Should You Buy J.C. Penney?

This has been an excellent year for most department stores. Year-to-date, shares of Macy's (NYSE: M  ) have gained nearly 43%, while Kohl's (NYSE: KSS  ) has gained nearly 30%. One notable, but not surprising, exception has been J.C. Penney (NYSE: JCP  ) . Shares of the Plano, Texas-based company have fallen more than 55% this year as the company has continued to struggle. However, last month the company reported encouraging quarterly results which indicate that its turnaround plan is working. So, is this a good time to buy J.C. Penney?

Putting the Johnson era behind it
J.C. Penney appointed Ron Johnson as its CEO in 2011. Johnson, who previously served as senior vice president of retail at Apple, replaced Mike Ullman. Shortly after taking charge, Johnson implemented a new strategy. Unfortunately, his strategy completely backfired, resulting in substantial losses for J.C. Penney. As the losses continued to mount, J.C. Penney's board was forced to fire Johnson earlier this year. The board reappointed Ullman as the company's CEO. 

Signs of improvement under Ullman
Under Ullman, J.C. Penney has shown signs of improvement. In the second quarter of fiscal 2013, the company reported an improvement of 470 basis points in comparable-store sales on a sequential basis. In addition, sales results improved sequentially each month within the second quarter. 

The improvement continued in the third quarter of fiscal 2013. On a sequential basis, J.C. Penney's comparable-store sales improved by 710 basis points, and the company achieved positive comparable-store sales growth for the month of October. Also encouraging was a significant increase in online sales. The company's online sales rose 24.5% on a year-over-year basis to $266 million in the third quarter.

Earlier this month, J.C. Penney provided a preliminary update on its performance in the month ended Nov. 30, 2013, which included the crucial Thanksgiving weekend. The company registered a 10.1% increase in comparable-store sales for the month of November. The company achieved this result even though the Thanksgiving weekend turned out to be disappointing for retailers.

J.C. Penney's recent performance certainly suggests that the company is making a comeback. The company can also take heart from the fact that the macroeconomic environment is improving. Holiday season sales have been disappointing, with mall-traffic tracker ShopperTrak recently reporting a 3.1% drop in holiday in-store sales and a 21% drop in store traffic in the all-important shopping week ended Sunday, Dec. 22, 2013. However, consumer sentiment in the U.S. has been improving.

Earlier this week, the final reading on the Thomson Reuters/University of Michigan's consumer sentiment index for the month of December came in at 82.5, versus 75.1 in the month of November. The consumer confidence data certainly suggests that early next year Americans will be spending quite a bit. This is a good sign for J.C. Penney, but the big question is whether or not J.C. Penney is a buy given its recent improvements and the macro environment for retailers.

Still the early days
Although J.C. Penney's recent performance has been encouraging, these are still the early days. The company's biggest concern is its balance sheet. J.C. Penney had $5.61 billion in debt on its balance sheet at the end of the third quarter of fiscal 2013. With a debt/equity ratio of 2.12, J.C. Penney is highly indebted at the moment. Macy's currently has a debt/equity ratio of 1.32, while Kohl's has a debt/equity ratio of just 0.82.

Indeed, if a downturn occurred, J.C. Penney is in the worst position among department store operators. Of course, if consumer confidence remains robust and J.C. Penney's performance continues to improve, there could be huge upside. However, there is far too much uncertainty with J.C. Penney at the moment.

Final Foolish thoughts
I would recommend Macy's and Kohl's if you are looking to gain exposure to department stores. Despite posting significant gains, both stocks are attractively valued at the moment. While Kohl's is trading at a forward P/E of 12.29, Macy's has a forward P/E of 12.15. Of course, the potential upside with these stocks won't be as much as it is for J.C. Penney.

However, with a stretched balance sheet J.C. Penney is a very risky bet. In addition, a disappointing holiday season could derail J.C. Penney's nascent recovery. As I mentioned, the company is not in a position to withstand a downturn. I would remain on the sidelines with J.C. Penney at least for the next two quarters.

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