Kohl's, and while the recession wasn't kind to the company, both revenue and profits have rebounded as the economy has recovered. One big Macy's initiative is its ambitious ship-from-store program, where online orders can be fulfilled from both warehouses and stores themselves. This initiative helps ensure that merchandise is available on Macy's website even if it's out of stock at the warehouses.
Electronics retailer Best Buy is doing something similar, and J.C. Penney would likely benefit from adopting this program. This would make J.C. Penney more competitive against other department stores and online retailers.
The bottom line
J.C. Penney has an extremely tough road ahead of it. Customers may not return after the Ron Johnson debacle, instead choosing Kohl's or another competitor. J.C. Penney has only a couple of years to sort this out before it runs out of cash, and greater debt and interest payments will only make it more difficult. The odds of a full recovery are low, and the risk involved seems far too great to buy the stock on a turnaround bet. I'd avoid J.C. Penney.
The article Can J.C. Penney Recover After Ackman's Exit? originally appeared on Fool.com.Timothy Green has no position in any stocks mentioned. 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.