Target, Penney in Battle Trim

Recent steps by J.C. Penney ( JCP) and Target ( TGT) to hive off noncore assets are the retail sector's latest symptoms of Wal-Mart ( WMT) disease.

The operations being cut loose aren't alike. Penney's Eckerd unit is a chronically underperforming drugstore franchise whose margins were flattened by cutthroat competition, while Target's Mervyn's and Marshall Field's divisions have seen their high-end offerings fall out of favor with hurried bargain-hunters.

But with each divestiture, the parents are leaving behind disadvantages that exist at least partially because of Wal-Mart, the country's biggest retailer. The moves were both motivated because "the consumer is more interested in getting the most bang for their buck," said Adrian Bachman, a portfolio manager at Rydex.

At J.C. Penney, keeping a hand in the drugstore space made no sense, given larger competitors that could offer much more than just drugs and cosmetics at a single outlet. Meanwhile, Target has seen profit and sales stumble and growth disappear at its department store chains.

Analysts generally expect both stand-alone J.C. Penney and Target stores to succeed as separate entities from the divisions that were holding them down. "Target is more in an offensive position, whereas J.C. Penney is in a defensive position," Bachman added.

The 'Turnaround of the Decade'

A stripped-down J.C. Penney may be up for the fight, according to Richard Hastings, an analyst at Bernard Sands, citing its ability to adapt to changing consumer tastes quickly.

"The stores look good, and the online performance is rated very high," he said. "They're starting to perform well across a wide variety of performance measures. ... People like the quality and variety and the very contemporary styles that J.C. Penney offers."

Merrill Lynch analyst Dan Barry called J.C. Penney the "turnaround of the decade." He said the company's new centralized distribution center will contribute to stronger gross margins. "Centralized decision-making allows Penney's buyers to act more swiftly to respond to fashion trends and good buying opportunities," he said.

Prudential analyst Wayne Hood sees the company buoyed by strengths in its improving catalog and Internet divisions, which account for 15% of the stand-alone company's sales. He expects double-digit sales and earnings-per-share gains over the next five years.

In its latest fourth quarter, J.C. Penney said it lost $1.07 billion, or $3.42 a share, compared with earnings of $202 million, or 68 cents a share, in the prior-year period. The quarter included a charge of $450 million to write down Eckerd, and another $875 million charge from a deferred tax liability at the drugstore unit. Excluding Eckerd, however, earnings rose 43%, which beat analysts' estimates.

The Cache of Target

Target, which has spent the past five years redefining itself as Wal-Mart's hip alter ego, can ill afford to be weighed down by dinosaurs if it wants to be a vulture. Its department-store chains are profitable but represent a similar weight on their parent's growth. In 2003, sales fell 6.9% at Mervyn's and 4% and Marshall Field's. Meanwhile, operating profits plunged 32.6% at Mervyn's and 21.1% at Marshall Field's. In contrast, operating profits at Target's discount store chain jumped 12.3% last year, while sales increased 12%.

"It's easier to manage the business" by selling the units, said John Escario, another Rydex manager. "They're making Target a leading name instead of fighting a war on three fronts."

In the long term, Robert W. Baird analyst J. David Cumberland expects 15% annual sales growth from Target, minus Marshall Field's and Mervyn's.

Prudential's Hood noted that Target's core monthly same-store sales gains have been above Wal-Mart's core results for the past eight months, and he expects the gains to be remain above Wal-Mart's in the upcoming quarters. He also noted that the Target division's core operating margins are zeroing in on Wal-Mart's; they are now in the 7.3% range, compared with Wal-Mart's 7.4%.

A Stumble at Sears

Although department-store chain Sears ( S) attempted a similar flight from diversity, it didn't exactly take off as planned.

The company sold its credit card operations to Citigroup ( C) in November and its National Tire and Battery unit in October to TBC ( TBCC). In each case, Sears said it wanted to focus on its core retail operations as part of a multiyear corporate restructuring plan. The restructuring started in 1992 with a goal of improving profitability and cost structure.

But despite its divestitures, sales at Sears have continued to fall prey to the discount chains. Escario says Wal-Mart and Target have the advantage over Sears because cost savings are built into their business models. In contrast, Sears has been markdown-happy and highly promotional, especially over the holiday season.

Despite its promotions, however, Sears earned $2.26 a share in its latest fourth quarter, excluding a gain on the sale of the credit card business and other one-time items. Sears' results were down from $2.67 a share earned in the prior-year quarter. Nevertheless, results beat the Wall Street consensus estimate of $2.02 a share.

However, its outlook for 2004 was dismal. The retailer expects to earn between $3.60 and $3.80 a share, including debt from the credit-card business sale, which, when announced, was 13% to 17% below the Wall Street estimate of $4.36 a share. Analysts now forecast $3.73 a share.

There is hope in the company's somewhat new experimentation with stand-alone stores, developed in part to compete with the big-box discounters. The company opened its second Sears Grand pilot store in Gurnee, Ill., on April 3. The first was opened in October in Salt Lake City. The company plans to open three more Grand stores in 2004 and 2005, with the third in Las Vegas this fall.

The company calls the Grand stores "one-stop home and family centers." They offer appliances and tools as well as merchandise such as milk, fertilizer and laundry detergent. It has also been reported that Sears is considering adding pharmacies to the Grand stores.

Sears is "trying to fight against all the other stand-alones: the Wal-Marts, the Best Buys ( BBY) and all the strip-mall stores that are booming right now," said Joe Bonner, an analyst at Argus Research.

Amid such brutal retail wars, it remains to be seen whether the leaner, meaner versions of Penney and Target can put up a healthy fight against their biggest competition.

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