J.C. Penney Q4 2009 Earnings Call Transcript

123jump.com Staff
01 Mar, 2010
New York City

Sales fell 3.6% to $5.55 billion and net income fell 5% to $200 million or 84 cents a share. Gross margin rate was 38.2% for the quarter, an increase of 360 basis points versus last year

J.C. Penney Company, Inc. ((JCP))
Q4 2009 Earnings Call Transcript
February 19, 2010 9:30 a.m. ET

Executives

Phil Sanchez – Vice President of Investor Relations
Myron E. Ullman III – Chairman and Chief Executive Officer
Robert B. Cavanaugh – Executive Vice President and Chief Financial Officer

Analysts

Deborah Weinswig – Citigroup
Charles Grom – J.P. Morgan Chase
Michael Exstein – Credit Suisse
Robert Drbul – Barclays Capital
Lorraine Hutchinson – Bank of America/Merrill Lynch
Dana Telsey – Telsey Advisory Group
Liz Dunn – Thomas Weisel Partners
Adrianne Shapira – Goldman Sachs
Wayne Hood – BMO Capital Markets
Michelle Clark – Morgan Stanley
Jeff Klinefelter – Piper Jaffray
Erika Maschmeyer – Robert W. Baird

Presentation

Operator

Greetings and welcome to the J.C. Penney Incorporated Fourth Quarter 2009 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. If any one should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder this conference is being recorded. It is now my pleasure to introduce your host, Phil Sanchez, Vice President of Investor Relations for JC Penney Company, Inc. Thank you, Mr. Sanchez, you may begin.

Phil Sanchez

Thank you, Bob and thank you all for joining us on the call this morning to review JC Penney’s fourth quarter and full year earnings. Before we begin, let me remind everyone that the discussion this morning includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 which reflects the company’s current view of future events and financial performance.

The words expect, plan, anticipate, belief and similar expressions identify forward-looking statements. Any such forward-looking statements are subject to risks and uncertainties and the company’s future results of operations could differ materially from historical results or current expectations. For more details on these risks, please refer to the company’s Form 10-K and other SEC filings.

Also please note that no portion of this call may be rebroadcast in any form without the prior written consent of JC Penney. Replays of today’s webcast will be available for 90 days. For those listening after February 19, 2010, please note that this recording will not be updated and it is possible that the information discussed will no longer be current. On this morning’s call, we’ll have two speakers, Mike Ullman, Chairman and Chief Executive Officer and Bob Cavanaugh, Executive Vice President and Chief Financial Officer. Now, I will turn it over to Mike Ullman.

Myron E. Ullman III

Good morning. Thank you for joining us. In reflecting back on our approach to last year, I would say that 2009 was certainly a year of great discipline and planning for growth that delivered better than expected results for our company. We accomplished what we set out to do in 2009. In fact, we beat every planned metric across the board in spite of the most difficult economic climate that most of us can remember.

While we planned our business for a tough retail environment, understanding how difficult it would be for America’s families, we also saw 2009 as an opportunity for us to strengthen our business by stepping up our styles that we offer and significantly improving many aspects of our operations in order to put in place a strong foundation for growth. This time last year we planned for a comparable store sales decline of 10% for the year but in fact, delivered 370 basis points better than that with a decline of 6.3% for the year.

We planned for our EPS to be $0.20 for the year and actually delivered $1.07 per share even with the impact of our non-cash pension expense, having successfully executed our strategy to generate profitable sales during the year. We planned gross margins to modestly improve but delivered gross margins that were 200 basis points higher than 2008. At 39.4% of sales, our margins beat our historic peak.

We expected free cash flow to be $100 million, but we delivered $806 million and ended the year with $3 billion of cash on our balance sheet. In short, our balance operating strategy worked. We made it our mission to protect our profitability by tightly controlling our inventories and planned our business around the lower sales levels for the year which including not choosing to anniversary several promotions during the year which would have not been productive to our bottom line.

For example, the impact of our total sales for the year from lower clearance merchandise was about 350 basis points in sales for the year. This was the essence of our bridge plan which we put in place when the economy began to turn down two years ago and it has proven to be the right approach. In a moment, Bob will walk you through the details of the fourth quarter but from a full year operational perspective 2009 marked a year of refinement for our business in two key areas.

First, refinement in our merchandising structure and execution and, second, refinement in our customer experience. In terms of our merchandising structure, rather than appoint a single chief merchandising officer, we chose to align our merchandising organization with three seasoned merchandising executives, two who focus on the apparel offerings and one who focuses on our big ticket businesses.

These three senior GMMs are supported by a depth of talent within our company including five general merchandise managers, 22 divisional merchandise managers and 96 merchandise action teams. A MAT team is focused on a key business and we have a fully integrated process to offer up-to-date stylish merchandise in order to ensure that we deliver the right assortment and correct quantity for each community we serve.

Our merchandising leaders will help maximize the potential of our newly launched brands as well as to continue the leverage the power of our highly recognized private brands. With our merchants is our merchandising execution team. In 2009, we refined our technology platform that supports every aspect of our merchandise operations including the planning and allocation systems that enable us to drive profitability of our sales by controlling inventory flow through smaller and more frequent deliveries.

As we have said in the past, we have a great advantage in this area by having top talent and highly sophisticated integrated systems. We also rolled out our new door to floor process across the entire organization which allows stores to plan, receive and execute merchandise sets while improving overall team productivity.

This ultimately reduces the time spent by store associates on non customer facing tasks and allows us to reinvest associate hours back into taking care of customers. It also has the additional benefit of getting new fresh merchandise to the selling floor in less time.

Additionally, we completed the design of our new Red Zone clearance strategy. We recognized it was difficult for our customers to interpret what 25% off already reduced prices means and estimate how much they’re going to pay when they check out. Red Zone clearance focuses on communicating true out-the-door price points for our customer, helping them to simplify their purchase decision.

The second area of refinement was our overall customer experience at every touch point. We streamlined our marketing to highlight our stepped up style and enterprise wide merchandise offering to reach the broadest spectrum of our customers and also to reinforce why they should shop with us. This refinement resulted in the discontinuation of our big book catalogs.

