J.C. Penney Shares Sparkle

Where other chains have flailed, its turnaround strategy continues to bear fruit.
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First, it was one of the only clothing retailers to post decent numbers at back-to-school time. Now, with retail crunch time bearing down,

J.C. Penney

(JCP) - Get Report

is again one step ahead of the competition heading into 2005.

While its future in the increasingly off-mall, discounter-dominated world remains a big question mark, the department store's promotional success has turned it into an outperformer.

Fresh off a turnaround orchestrated by its former chief executive, Alan Questrom, Penney posted a 12% jump in November same-store sales, a key retail measure of top-line growth at stores open for at least a year. That figure beat Wall Street's already optimistic forecast for an 11% gain.

While operating earnings rose just 3.8% in 2003, they're expected to jump 67% this year. Looking ahead, analysts estimate earnings will add 17% in 2005 and 19% in 2006. Thomson First Call puts the consensus earnings estimate at $2.12 a share in 2004 and $3.02 a share in 2005.

November, which included the post-Thanksgiving shopping rush, saw widespread sales disappointments elsewhere in retail, particularly in the apparel sector. Dejected store chains leaned on discounts, and consumers seemed slow to hit the malls. But Penney already had beaten them to the punch with marketing gimmicks such as its $10-off coupons.

"Their ability to leverage the right prices with excellent advertising and product promotion is showing itself so far this season," said Richard Hastings, a retail analyst with Bernard Sands LLC. (He does not own a position in J.C. Penney, and his firm has no banking relationship with the company.) "They are good at what they do."

The stock has rocketed up 18% since plunging in late October after Questrom announced his early resignation. A series of upbeat reports, including an 83% rise in third-quarter earnings, gave Wall Street a short memory when it came to his departure.

"Clearly, Questrom is a turnaround artist," said Kurt Barnard, president of Barnard's Retail Consulting Group. "He has demonstrated this, and nobody disputes it."

Questrom rescued Penney from the clutches of new-generation, off-mall discount chains like


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, in the midst of an economic downturn.

Starting in 2001, he steered the company with a plan to centralize merchandising decisions and improve distribution efficiency and inventory data. Since then, operating margins have risen consistently, and inventory is under better control. Selling off its Eckerd drugstore chain enabled the company to pay down debt and improve its balance sheet.

Now, J.C. Penney is one of the few old-line department stores to succeed in protecting its customer base from the discounting revolution, and it seems plausible it could hit its operating margin goal of 6% to 8% earlier than expected.

This week, the stock has been on a roller coaster. It was down 2.4% on Monday, then up 4.4% on Tuesday, and back down more than 1% Wednesday -- all on spikes in volume. Analysts said it was probably being buffeted amid holiday retail mania by hedge funds trading on reports of shopping levels over the weekend and emerging cold weather. Other apparel chains showed similar patterns, like Kohl's and

May Department Stores



"The weather has been warm until this week, and sales of winter outerwear

have suffered from October into December, so when the forecast for chillier weather occurred earlier this week, apparel retailers have responded with some volatility," said Bernard Sosnick, analyst with Oppenheimer Funds. (He does not own a position in J.C. Penney, and his firm has no banking relationship with the company.)

In the case of J.C. Penney, investors may be taking a second look at the company's prospects after holiday selling abates and a new management team faces down its longer-term prospects.

"The stock market is a forward-looking mechanism, and uncertainty over future direction of the company has risen significantly," Hastings said.

Penney's new chief executive, Myron Ullman, is an outsider from LVMH Moet Hennessy Louis Vuitton. Formerly the chief executive of Macy's Department Stores, he has some big shoes to fill.

"In our opinion, the biggest uncertainty investors have right now regarding J.C. Penney is how the appointment of Mike Ullman as CEO will impact the company, both in terms of strategic focus and management structure," wrote Bear Stearns analyst Christine Augustine in a recent research note. (Bear Stearns is affiliated with a specialist who makes a market in J.C. Penney shares. The firm has a non-investment banking business relationship with the company.)

So far, the most significant impact of Ullman's tenure has been the departure of Penney's No. 2 executive, Vanessa Castagna. Previously seen as a possible successor of Questrom, the company's board passed her over for the job, and Castagna left the company, making no secret of her disappointment.

Now, Barnard said there is widespread speculation that Ed Lampert, soon-to-be-chairman of the combined





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, is courting her. If Castagna heads to Lampert's new retail empire, she could bring some of her former colleagues from J.C. Penney with her.

"It is usually inevitable when something like this occurs that the executive brings along colleagues that he or she has worked with in the past and been happy with," Barnard said. "So, if Vanessa were to join Sears, it would have to be expected that she would bring along a number of others."

Such personnel shake-ups could unnerve investors, and there is a risk that any strategic missteps by Ullman could lose the momentum left behind by Questrom. Furthermore, long-term trends in retailing don't bode well for the company. Competition is increasing from discounters with considerable pricing leverage, and consumers are widely viewed to be flocking to off-mall locations with greater frequency.

"J.C. Penney operates in a crowded field and lacks sustainable long-term competitive advantages," wrote Morningstar analyst Kim Picciola in a recent research report. "

This leads us to be cautious of investing in this no-moat stock."

Sales growth has been nearly flat in recent years. Without Eckerd, Penney's top line is expected to add 3% this year, followed by 2.7% in 2005 and 4.8% in 2006. If the upward trend continues, the company's forward price-to-earnings ratio of 13 could well be justified. In the meantime, J.C. Penney investors should have a happy holiday.