Thursday, July 13, 2006

J.C. Penney's Stock: Wearing Well

News Analysis
July 13, 2006

Business Week Online

J.C. Penney's Stock: Wearing Well

The department store chain's turnaround has meant handsome profits for shareholders. Will the stock stay in fashion or be a fad?

A slave to fashion? Not J.C. Penney (JCP ). With weak stocks the hot retail trend this season, the Plano (Tex.)-based department store chain's shares have been strutting to multiyear highs. More gains could still be in store for the 104-year-old retailer, but they won't come easily for a company just completing a lengthy turnaround.

Penney hasn't always been in style with investors (see, 1/9/06, "Penney: Back in Fashion"). The stock fell below $10 in 2000 following a period of declining sales growth, as chief rival Kohl's (KSS ) and discounters such as Target (TGT ) and Wal-Mart (WMT ) began stealing market share from the company and other traditional retailers such as Sears (SHLD ), Dillard's (DDS ), and Macy's (FD). In the early 2000s, Penney embarked on a restructuring program that included overhauling its merchandising and selling its Eckerd drugstore chain.

SAME-STORE STORY.  Since then, the revamp has paid off with improved revenues, earnings, and, most recently, stock prices. On July 12, Penney shares reached $69.34, their highest level since June 23, 1998, and a 24.7% jump since the beginning of 2006. Shares eased to $64.78 at the close July 13 amid broader market weakness. "We have a growing company with new stores, powerful private brands, and the leading department store Internet business," Penney President Ken Hicks said in a May 11 conference call. Company spokespeople were unavailable to comment prior to deadline.

Despite an ominous economic horizon, Penney's remarkable comeback will likely continue, analysts say. However, it's less certain whether the stock can keep rising beyond its recent peaks. As the company shifts from righting the ship to facing fresh challenges, investors may want to strike a cautious pose.

Penney's resurgence is particularly noteworthy when compared to its competitors' recent stock performance. The Standard & Poor's retail index was down 6.3% for the year through July 13. Same-store sales reports for June were mixed across the sector, with Wal-Mart, Federated (FD ), and Limited (LTD ) among retailers disappointing the Street. By contrast, Penney's 4.3% sales growth handily beat projections for a 2.8% increase.

ANALYST EXPECTATIONS.  At the same time, some analysts say the retail sector's shrinking payrolls bode poorly for the economy at large (see, 7/12/06, "The Real Problem with Job Growth"). Retail employment has recorded year-over-year declines, which had previously only ever happened during a recession, points out Jan Hatzius, chief U.S. economist at Goldman Sachs (GS ). "What do retailers know that the rest of us don't?" Hatzius asked in a July 10 report.

Still, Penney may have a leg up on some of its department-store competitors, analysts say (see, 1/24/06, "Analysts' Picks: Energy, Retailers, Steel"). Strong sales, higher markups from private-label business, and more efficient operations should allow the stock to trade at higher price-to-earnings multiples compared to the market, according to a June 30 report by Merrill Lynch (MER ) analyst Stacy Turnof, who targets a price of $74 for the stock. (Merrill expects to receive or intends to seek compensation for investment banking services from Penney, makes a market in the company's securities, and owns 1% or more of its common stock.)

Other analysts have been revising their estimates higher for Penney, as well. On July 6, analysts from Citigroup (C) and Goldman Sachs raised their earnings forecasts for the retailer after the company reported better-than-expected June sales and guided its second-quarter profit upward.

SEVENTH INNING.  Nevertheless, the company isn't impervious to bearish macroeconomic headwinds. Its core middle-income customers may soon have less cash for clothes, analysts say. "Strong merchandise initiatives may not be enough to offset an expected consumer slowdown, driven by higher interest rates, higher gasoline and energy prices, and a slowing housing market," noted Deutsche Bank (DB ) analyst William Dreher in a June 9 report. Dreher has a hold recommendation on the stock. (Deutsche Bank makes a market in Penney securities and owns 1% or more of any class of its common equity securities.)

Even setting aside economic concerns, it's unclear how much further Penney's performance can improve following its successful recovery. On July 10, Prudential initiated coverage of the stock with a neutral rating. "We are tremendously impressed with what Penney has accomplished over the last five years," analyst Lizabeth Dunn wrote. But she added: "Earnings growth should normalize going forward."

Others argue that Penney's comeback still has further to go. The turnaround is merely "in the 'seventh inning of a doubleheader,'" wrote Citigroup analyst Deborah Weinswig in a June 27 report. The stock's optimistic outlook justifies a higher price-to-earnings multiple for 2007, says Weinswig, who gives it a buy rating. (Citigroup has a non-investment-banking relationship with and a significant financial interest in Penney and also makes a market in the company's securities.)

PRIVATE LABELS.  Either way, Penney is moving from cleaning up its past problems to launching new initiatives. One of those is an anticipated expansion. While the department store has typically been located in malls, the company is stepping up its presence in locations where customers are used to seeing Target or Wal-Mart stores. Earlier this year, Penney unveiled plans to open more than 175 new stores through 2009, primarily in off-mall sites.

Some retail observers worry that Penney's growth push is a case of misplaced priorities. The company should concentrate first on new private-label likes like a.n.a. and East 5th, or its Sephora cosmetics sections, according to Credit Suisse analyst Michael Exstein, who has a neutral rating on the stock. "We would rather see a focus on improving the productivity of the existing store base," Exstein wrote in a May 11 report. (Credit Suisse has an investment-banking relationship with Penney and makes a market in the company's securities.)

With other retailers' shares heading south, Penney's surge could make the formerly dowdy chain look positively alluring to investors. Still, they would be wise to consider just how much room the stock has left to grow before they try it on for size.

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