We stepped up our digital presence too, giving customers tools such as mobile applications and defined more pictures in our stores that makes it easy to shop with us in a format that is most convenient for them. And insofar as line we improved the functionality of JCP.com to allow customers to more easily find the right styles for them.

We created an innovative online runway experience showing customers our stylish head to toe looks. Customers are responding well to these things and our online business turned to a positive trend in 2009 and we expect solid sales growth for JCP.com in 2010. Refinements in store included we remodeled and refurbished approximately 100 stores and plan to continue investing in our future CapEx spending on our store environment as well as merchandising launches. This is particularly true in the stores with our Sephora initiative.

We currently have 155 Sephora inside JC Penney locations and will accelerate our openings this year with 75 additional new locations. We also opened 17 new stores in high potential markets last year, most notably Manhattan where JC Penney has proved to be popular with both locals and tourists and this is bringing good visibility to us in our exclusive brands. It has also had a halo effect for our other stores in the New York metro market. Finally, in terms of service, we continue to invest in our people providing ongoing training and leadership development. Once again, we were ranked number one in customer service among department stores in the annual independent and American Express customer choice survey.

We continued improvements in our customer score card rankings across all major customer facing categories. This is an independent survey that tracks the progress of service metrics for JC Penney and all of our peers. We enjoy a clear lead in customer service and in store execution.

I would personally like to thank all of our associates for their hard work and dedication throughout 2009. Their efforts were certainly instrumental in our success. And as a matter of fact, we’ll be rewarding our hourly associates today. Each will get a special bonus check in recognition of their efforts in surpassing our customer service goals in the fourth quarter. Taken together, in 2009, we put in place a platform for growth both operationally and financially.

Looking forward, our focus in 2010 is, put simply, to drive sales on both a comparable store as well as total basis. To do that, we’ll leverage what we achieved in 2009 with four key areas of focus to increase shareholder value. You will hear us refer to them consistently over the course of the year, number one, we will confirm JC Penney as a style destination.

This means we will maximize the potential of our existing and newly launched designer brands that bring newness and excitement to our shopping experience. In 2010, we will launch Liz Claiborne, one of the most desired brands in the retail world and the most popular with our core customer and that will expand to 30 categories in the fall of this year.

Second, MNG by Mango which will bring European runway design at affordable prices as fast passion in our stores. We’ll launch this fall in 75 stores and we’ll have it in 600 sisters by the end of 2011. We’ll also reintroduce and reinforce the leading position of our private brands such as Arizona, Decree, and St. John’s Bay.

Our private brands grew at a faster rate than our national brands and they generate consistently higher gross margins and higher profitability with continuing modest reductions in sourcing costs, both in first half and second half of 2010. We will continue to enhance our American Living brand to strengthen the marketing and messaging to grow brand awareness.

Number two, we intend to expand our market share. This means we work to increase visits and spending from our existing customers as well as find ways to reach new ones. This includes aggressively competing for business in key U.S. markets, continuing to improve our stores and the functionality of JCP.com, targeting our catalogs and importantly continuing to build on the success of JC Penney rewards.

Our loyalty program has now grown to more than 3.3 million members who are known to spend more than our average customer and visit more frequently. Third, we’ll invest in our associates. We expect to refine and expand our CustomerFIRST initiative which gives associates the right training and tools to serve customers consistently well. And to support this we’re committed to rewarding our associates for the meaningful contribution to our overall customer service scores and ultimately our profitability.

Finally, number four, we’ll maintain our financial and operational discipline. We expect the economy to remain difficult but against this backdrop we’re committed to top line growth. In 2010, we expect both total and comp store sales to be positive for the year above the forecasted entry average. Let me now turn the call over to Bob to provide you with greater financial detail in 2009 and our expectations for this coming year.

Robert B. Cavanaugh

Thanks, Mike and good morning, everyone. As Mike discussed, the company’s performance during the fourth quarter continued to show the benefits of our strategy to balance the top line and bottom line. Our gross margin and free cash flow performance were exceptional while lower inventory levels, especially in clearance merchandise, had an impact on sales. Since we have a lot to cover, I am not going to repeat all of the information contained in the release but I would like to highlight a few important areas.

Earnings from continuing operations were $0.84 per share in the fourth quarter and $1.07 for the year. This exceeded our most recent guidance and as noted in the release adjusted income, excluding qualified pension expense, increased 21% to $1.02 per share compared with $0.84 in last year’s fourth quarter.

Our gross margin rate was 38.2% for the quarter, an increase of 360 basis points versus last year’s fourth quarter and a new peak for fourth quarter performance. This reflects the success of our strategy to sell more merchandise at normal promotional prices and less at clearance prices.

SG&A dollars increased 1.4%, better than the guidance we provided for an increase of 4.5%. We invested SG&A to drive our business during the quarter while continuing to focus on optimizing resources across the organization and maintaining industry leading customer service levels. Real estate and other was an expense of $15 million for the quarter, an increase of $4 million over last year’s fourth quarter.

If we look at the fourth quarter excluding the non-cash pension expense, adjusted operating income was $454 million, a 28% increase versus last year’s fourth quarter. This is the first time in 2009 that adjusted operating income achieved a year-over-year increase and demonstrates the effectiveness of our balance strategy.

I should also note that our fourth quarter results reflect a change in our inventory costing method from LIFO to FIFO which is a more appropriate method for the current environment and a better representation of current operations. With this change, we now join the majority of our industry peers. This change did not have a material impact on the fourth quarter or the year.

Moving onto full year performance, let me add some more detail to what Mike has shared. Total sales decreased 5% for the year while comparable store sales decreased 6.3% compared to our plan to decrease approximately 10%. It is important to note that even in the difficult economic environment over half of the sales decline can be attributed to lower sales of clearance merchandise.

For 2009, the gross margin rate reached 39.4%, a 200 basis point improvement over 2008 which exceeded the previous historic peak. Looking at it another way, gross margin decreased only $5 million despite a $930 million decrease in sales, essentially a 0% decrease in dollars versus a 5% decrease in sales. And, with SG&A dollars also decreasing slightly, the company has held SG&A expenses essentially flat for the last four years.

As we have noted previously, since 2006 this represents an 8% decrease per store or a 9% decrease per square foot while consistently improving customer service levels. For the year, adjusted operating income excluding qualified pension decreased only 4.1% in dollars but improved 10 basis points to 5.5% of sales in 2009.

