J.C. Penney (JCP)

JC Penney Company (JCP), through its wholly-owned subsidiary JC Penney Corporation, sells family apparel, jewelry, shoes, accessories, household goods, and home furnishings through its stores, catalogs and website. The company operates 1,093 department stores in the United States. JC Penney Catalog, including e-commerce, is the nation's largest catalog merchant of general merchandise, and JCPenney.com is one of the largest apparel and home furnishings sites on the Internet. JC Penney's fiscal year ends in January.

We rate JCP shares a Sell with a target price of $14, which is about 8x our fiscal year 2009 EPS estimate. We would be sellers on any rally in JCP shares. In our view, JC Penney got a boost from the government stimulus checks that went out in the second quarter. This was a one-time event that will not carry over into the third and fourth quarters. In fact, many retailers began to report slower traffic in July and store traffic fell off a cliff in September. The company had to reduce its guidance for the third quarter and, more recently, the fourth quarter. This slowdown is part of a much larger problem.

While we still believe that JC Penney is a top-notch retailer, we don't think the company will be able to overcome the macro headwinds negatively affecting consumer discretionary spending. These headwinds include a terrible housing market, historically high levels of consumer debt, tighter credit standards, and higher unemployment. These factors are putting a great deal of pressure on consumers, who are unable to spend the way they did for the last several years.

With easy access to the debt markets via home equity loans, consumers could easily live beyond their means. And when credit card balances became too large, those consumers would simply borrow against the appreciation in their homes to pay off those pesky credit cards. Unfortunately, home prices are dropping and banks have shut off the home equity spigot. This has left many consumers strapped with large credit card balances, homes they cannot afford, and lifestyles that exceed their incomes.

Consumers have been forced to cut back on spending, pay down debt, and look for ways to stretch their weekly paychecks. The result has been the move to trade down to lower priced substitutes typically sold at discount stores or wholesale clubs. The losers in this move to trade down are the higher-priced specialty shops and general merchandise department stores. We don't see the pressures from these macro headwinds abating until housing prices finally stabilize. To be sure, JC Penney is doing what it can to protect its margins. It is focusing on merchandise, inventory levels, and cost controls. But we think this will not be enough to overcome the larger macro trends.

In addition, we would caution those investors that are looking past JC Penney's current problems and focusing on the company's eventual recovery. That recovery may not turn out the way the market currently expects. The real risk for retailers is that consumers' attitudes will change during this downturn. During the current down cycle, consumers have scaled back on discretionary purchases and have been looking for ways to save money on those purchases that they have to make. In other words, consumers are becoming more frugal. If consumers become accustomed to living a more frugal lifestyle (i.e., living within or even below their means), they may choose to continue living that way once housing prices begin to appreciate and credit markets return to normal. A more frugal customer will continue to shop at discount stores and wholesale clubs, but will also continue to avoid mid-level stores except when they offer discounts and sales events. At this point, investors are not discounting a scenario where consumers choose to become more frugal, but we feel it is a scenario that could become reality. If it does become a reality, JC Penney's long-term earnings power will be much lower than most forecasts.

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