JC Penney Takes One Step Forward, But Two Steps Back

J C Penney Company Inc JCP reported a 63 percent increase in its 1Q EBITDA, driven by the largest quarterly SG&A cut since 4Q13. Morgan Stanley’s Kimberly C Greenberger maintained an Underweight rating for the company, while reducing the price target from $8 to $7.50.

Although JC Penney executed well on expense control, this was not a sustainable path to restore free cash flow generation and pay off outstanding debts. “Further, it’s unclear whether these expense cuts will permanently impair sales trends or dampen employee morale,” analyst Kimberly Greenberger said.

Decelerating Gross Profit Growth

JC Penney’s turnaround and future equity value creation are dependent on the company’s gross profit dollar growth, which had increased for nine consecutive quarters from 4Q13 to 4Q15. Greenberger pointed out, however, that growth appears to have stalled, with the company reporting a 2.2 percent decline in its 1Q16 gross profit dollars, due to comps of -0.4 percent and 20bps contraction in gross margins.

Another concern area is JC Penney’s inventory growth outpacing the 2Q sales estimate by 340bps. The analyst added that this has elevated near-term downside risk to the company’s gross margins.

The EBITDA estimate for 2016 has been raised from $1.0 billion to $1.04 billion, while the estimate for 2017 has been reduced from $1.13 billion to $1.1 billion.

“Until JCP proves it can increase gross profit dollars (in a healthy manner), the market will continue to worry about leverage levels and the sustainability of free cash flow,” Greenberger wrote.