Our full year results led to a significant improvement in the company’s financial position. Free cash flow, which is a non-GAAP measure represented by cash from operating activities, less capital expenditures and dividends, plus proceeds from the sale of assets was $806 million compared with our plan of $100 million.

We finished the year with $3 billion of cash and cash equivalents, an increase of $659 million over the prior year. At year end, long-term debt including current maturities was $3.4 billion. We have a $393 million maturity in March of this year which we will retire using cash from our balance sheet.

We have no other long-term debt maturities until $230 million maturity in August of 2012. This increase in financial flexibility is consistent with our plan to create a platform for growth in 2010 and beyond, which Mike noted earlier.

Capital expenditures for the year were $600 million, in line with our plan and included 17 new stores, 20 major renovations and 64 new Sephora inside JC Penney locations. We closed two stores during the year, one of which was a relocation in the first quarter and the other a small store in an under performing mall in the fourth quarter and we finished the year with a store count of 1,108 stores. Total inventory at year end was 7.2% lower than year end 2008.

Now, let’s take a look at our expectations for 2010. As Mike indicated earlier, our focus will shift to driving top line growth. In the second half, when many of our initiatives begin to take effect, is expected to be better than the first half. While we expect the economic environment to remain challenging for our consumers, we are planning a low single-digit comparable store sales increase in 2010.

For total sales, we expect an increase that is 30 to 50 basis points lower than the comparable store increase. This will result from the ongoing transition in catalog from the elimination of our big books. The gross margin rate is expected to be flat in 2010 and remain at the peak level achieved in 2009 and as sales begin to turn positive, we will start to see some upward pressure on SG&A which should also see a low single-digit increase in dollars.

This reflects increases from the new stores open in 2009 including Manhattan and the two new stores that will open in early 2010. A marketing budget plan flat as a percent of sales, 75 new Sephora locations and a resumption of merit increases for our associates.

The 2010 pension expense for our non-cash qualified pension plan will be $221 million or about $0.57 per share. This is a $77 million reduction from the 2009 expense. The supplemental plan expense will be about $35 million.

Our qualified pension plan finished the year at 100% funded level as measured against the accounting liability, an improvement from the 93% achieved at year end 2008. After the debt retirement in March, interest expense will decrease to about $230 million and depreciation will be about $515 million.

Taking these parameters together, the company expects 2010 earnings to be approximately $1.55 per share. Looking at the first quarter, we expect flat to slightly increasing comparable store sales. On a monthly basis, February and April are expected to be below the quarter, and March is expected to be better than the quarter.

Total sales are expected to be about 30 basis points lower than comp sales. Gross margin is expected to increase slightly versus the first quarter of last year. SG&A is expected to increase approximately 2% in dollars. For first quarter earnings, we expect to be in the range of $0.16 to $0.20 per share.

Finally, let me add to two more quick notes on 2010. Capital expenditures are planned at $500 million for the year which includes two new department stores and the 75 new Sephora locations Mike mentioned earlier. This is a $100 million increase compared to our previous guidance for 2010 which reflects continued investments in upgrading our stores and the support of our merchandise initiatives and free cash flow for the year is expected to be approximately $200 million.

In addition to inventory, moving from a source of cash to a use of cash to support sales growth, we will also be subject to certain timing impacts such as incentive compensation that was accrued in 2009 but will be paid in the first quarter. In summary, the company’s liquidity and financial position remains very strong and we are well positioned to support the initiatives and programs planned for 2010 as well as those of our new long range plan. With that, I will turn the call over to Mike.

Myron E. Ullman III

I will briefly recap, 2009 was a year of discipline and building for the future. Our strategy to drive the quality of sales and improve bottom line paid off and our team proved its ability to execute. Given the circumstances of the last two years putting our long range growth plan on hold and creating a bridge plan, we moderated rated certain initiatives to make us more efficient and preserve our strong financial position.

We maintained initiatives that reinforce our status as a retail industry leader and accelerated initiatives to give us a significant competitive advantage. This was the right course for us. Now, that our bridge plan is complete, we are focusing our attention in 2010 on driving profitable top line sales growth.

As I said earlier, we will do that by increasing the realization of JC Penney as a true style destination, expanding our market share and consolidating market, investing in our associates and maintaining our financial and operational discipline by executing extremely well and not losing sight of what we accomplished through the bridge plan.

Our objective continues to be to drive long-term shareholder value. In that regard, we look forward to covering our new long range plan at our upcoming analyst investor meeting in New York City on Tuesday, April 20th. And with that, we’ll now open the call for your questions.

Question-and-Answer Session

Operator

Thank you. We will now be conducting a question-and-answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two, if you would like to remove your question from the queue. Participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key. One moment please while we poll for questions. Thank you. Our first question today is from the line of Deborah Weinswig with Citigroup. Please go ahead with your question.

Deborah Weinswig – Citigroup

Good morning.

Myron E. Ullman III

Good morning.

Deborah Weinswig – Citigroup

So obviously, a real change in terms of strategy and obviously the most important, I think, being on the top line. Can you dive into the top-line drivers being, obviously, in the back half of the year, you will have M&G by Mango and Liz Claiborne, and throughout the year you’ll have more Sephoras inside JC Penney’s rolling out. But as we think about status quo, is it greater traffic, ticket? Can you just really help us because obviously going from January where you posted negative 4.6, what gives you confidence that in February that we’ll see a positive comp and what are the real key drivers?

Myron E. Ullman III

Fair enough. I think what is different in our strategy to some of our competitors is last year we chose not to chase sales at any cost. We maintained our average unit retail as opposed to trading down our business in price point. Having said that, throughout the year what we noticed is customers were responding to newness and fashion across all categories. So as we planned for 2010, you mentioned some of the key issues, Liz Claiborne, additional Sephora locations, M&G by Mango -- we also feel that we owned some business in the way we are merchandising our clearance, our new clearance initiative.

We also believe we’re owned some business in terms of incremental volume through our JCP rewards program. And quite honestly we looked through our center core accessories and intimate apparel and shoes and other categories where we felt that we had an opportunity to step up our style and bring in additional newness. So if you take those in the aggregate, obviously it skewed a bit towards the end of the year because of the new lunches but we believe we can grow each quarter. And we feel the hard work on not chasing promotional business last year will pay off by chasing profitable increased business this year.

