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J.C. Penney's Risks

Wednesday - 1/9/2013, 5:02am  ET

There's little doubt that J.C. Penney was one of the market's more entertaining stocks in 2012. Unfortunately for investors, the drama surrounding the retailer has been more of the tragic variety than anything else, and a happy ending is far from guaranteed. Recently, we took a look at the opportunities that could help drive future gains for Penney's. Now, in this excerpt from our premium research report, we examine the risks facing the transitioning company.

Risks
The biggest threat to J.C. Penney is the risk that this grand brand revamp doesn't pan out. Johnson is essentially making an all-or-nothing bet. As the dramatic same-store sales drop indicates, the initial results aren't good, and that's not the only reason for concern.

Johnson's handpicked No. 2, Michael Francis, a former Target executive and head of marketing, merchandising, and product development at Penney's, left in June after just nine months on the job as the retailer's new strategy was not adequately communicated to customers. Some analysts have also suggested he was forced out by Johnson as a fall guy. Former CFO Michael Dastugue also left in January, another indication of instability in the management team.

And while the retailer claims it's offering lower prices under its "Fair and Square" model, that's not the perception customers have had, according to recent surveys. The company has yielded to criticism in some regards, by using the word "sale" once again after resisting it earlier. In many ways, management seems to have misread its customer base, which actually enjoys coupon-clipping and getting deals instead of the "everyday low prices" strategy.

More recently, a September tour for 300 analysts of a new store prototype fell flat as shares dropped 11% in one day. Deutsche Bank's Charles Grom, one of the many critics, said, "Some of the air needs to come out of the proverbial bubble as reality sets in that although JCP is taking steps in the right direction, the road to recovery is a few years away." This store redesign will only be implemented at 700 stores, while Johnson has said the company will provide detailed plans for its 400 locations in more rural areas "in the near future." Revamping those stores will be just as important for the financial health of the company, as they could otherwise turn into an albatross. Improving sales at 60% of stores will not be enough for a complete turnaround.

But Penney's faces external threats as well. Sales in nearly all retail segments are shifting toward the online channel, but the venerable retailer has struggled even more here than it has in the bricks-and-mortar segment. Online sales fell 27.9% in the first quarter and 32.6% in the second. With Amazon.com  and Wal-Mart  each moving to offer same-day delivery, it's clear that online competition is only going to get stronger. With little of its own proprietary goods, much of J.C. Penney's merchandise could easily be purchased from competing retailers' websites or directly from an array of self-branded supplier outlets. Getting customers in the store might be the company's biggest challenge moving forward.

Finally, J.C. Penney doesn't have the financial health to withstand a long retreat even if it could eventually lead to a stronger company. The company was forced to cut its dividend in May and carries more than $3 billion in debt with only $171 million in cash as of its latest report. Net income has been negative for the last four quarters as restructuring charges have mounted, and free cash flow has gone negative as well, with a $439 million loss over that time period.

If you found this analysis useful, I encourage you to pick up a copy of our full report on J.C Penney, which features discussion of its leadership, reasons to buy and sell, and the opportunities available for the retailer. The report also comes with a year's worth of free updates. Just click right here to get started today. 

This article was originally published as J.C. Penney's Riskson Fool.com

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