4/1/2008
By Brian Sozzi

On March 28, department store giant JC Penney Corp. (ticker: JCP) issued a material 1Q`08 earnings warning.  Citing extreme constraints on households budgets that led to comparable store sales (comps) over the crucial Easter holiday selling season falling well below expectations (declined by a double-digit percentage), the retailer issued 1Q`08 earnings per share guidance of $0.50 (consensus $0.75).  This was particularly troubling in the sense JC Penney serves predominantly low-end consumers, a group of population most prone to economic duress when conditions deteriorate.

The news was equally worrisome for Polo Ralph Lauren Corp. (ticker: RL) as it supplied JC Penney with the initial round of goods under the new American Living brand in February.  Launched at 575 JC Penney store locations, and spanning 40 home/apparel merchandise categories, American Living was supposed to help elevate the department store’s cachet with consumers in addition to leveraging a new business opportunity for Polo.  However, we observed significant discounts of the American Living brand almost immediately following the launch, a sign that price conscious consumers failed to respond to the higher priced wares.  The good news for Polo is that JC Penney bears the markdown risk associated with American Living.  But, underperformance of American Living could lead to canceled orders from JC Penney and that would have a profound negative impact on the value of inventory (note inventory was up 21.0% at 3Q`08 end mostly due to stock for American Living). 

In our view, this issue in tandem with ongoing investment spending on new growth vehicles and softening demand at Polo’s retail stores elevates the risk of a reduction to management’s current FY`09 earnings per share guidance ($3.95-$4.05).  As a result, we have reduced our FY`09 earnings per share estimate to $3.85 from $4.00.  We are reiterating our underweight recommendation and issuing a price target of $53.00.

Written by Brian Sozzi, a Research Analyst for Wall Street Strategies (www.wstreet.com) specializing in the apparel/hardline goods sectors of the retail industry.

Wall Street Strategies