Deborah Weinswig – Citigroup

Mike, you mentioned the JC Penney rewards which I think, if memory serves me correct, was rolled out in August. I don’t know if you are prepared at this point in the game to talk about what percentage of sales those customers represent or what the size is like and any trends you’re noticing at this point in the game in terms of customer behavior.

Myron E. Ullman III

We’re in the ramping up process as we offer the opportunity to join the program to customers at the point-of-sale as well as through other promotional activities. I think what we can say is we understandably are pleased with the fact we get additional visits and additional spending from rewards customers. So we think we’re just getting started in terms of growing the base.

Deborah Weinswig – Citigroup

Okay. And then I thought there was something else that was very interesting that was stated in the prepared remarks which was modest reductions in sourcing costs. Many other retailers are talking about 2010 as being more of an inflationary environment, and obviously JC Penney is very highly regarded in terms of its sourcing organization. Can you provide some additional details in terms of what you have obviously experienced? I would assume most of 2010 is locked in so far, but what you have seen as you have gone to market and what you expect to experience throughout the rest of the year?

Myron E. Ullman III

As you rightly point out, we have bought 2010 so we know for certain what our costs are, and they are modestly lower costs at sourcing than they were a year ago, which I think was the result of the hard work of our sourcing organization. I think our size and our skill in this area gives us advantages working with the best manufacturers, planning far ahead, making sure they understand our expectations on flow.

Some of the most successful programs we had this last year were some of the shortest cycle times, so we will take advantage of the costing as there is still not a big inflation factor in play. I think most people are looking at what’s going on in Asia. There has been some capacity that’s been taken out of the system during the downturn. There is certainly some commodity issues that are likely to put pressure on costing in 2011 going forward. We’re probably one quarter ahead of the others in terms of being able to take advantage of our strength, but we can’t be shielded forever as the world economy starts to rebound.

Deborah Weinswig – Citigroup

And then last question, Penney’s has been a real standout in terms of women’s apparel business and fine jewelry has started to out perform. Can you talk about what you’re doing in fine jewelry to drive the traffic in that category and also what might that say to you in terms of where the consumer is at?

Myron E. Ullman III

I think we had excellent response in fine jewelry to fashion, diamond fashion and price points and that drove our business Christmas, although some of the inventories hadn’t really transitioned completely. I think Valentine’s Day was a great opportunity for us to prove that as a viable strategy. So we feel modestly optimistic about the category. Obviously, fine jewelry is a totally discretionary purchase. We don’t expect it to be explosive, but we don’t think it is going to be a negative comp in this year.

Deborah Weinswig – Citigroup

Great. Thanks so much. Best of luck in 2010.

Myron E. Ullman III

Thank you.

Operator

Thank you. Our next question is from the line of Chuck Grom with J.P. Morgan Chase. Please go ahead with your question.

Charles Grom – J.P. Morgan Chase

Thanks. Good morning. Just, on your January sales release you spoke to spring product comping up high single digits, wondering if you can shed some light for us on February sales, realizing that the snowstorms throughout the country have probably been a little bit of a drag. But just wondering if you can shed some light on what you’re seeing in those categories month to date.

Myron E. Ullman III

Obviously, we report on February in a week and-a-half or so, but I will say that we’re encouraged by the continuation of the trend that the customer is responding to freshness and newness. We don’t have a lot of clearance so most of what we’re seeing has to come the old-fashioned way by selling new merchandise at the right price. So, I think particularly the young businesses are responding well to spring and as I mentioned, fine jewelry, we felt good about the response at Valentine’s Day. We have a week and two days left and we feel good about the month.

Charles Grom – J.P. Morgan Chase

Okay. Great. Clearly, the home business can be an asset at times and also a liability at times. Just wondering within the context of your expectations for sales to be up low single digits, what are you actually thinking about for that category? Some of your peers, both within department store land and outside of department store land, have actually shown some nice improvement over the past few months. It’s tough to tell how much of that is really from an easy compare but clearly the home category seems to be showing some signs of life so wondering what you guys are seeing in that area?

Myron E. Ullman III

We see in soft home, where the fashion elements, we’re seeing the same kind of reaction that customers are showing us in apparel. So in soft home categories, we’re seeing a bounce on newness. Obviously, sharp price points are important. Our home business online is starting to respond. That’s usually a leading indicator that the people are starting to spend again in that category.

Window and furniture, which are the two big ticket categories, are a bit tougher. They’re bigger purchases. Frankly, the constriction of credit that congress more or less created as a result of the “improvements” has made it more difficult in the big ticket categories for extended payment plans.

So we don’t know how much of that is related to those issues as opposed to just the customers’ caution in terms of investment in bigger ticket home. But again, it may not be the number one category in growth for the year, but we feel good versus our plan. We plan for it not to be the leading growth category.

Charles Grom – J.P. Morgan Chase

Okay. One more for me. Trying to reconcile your gross profit margin guidance of flat with your comments that sourcing costs are going to be down throughout most of the year, obviously the front half a little better than the back half. Can you just help us connect the dots?

Myron E. Ullman III

Gross profit has a lot of moving parts, obviously, in terms of mix and other factors. We are, in fact, not trading down our average price point. We had 100 year high on gross margins, so a little hard to want to forecast it up aggressively. I think maintaining it is our objective as we look at the calculus of our profitability for the year. We’ll take a higher attainment if we get it.

Charles Grom – J.P. Morgan Chase

Okay. One more from me. I might have missed it. How many remodels are you doing this year within the $500 million of CapEx?

Myron E. Ullman III

Well, virtually every Sephora installation is a remodel in the center core, so there’s75 of those. We’ve got 75 MNG Mango which again is a remodel of the contemporary fashion area and probably around 20 major remodels across the portfolio. So we touched 100 stores last year in a meaningful way. I would say we’ll touch at least that many this year. The good thing about having free cash flow well in excess of our plan last year is it gives us great confidence that we have the cash to spend where we think it is appropriate.

Charles Grom – J.P. Morgan Chase

Great. Thanks a lot.

Myron E. Ullman III

Thanks, Chuck.

