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J.C. Penney Company, Inc. Earnings: Mixed Signs in the Second Quarter

The exterior of a JCPenney store

J.C. Penney (NYSE: JCP) stock has plunged in 2017, as investors have started to become more skeptical about the company's turnaround prospects. While J.C. Penney expects to produce positive adjusted earnings per share of $0.40 to $0.65 this year, much of that profit will come from real estate gains . Meanwhile, comparable-store sales fell 3.5% in the first quarter, making the goal of consistent comp sales growth seem as far-fetched as ever.

J.C. Penney started to get back on track in the second quarter. While comp sales continued to decline, the trend improved significantly relative to the first quarter. Management also indicated that sales are off to a strong start in August.

The exterior of a JCPenney store

J.C. Penney's sales trend started to improve last quarter. Image source: J.C. Penney.

On the other hand, the company slashed its full-year gross margin forecast. This stoked ongoing worries about competition, causing J.C. Penney shares to plummet even further on Friday morning.

Revenue begins to turn

In the second quarter, J.C. Penney returned to revenue growth, although comp sales slumped 1.3%. Gross margin suffered, due to the impact of liquidation sales at 127 stores that closed during the quarter. Even so, the company reported a fairly small loss in Q2. Here are some of J.C. Penney's key second-quarter performance metrics:

Metric Q2 2017 Q2 2016 Year-Over-Year Change
Revenue $2.96 billion $2.92 billion 1.5%
Comparable store sales Down 1.3% N/A N/A
Gross margin 35.1% 37.1% Down 200 basis points
SG&A expense ratio 28.4% 29.2% Down 80 basis points
Adjusted EPS ($0.09) ($0.05) N/A
Free cash flow $303 million $69 million 339%

Data source: J.C. Penney Q2 earnings report. Chart by author. 1 percentage point = 100 basis points.

The sharp decline in gross margin was definitely the most worrisome aspect of J.C. Penney's Q2 results. On the flip side, its strong free cash flow was a big accomplishment. On a year-to-date basis, free cash flow was slightly positive at $10 million, compared to negative $352 million in the first half of 2016.

The gross-margin game

In addition to reporting a steep drop in gross margin last quarter -- which management attributed to the impact of closing so many stores during the period -- J.C. Penney also slashed its full-year gross-margin guidance. The company now expects gross margin to fall by 30 to 50 basis points year over year, whereas its previous forecast called for an increase of 20 to 40 basis points.

To some extent, the issue may be that J.C. Penney's original plan to expand gross margin in 2017 was unrealistic. The growth of its appliance and e-commerce businesses -- both of which have lower gross-margin structures than the rest of the company -- is offsetting the benefit from J.C. Penney's other initiatives to improve gross margin.

The selling floor of a JCPenney appliance showroom

J.C. Penney's new appliance business is holding down gross margin. Image source: J.C. Penney.

That said, J.C. Penney ended Q2 with inventory down 6.8% year over year. Even excluding the stores it closed, inventory was down by more than 3%. This should support stronger gross-margin performance in the months ahead.

Indeed, considering that gross margin declined by 100 basis points year over year in the first half of 2017, J.C. Penney's full-year guidance implies that gross margin will be roughly flat (or even slightly positive) in the back half of the year.

Investors want more proof

The best word to describe J.C. Penney's second quarter results may be "ambiguous." For example, the company's comp sales trend improved relative to Q1 but still didn't turn positive. Meanwhile, gross margin plunged, but management forecast that gross margin will be roughly flat or slightly positive going forward.

Year-over-year revenue comparisons will get a lot easier in the next few quarters. Comp sales increased 2.2% in the second quarter of fiscal 2016, but declined 0.8% and 0.7% in the next two quarters. This gives J.C. Penney a clear path to return to comp sales growth this quarter.

Nevertheless, J.C. Penney stock fell about 15% in the first few minutes of trading on Friday morning, reaching a new all-time low. Clearly, investors have lost confidence in J.C. Penney. To get back in investors' good graces, it isn't enough to show that sales and margin trends are on track to turn positive again -- J.C. Penney needs to follow through and deliver the expected improvements.

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Adam Levine-Weinberg owns shares of J.C. Penney. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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