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J.C. Penney (JCP
) received plenty of applause when it released its third-quarter results on Nov. 12. Investors bid up its shares 13%, to $21.50, after the retailer said results at its namesake department stores were stronger than expected, thanks to its turnaround strategy. Penney has spent the past two years setting up centralized distribution and merchandising systems and remodeling hundreds of its Eckerd drugstores. That helped deliver profits of $89 million in the quarter, or 30 cents a share, more than double last year's 13 cents. Revenues were $7.9 billion, up slightly from $7.7 billion a year ago.
As impressive as those numbers look, some analysts worry that they mask a potentially serious problem. Eckerd now accounts for about 43% of Penney's overall sales, making it a huge factor in its performance. And for now, "Eckerd's sales [trends] are lagging its peer group," says Shari Schwartzman Eberts, a JP Morgan Chase analyst. "With the gap widening lately, it looks as if Eckerd may be losing market share in pharmacy sales, which is the traffic driver for the drugstore business." Eberts doesn't own J.C. Penney stock, though JP Morgan has collected investment banking fees from it within the past year.
HIGHER-VALUE BUSINESS. Most drugstore chains have seen sales growth of prescriptions slow over the last year because of the stagnant economy and increased competition. But the monthly sales figures appear to be weaker at No. 3 Eckerd than at competitors such as Walgreen (WAG
), CVS (CVS
), and Rite-Aid (RAD
). Eckerd's sales in May climbed 9%, vs. an average 11.1% at No. 2 CVS and No. 4 Rite-Aid. In October, sales at Eckerd rose 5.9%, while CVS and Rite-Aid chalked up a 10.1% gain. Factor in the higher sales growth of fast-expanding Walgreen, and the comparisons look even worse.
Left unchecked, that trend could be bad news for Penney investors. Though the Plano (Tex.) retailer derives a majority of its sales and earnings from its department stores, analysts assign a greater market value to its drugstore business, which they expect to grow faster over the long term. Thus, Eckerd accounts for some two-thirds of Penney's stock value.
Prudential Securities analyst Wayne Hood figures that the department-store division is worth $8 a share, or 8.6 times his 2003 earnings-per-share estimate of 95 cents for the business. However, he assigns the drugstore division a $12 value, or 13.8 times his 2003 EPS target of 90 cents for it. Hood, who expects 2003 per-share earnings of $1.76 for the overall company, including an amortization expense for goodwill on previous acquisitions, doesn't own Penney shares, and Prudential has no banking ties with the outfit.
BELOW CONSENSUS. The analysts' concerns show up in the hold rating many have on the stock, even though Penney has predicted an upbeat fourth quarter. And that may be good advice for the time being. Eberts recommends taking profits as Penney prepares to deal with a more difficult year in 2003. "We're increasing our 2003 estimate to $1.45 but remain below consensus, due to our more conservative outlook for margin improvement at Eckerd, especially as it begins to roll out new stores next year, which is likely to take a toll on [selling, general, and administrative expenses]," Eberts wrote in a recent research note. She raised her 2003 earnings per share from $1.40, well below the consensus estimate of $1.65.
Not everyone is so bearish. In her latest report, Deborah Weinswig, an analyst at Salomon Smith Barney raised her stock-price target to $25. However, she added that she's "concerned about decelerating sales trends at the Eckerd business, as weak customer traffic, lackluster pharmacy same-store sales, and intense competition at the front-end of the business continue to pressure" revenues. Better sales at Eckerd would improve her outlook for Penney overall, she says. Weinswig, who has a neutral rating on the stock, doesn't own shares, but Salomon has received investment-banking fees from Penney within the past year.
Eckerd CEO Wayne Harris minimizes his chain's prescription-sales decline, characterizing it as not particularly meaningful. He adds that its sales of general merchandise are more robust than those of its competitors, even though a tourism slowdown in Florida is hurting Eckerd. "If you take the three other [chains] as a group, the decline for everybody -- including Eckerd -- is about the same," he says. Harris adds that Eckerd's revenues have suffered as doctors have prescribed more generic drugs, which cost less than brand-name pharmaceuticals but have higher margins.
FLORIDA TANGLE. He also notes that sales of the top two chains, Walgreen and CVS, have been boosted by the addition of new stores the past several years, while Eckerd has opened fewer outlets. He expects that to change. "We'll be on a level playing field in 2003 and 2004" after adding an expected 220 new and relocated stores, he declares.
CVS and Walgreen aren't standing still. Both plan to add more stores in 2003 in Eckerd's core markets -- Florida and Texas. Walgreen, with 580 stores in Florida, has already turned up the heat on Eckerd, which also has 580 stores there. "These are growth markets and can support some incremental competition," notes Eric Bosshard, an analyst with Midwest Research in Cleveland.
However, he thinks new competition will hurt Eckerd. He notes that discounters such as Target (TGT
) and Wal-Mart (WMT
), plus wholesale club Costco (COST
), are putting more emphasis on their drugstore businesses.
"TREMENDOUS KICK." It's unclear how easily Eckerd can fight off such players in its most important markets. Its expansion plans next year are modest -- 135 new stores and 85 relocated ones. Harris says moving stores, a priority for him in 2002, can provide a "tremendous sales kick," though he concedes that the overall impact will be muted as Eckerd's upgrades next year will affect just 5% of its 2,656 stores nationwide. Yet, he adds: "Those [relocated] stores will be profitable very quickly."
At the same time, others question whether better results at Penney's department-store division can last. In the third quarter, same-store sales rose 3.9% -- down from a 5.1% increase in the same quarter last year. And like every other retailer, Penney will have to discount heavily to boost its foot traffic in the fourth quarter.
"They're trying to create a department-store-like profitability model. But prices are so much lower at J.C. Penney [compared to stores like Macy's and Bloomingdale's that] it's very difficult to do that," says Steve Martin, president of Slater Capital Management in New York City. He doesn't own Penney shares.
Martin expects that competition will only increase among moderate-price department stores such as Kohl's (KSS
) and Sears Roebuck (S
). And higher-end chains, such as May (MAY
) and Federated (FD
), aren't likely to stand back and watch Penney steal their business. So even though Penney's makeover offers lots of reasons to cheer, it could well be that the retailer's work has only just begun.
Tsao covers the markets for BusinessWeek Online and writes for the Street Wise column
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