Operator

Thank you. Our next question is from the line of Michael Exstein with Credit Suisse. Please go ahead with your question, sir.

Michael Exstein – Credit Suisse

Thank you very much. A lot of these are going to be for Bob. Very quickly, the cash flow estimate for the year looks pretty low, are you including the debt repayment in that number, number one? Number two, can you talk about what you expect to grow the inventories year-over-year fourth quarter in ‘09 versus ‘10? And can you talk about where you are in terms of the credit rating agencies and possibly getting back to investment grade? Thank you very much.

Robert B. Cavanaugh

Sure. I think, Michael, the $200 million, if we take a look at the where we exceeded first over plan. As Mike Ullman started the presentation, it was about a third in net income over plan, approximately a third in inventory reduction as I indicated in my comments, in a moderating sales environment as opposed to a growing sales environment. And there was also several hundred million dollars in there of improved cash flow from, first, the contribution to the pension plan, lower taxes, which won’t comp next year. That was $131 million, you may recall, from our pensionomics investor meeting, which some of us are trying to forget.

And then we also had the compensation accruals which will be paid out in March, several hundred million dollars and we also had actually better flow benefits, as you see on our balance sheet with improved inventory turn over. We had better flow benefits on our trade payables as a percent of inventory. And those, we’re not planning on those to repeat next year.

So in effect, when inventory goes from the moderating environment to a modest growth environment, if you will, the change in cash is several hundred million dollars plus the $300 million from the other working capital is about $600 million of difference between the $800 million this year and the $200 million for next year being planned.

Michael Exstein – Credit Suisse

How much are you expecting inventories to be up year-over-year fourth quarter to fourth quarter?

Robert B. Cavanaugh

Very moderately. The question was on the inventory.

Myron E. Ullman III

On inventory, as you can imagine, it’s planned in line with expected sales. So if we have moderate low single-digit comp expectations for the year, you expect inventories to track that.

Robert B. Cavanaugh

Right, inventory to track that. So those are the elements impacting free cash flow for next year. I believe the other part of your question was on the rating agencies?

Michael Exstein – Credit Suisse

Correct.

Robert B. Cavanaugh

We have continued, of course, three financial goals, Michael, which we have communicated consistently. Mike touched on the most important one, to drive long-term shareholder value, to do that with a strengthening financial position and an improved credit rating profile. And clearly the platform for growth that Mike discussed in his remarks will serve us well going forward.

We ended with several other peaks. Obviously the $3 billion in cash is a peak for us historically. Our debt-to-capital ratio, in effect, is the best in 35 years essentially. And over the last two years, even in the challenging economic environment, we have been able to reduce our debt almost $700 million, almost 20% since year end 2007. We will have done that in two weeks from today when we retire the $393 million and, as well, last year we re-equitized the balance sheet to help diffuse, if you will, the pension economic liability with the $340 million stock contribution to the plan.

All of that puts us in excellent shape going forward with a great platform here. Our three financial goals remain the same, to drive shareholder value, strengthen our overall financial position and flexibility and improve the credit rating profile. We’ll have more to say on it in April but we’re still focused on a restoration to investment grade. But it will take, as Mike said, it will take some time to deliver that performance and to drive the top line and to enhance shareholder value.

The other component of financial flexibility also it provides a hedge, of course, in terms of any macroeconomic drag, if you will, on performance. So that’s what the flexibility, we feel terrific about our financial position. It is the strongest it has been in many, many years and so we have a hedge against any macro unforeseen events and as well a great platform for growth going forward to support the long range plan.

Myron E. Ullman III

I think it’s also fair to say, Michael, that rating agencies are very focused on the macro environment in our sector. So I think we would benefit as they gain more confidence in our customer’s discretionary spending.

Michael Exstein – Credit Suisse

Thank you very much, gentlemen.

Operator

Our next question is from the line of Bob Drbul with Barclays Capital. Please go ahead with your question.

Robert Drbul – Barclays Capital

Good morning. Two questions. First, Mike, can you talk a little bit, you didn’t really mention much about American Living in terms of how that’s been going and any adjustments or tweaks you have planned for 2010. And a question for Bob which is can you talk a little bit about the cash incentive comp and the moves from ‘09 to 2010 and how it would impact 2010 free cash flow?

Myron E. Ullman III

As to American Living, we’re very satisfied as to PRL as to the product at this point, as well as the pricing. Both have been modified as we learn from the customer. I think the remaining opportunities for us are, obviously, brand awareness as well as improving our profitability going toward as we get better sell throughs.

Both teams are highly aligned on those two topics. Having said that, just to give you some sense, it’s the second largest external brand we have in the company, so while it may not be yet a billion dollar brand, it is substantial. It is across extensive number of categories. We’re having an excellent reaction in some categories and slower in others, but that’s what we’re learning. We’re optimistic, sitting next to Liz Claiborne on that pad on the upcoming seasons will benefit both brands.

Robert B. Cavanaugh

Bob, to your other question and I highlighted some of this in the response to Michael a moment ago, but on the non-comparables, if you will, between 2009 and 2010, there are about $400 million of non-comparables and about a third attributed to each -- the tax reduction on the -- equity contribution to the pension plan we made in 2009 as well the incentive compensation payments from 2009 that will be paid in March of 2010.

And as well benefits we generated through better flow and better normalization of our inventory during 2009 from 2008 on our trade payables. So about $400 million of working capital improvements that will not be repeated next year and as I indicated to Michael and then Mike Ullman followed up on it, when inventory goes from a reduction of 7.2% to a moderate increase to follow our sales growth for next year, you can do the arithmetic and that also is not quite $400 million.

And when you do that, the $400 million and the $400 million is $800 million, really is offset by improved net income which we guided to, as well as lower capital expenditures of another $100 million. So the $800 million less the $200 million gets you to the $600 million differential from this year’s $806 million to the guidance of $200 million for next year.

Robert Drbul – Barclays Capital

Got it. Thank you very much.

Operator

Our next question is from Lorraine Hutchinson with Bank of America. Please go ahead with your question.

Lorraine Hutchinson – Bank of America/Merrill Lynch

Thank you. Good morning.

Robert B. Cavanaugh

Good morning.

Lorraine Hutchinson – Bank of America/Merrill Lynch

Even with the CapEx and the debt repayment you still have quite a large cash cushion on the balance sheet. Would you consider a share buyback here and do the rating agencies have to say about that?

Robert B. Cavanaugh

As I think I highlighted in my comment to Michael earlier, the additional cash that we have and the additional strength in our capital structure that we put in place during 2009 will be our platform for growth going forward. Our three financial goals remain the same, drive long-term shareholder value, strengthen our financial position and flexibility, and improve the credit rating profile.

In effect, the additional liquidity, as you pointed out, Lorraine, will go first to almost a $400 million debt reduction from balance sheet cash in two weeks from today. And we will look for other opportunities to strengthen our capital structure and provide an even stronger platform going forward. And as I indicated a moment ago to Bob, we will look to restore our investment grade credit ratings that continues to be a goal, so we can be consistent and competitive with industry leaders, and ensure access to the global debt capital market, short-term markets as well as long-term, which we have discussed before.

So I think we’ll provide more details in April on this, but our focus would be on debt reduction as opposed to equity reduction and share repurchases. And as you pointed out in your note yesterday, the EPS impact differential of both those are essentially neutral, but of course the financial risk and flexibility impact is significantly more enhanced through debt reduction than equity reduction.

Lorraine Hutchinson – Bank of America/Merrill Lynch

Great. Can you just talk a little bit about your marketing plans for the year? Are you planning marketing spend up year-over-year and where will you spend most of those dollars?

Myron E. Ullman III

Fair enough. I think as I mentioned in my remarks we chose not to chase unprofitable clearance last year. We actually reduced our marketing spend last year by something like $150 million during the year, that was a conscious strategy. This year it is a conscious strategy to be sure we invest in the marketing area not only to make sure the customer understands our sales promotion strategy but also to improve the understanding of the image and style that we have invested in. I think as we look at what the marketing people call the net promoter scores of the highly satisfied, subtracting the unsatisfied customers in terms of image, appeal, my favorite store and the store I would recommend to a friend, we have moved up double-digit in that score over the last four years.

We think that is largely because we have done a better job of messaging what we stand for and the fact that we do offer compelling style and quality at exceptionally good value. We’re going to continue that. We want her to understand we’re a destination for style and quality at prices that are very, very reasonable and also we’re investing in our dot com marketing in terms of digital marketing, so you will see a major shift in effect in terms of the media we use to reach customers.

So I would say the overall category is going to increase as well as components within the category are shifting.

Lorraine Hutchinson – Bank of America/Merrill Lynch

Thank you.

Operator

Thank you. Our next question is from the line of Dana Telsey with Telsey Advisory Group. Please go ahead with your question.

Dana Telsey – Telsey Advisory Group

Good morning, everyone. As you talk about return to growth, thoughts on real estate, how you’re looking at the market especially with the potential Simon GGP combination? And as you think about the gross margin with private brands and the Liz Claiborne coming on, what would change your expectations for a flat gross margin? Thank you.

Myron E. Ullman III

In terms of real estate, everyone knows there is not a lot of new real estate development occurring in the retail world. There clearly could be consolidations over the next several years, we’ll look at those carefully. We’re pretty well represented in terms of our footprint in most major markets, with a few exceptions.

The general growth situation, we have about 95 shopping centers that declared Chapter 11 within the GGP portfolio. We’re watching that very closely. It would be premature to comment on how they’re going to exit chapter proceeding. I guess we have to say we’re satisfied by the way they’re managing the malls in that interim period. We have about 550 regional malls that are located out of our 1,108 stores.

As we mentioned in previous sessions, we’re very satisfied with the condition of the vast majority of those malls and we’re investing in those properties. Real estate I think is going to be certainly moderated in terms of new locations, but we’re not going to moderate our interest in investing in the existing ones. As to gross profit improvement, the right answer in any merchandising conversation is, to the extent you sell more merchandise early in the product cycle and less at below cost clearance cycle, gross profit goes up, that’s been largely the reason for our extraordinary margin performance last year.

We cleared the clearance as quickly as we could in the year and chose not to chase volume. I think in this coming year, to the extent we continue to improve our selling and sell through at the early promotional price and less at the last price, I think we’ll continue to improve margins. We are not planning them up dramatically because that would probably generate some difficulty behaviors in terms of pricing to the customer as well as our competitive posture with our peers.

Dana Telsey – Telsey Advisory Group

Thank you.

Operator

Our next question is from the line of Liz Dunn with Thomas Weisel Partners. Please go ahead with your question.

Liz Dunn – Thomas Weisel Partners

Hi. Good morning.

Myron E. Ullman III

Good morning.

Liz Dunn – Thomas Weisel Partners

I guess, my first question relates to Sephora inside JC Penney. Are you able to provide any clarity on what that does to productivity or comp because it is the vast majority of your investment looks like for 2010. So have we now got to the point where you can maybe provide some information along those lines?

Myron E. Ullman III

First of all, I wouldn’t say it is the vast majority of our investment in stores. I mean, while it is an important initiative. We figured out how to put Sephora inside our stores at what we think is an appropriate amount of investment. We’ve said in the past that Sephora inside JC Penney productivity is about three times the average of accessories core.

That’s, if anything, been exceeded, so we’re very satisfied the way it is performing. In terms of what effect it has on the overall company, we have also messaged in the past that that customer tends to be very much across shopping customer into other parts of the store, in the fashion areas of ANA and I think with Mango, Liz Claiborne, Sephora inside JC Penney in the entrance of the store.

That will continue to be accretive to our results and our image and performance for the younger customer as well. So I think we feel very good about Sephora. Sephora ended up over plan last year. We expect to be over plan again this year. Everything we had promised for Sephora inside JC Penney has come to pass.

Liz Dunn – Thomas Weisel Partners

Okay. As we look at the fourth quarter and you think about the comp store sales result relative to your competitors, do you think that the under performance was because you were under invested in marketing or do you think that it was that you were too focused, or maybe you don’t think too focused? What is your comment on gross margin as we look having been through the quarter? Do you think if you had it to do all over again you would have maybe gone for a little bit more comp, a little less margin?

And then as we look at 2010 what’s the number one metric you’re driving towards? Is it comp, is it operating margin, EPS, returns? Maybe if you could just help us with what you’re thinking because in the past you have talked about market share as being really important, but it seems like you made a strategic decision in 2009 to go a different direction.

Myron E. Ullman III

First of all, I never admit to being too focused. In any case, I think 2008 and 2009, the bridge plan was quite intentional and very different than our key competitors in terms of how they approached the recession.

To the question of the fourth quarter, we didn’t have the merchandise to clear at clearance prices. Essentially, we didn’t buy into product we didn’t think we could sell at profitable prices. If I had it to do over again, quite honestly we probably could have promoted in the month of December a bit more aggressively to get a comp in the month of December.

If you look at the month of January, as an example, had we anniversaried promotional sales of a year ago, we would have had 700 basis points higher comp in January. Had we been mostly off mall, we probably would have had 200 basis points more. But being in an off mall discount format, you can do the comparisons and get yourself a bit crazy. But we intentionally chose to run the business to improve our margins, to improve our cash flow and to build for the future.

So we saw no benefit of just driving market share at lower price points, training our customer to appreciate the offer. So I think that it was the right strategy. I think, frankly, it’s also the right time to stop doing that. We have the opportunity now of cleaning up the sales promotion calendar, cleaning up the inventory and improving our process in stores and online to go after profitable growth. So if you ask what we’re solving for, we think the infrastructure of our profitability is in place. So we’re obviously focusing on top line to drive incremental volume through the structure, and obviously profit conversion is what we’re focused on.

Liz Dunn – Thomas Weisel Partners

Okay. Great. Thanks.

Operator

Our next question is from the line of Adrianne Shapira with Goldman Sachs. Please go ahead with your question.

Adrianne Shapira – Goldman Sachs

Thank you. I made it. Mike, I appreciate the shift to go after share, but if I understood, it seemed as if you were looking for it to be skewed more to the back half, and understandable because that’s when Liz and Mango are coming. However, if we look at the Q1 expectation, we’re looking for a meaningful recovery on the two-year trend to down mid-to-high singles versus the down mid-teens we saw throughout the year last year. So maybe help us reconcile if you are looking for this to be skewed to the back half why Q1 looks as aggressive as it does to us.

Myron E. Ullman III

Well, I think, there’s a lot of moving parts here, Adrianne. I think, first of all, our inventories are in much better shape than it was a year ago, so we’re not going to rely so much on clearance. We know what is selling now and what’s selling is newness and freshness in the young businesses. Part of the skew to the back half is, frankly, the economic forecast for the consumer are more skewed to the back half, so we can’t necessarily buck the trend of the overall economy for the consumer.

We hope to do better than our plan on every metric. I think it would be wrong to over plan, and start the year with basically trying to run uphill by having more inventory than we can profitably sell or being expensed at the wrong rate or have wrong expectations.

Adrianne Shapira – Goldman Sachs

Okay. And then just maybe give us a sense on recent traffic trends, what you have been seeing in the past few months and how we should think about, as you’re going after share, the composition of positive comps? Should we expect both ticket and traffic to be up this year?

Myron E. Ullman III

Traffic trends are certainly improved over a year ago. The mall metric that we use, obviously the mall is the center of discretionary spending so it is a pretty good metric in terms of where the middle income customer is focused. Mall trends were about 8% down in terms of traffic a year ago at this time, and purchase conversion was maybe as much as 10% down for those that were there.

I would say, first of all, purchase conversion is returned to year-over-year the same and mall traffic kind vacillates between 2% and 3% down. It wouldn’t comment so much on ours. I think, if anything, it is favorable to the mall trend and our off mall stores traffic has consistently been better off mall than on mall.

I think that tracks with the customers opting more for need than discretion and closer to home, closer to discount, less family shopping on the weekend. Although I think you can see there is some return to more normal behavior and in terms of the upscale stores we’re seeing a better trend, and those that have traded their price points down a bit have gotten a bump. We think that we’re properly positioned for the climate we’re operating in.

Adrianne Shapira – Goldman Sachs

So just to be clear, it sounds as if traffic is still negative and should we expect you would hope for it to turn positive through the year and does overall mall traffic have to get positive for you to be in positive territory, as well?

Myron E. Ullman III

We tend to run 100 to 200 basis points better than the mall, so in other words we’re a better attraction, in a sense, than the mall, in some cases. So we don’t completely depend on the mall. But it is, in fact, a regional shopping visit as opposed to a more local closer to home visit.

I don’t have any way of forecasting what mall traffic is going to be in the second half of the year. I am not that much of a clairvoyant. I can tell you it is moderated from what it was a year ago and I would expect as the customer feels better about the employment picture as the political climate starts to be less volatile, and as the dialog is more positive about people’s future family income. I think that will be reflected in mall traffic.

Adrianne Shapira – Goldman Sachs

Thank you.

Operator

Thank you. Our next question is from the line of Wayne Hood with BMO Capital. Please go ahead with your question.

Wayne Hood – BMO Capital Markets

Yes, Mike, just to follow up on Adrian’s questions, I think for all of us it is a real leap of faith to go to flat to up mid-single digit in the back half of the year. Maybe it might be helpful, I am not sure you will give it, but just what you expect the year-over-year swing to be in promotional markdowns in the back half of the year to drive that kind of revenue or clearance year-over-year swings. And how much the new launches really could mean because we’re just taking it for leap of faith that you will get there?

Myron E. Ullman III

First of all, we planned the year for each quarter’s comp to get better. It is a stair step up as we earn it by the new initiatives. So I wouldn’t read in anything about incremental clearance activity to drive the volume. I think, frankly, we want to run our business with new merchandise and use the flow and all the tools we have to optimize the pricing as the customer responds to the offer.

I don’t see it as a leap of faith at all. I think it is well planned. The pieces add up. We have initiatives behind every one of the pieces. Obviously, it is up to us to execute. We executed the bridge plan superbly and I would expect us to execute this well in the coming year.

Wayne Hood – BMO Capital Markets

And my second question relates to the off mall business. Can you talk a little bit about what the comp trend has been relative to your other largest competitor there? Did you see year-over-year improvement in profitability it in those stores in the fourth quarter?

Myron E. Ullman III

Yes.

Wayne Hood – BMO Capital Markets

Do you want to elaborate?

Myron E. Ullman III

Did I see it -- our competitors and I said yes. I think the trends off mall for us have been typical, the trends off mall for them and the response to profitability in the off mall stores has probably the same trend at theirs. I think the customer during the worst recession in 80 years opted to shop closer to home and discount boxes. So to the extent you’re in a box that looks like other discount boxes, whether you’re discounted or not, I think you had the benefit during the downturn.

I think that will start to moderate as people start to feel better about their own family situation. I don’t expect a knee jerk pop up in consumer confidence. I don’t think there is a lot of factors out there that would say the customer is ready to declare victory. I think what we’re saying is we see opportunities where the customer is responding. We’re going after those in a prioritized way. Picking the most popular brand for women and having it be exclusively JC Penney, which is Liz Claiborne, we think is a legitimate incremental opportunity.

Sephora, which is the best way to buy beauty in our space, is incremental opportunity, it has been proven. I think MNG by Mango is fast fashion at a price. No other department store is going to have that in the United States. We think that’s an attraction. We know that JC Penney rewards customers come more often and spend more. And we’re planning double-digit increase in sales in dot com. So if you add those together we think we have a legitimate plan we intend to execute against.

Wayne Hood – BMO Capital Markets

Great. Thanks, Mike.

Operator

Our next question is from the line of Michelle Clark of Morgan Stanley. Please go ahead with your question.

Michelle Clark – Morgan Stanley

Good morning. I don’t want to beat a dead horse here but if you take a look at your first quarter comp guidance obviously significant acceleration in the two-year trend of roughly 440 basis points sequentially. Mike, are there any regions of the country maybe where you’re seeing a pickup in economic activity, whether it be improvement in jobs, growth, or maybe the housing picture is getting better that is helping to drive your more favorable outlook on the top line?

Myron E. Ullman III

Unfortunately, the customer doesn’t have the two-year stack to look at so hopefully she is reacting to what she sees in the store and what she sees online. I will say there is a bottoming effect probably in Florida and the southeast. At some point, as the business traded down because of the housing crisis and other situations, our business in California is quite strong.

And I think that that’s a function of our effectiveness there as well as the exiting of two key competitors. So there probably is some bottoming effect in the Sunbelt states that had the worst impact. Having said that, I think we have to earn it. You just don’t show up and expect to get the business because it is a better month. I think you have to earn it by what you have in the store and how you talk about it and the service we have in the store.

Michelle Clark – Morgan Stanley

Okay. And then in your prepared remarks, you guys mentioned the comp for February, April would be lower than the quarter average, March better. Can you give us a sense in terms of a basis point differential between the monthly comps?

Myron E. Ullman III

No, we’re not giving monthly guidance for the quarter. I think we said more than we usually say which is that we expect the quarter to be a plus comp and that we know the way the calendar falls out with Easter in March, exactly the juxtaposition of the holiday that March is likely to be better than February and April. But I think anybody that’s in the business would tell you that.

Michelle Clark – Morgan Stanley

Great. Thank you.

Operator

Thank you. Our next question is from the line of Jeff Klinefelter with Piper Jaffray. Please go ahead with your question.

Jeff Klinefelter – Piper Jaffray

Thanks for all the details today. Mike, one more on your market share or top line outlook. When you -- if we assume the apparel sector overall this year is going to be somewhere under your forecast of low single-digit increase, which I think is a safe assumption, you’re picking up some share, do you see that? Do you see -- do you look at it that way as picking up net share during the year? Do you see it more as your core customer increasing their purchase or are you anticipating some tradeback into your concept? And more specifically on the west coast, do you anticipate accelerating your share gains in the west coast from your ‘09 performance? Thank you.

Myron E. Ullman III

We have had good experience in apparel across the board. I think it has been the strength of the company. Our women’s apparel business specifically probably has had the leading business over the last three or four seasons, so that gives us some confidence where we have gone after fashion and classification merchandising we have been rewarded.

So to answer your question, we expect to gain some share and we have been gaining share. In our men’s business, we had a particularly strong Father’s Day. We had a great Christmas holiday in men’s and kids is responding well, so I think apparel has been our strength. I think we have very strong merchants in those areas, and they have been together as teams for an extended period of time. We’re not inventing new processes or reorganizing or anything else. We’re basically focused on giving the customer what she wants.

I think our MAT team process essentially allows us to have people very, very focused on particular segments and going after it. The young businesses give us confidence. The new launches, obviously most of those have a bigger effect in apparel than in big ticket. So I guess the answer is we expect to gain share.

Jeff Klinefelter – Piper Jaffray

And on the west coast, Mike, do you see changes in 2010 versus ‘09?

Myron E. Ullman III

We had a good experience in the west coast, in ‘09 and we expect to continue to improve our trend there. I think, frankly, if you want to talk on a more industry wide basis you could argue that in our sector there is too much space and too much merchandise. You look over the last eight to ten years, it has been acceleration of openings. About 100 million square feet in our space was opened in the last eight or ten years which create as lot more merchandise per capita.

And if you look at the state of California, as Kohl’s Shops [ph] and Mervyn’s went out of the market, there was a more rational amount of merchandise per square foot and space per capita, so that’s benefited I think all the people that are still marketing and successful in California. I suspect that will be the case in other markets going forward as the recession takes its toll on people who are having difficulty in this environment.

Jeff Klinefelter – Piper Jaffray

Okay. Just lastly, Mike, in terms of how you plan your promotions and your pricing, do you see absorbing the share, taking the share more across the moderate competitive environment or do you think you have an opportunity more in the reaching up and taking some of the more aspirationally priced consumers who are trading and looking for value?

Myron E. Ullman III

Since I mentioned, we didn’t trade down our prices. We think the opportunity is in fact looking at the higher price specialty stores, higher priced department stores. We’ve had excellent reaction to what we’re doing with those customers. We think the Sephora, Liz Claiborne, the Mango, those are initiatives that really appeal to a slightly more affluent, moderate customer and we’re looking for frequency and spend.

Jeff Klinefelter – Piper Jaffray

Okay. Thank you.

Myron E. Ullman III

Next one.

Operator

Our last question is from the line of Erika Maschmeyer with with Robert W Baird. Please go ahead with your question.

Erika Maschmeyer – Robert W. Baird

Thank you. G