J.C. Penney Might Be Walking Into the Same Private Label Trap That Kohl’s Did

August 17, 2016, 9:45 PM UTC
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J.C. Penney (JCP) thinks it has found the ultimate weapon to keep its turnaround on track: ramping up its own house brands.

At Penney’s first investor day since 2014, company executives outlined their three-year plan: one of the centerpieces of the updated strategy is doubling down on its private brands.

J.C. Penney CEO Marvin Ellison, whom Fortune profiled earlier this year, has long said that house brands like clothing labels St. John’s Bay and Arizona, and houseware label Cooks, which generate just over half of Penney’s revenue, had a lot more potential.

And on Wednesday, company executives told Wall Street that private brands, that also include Ambrielle lingerie, Worthington, a.n.a. and Michael Strahan, would reach 65% to 70% of total sales by 2019 by adding new brands and expanding existing labels. Already in the last year, Penney has expanded its private label business, introducing Boutique +, a new Penney label targeted specifically at plus-size customers.

It’s easy to see why Penney is doubling down on that side of the business: private and exclusive brands offer higher gross profit margins than so-called national brands, or merchandise that is broadly available across retailers. (It’s about 40% for Penney private brands compared to 30+% for national brands.) They also give a retailer more control over supply, promotions and marketing of the items it sells. And best of all, such merchandise is not available on Amazon or elsewhere, given customers a reason to choose one retailer over another.

Of course, all that is predicated on customers wanting those brands in the first place, not an easy proposition. Even if a retailer’s brands are popular- indeed, St. John’s Bay and Arizona at their peaks were billion dollar Penney brands- any store chain needs to have an ample supply of national brands like Nike (NKE), Levi’s and Jockey to attract a broader swathe of shoppers.

That is a lesson Kohl’s (KSS) learned the hard way a few years ago. In 2014, Kohl’s private and exclusive collections reached a peak of about 52% of sales, way up from 30% in 2005. As part of its turnaround strategy, Kohl’s has since dialed that back down (to about 48% in 2015), with the CEO telling Fortune at the time that the focus on house brands had hurt Kohl’s reputation for national brands. (At Macy’s, it’s currently about 25%.)

More recently, Kohl’s this year re-launched its billion-dollar Sonoma apparel and home goods brand, it has also landed a deal to sell Under Armour (UA), while continuing to give prime real estate in its stores to national brands like Nike (NEE) and FitBit. (FIT)

As for Penney, it has a long history with in-house brands: a century ago, founder James Cash Penney was frustrated by vendors who would not sell him their products, so he started making his own merchandise in 1914, starting with Marathon Hats for men. Penney opened its first overseas sourcing office in 1959 and by the 1990s, Penney had centralized its design and sourcing functions to set itself up as a vertically integrated manufacturer. On Wednesday, Penney said it would cut the time it takes to get some new merchandise into stores by six weeks, the better to compete with fast-fashion retailers.

It’s easy to see why Penney is tempted by this massive private label expansion: after years of losses following a sales collapse in 2012 and 2013 after Penney tried to become a hip retailer, the company is eager to get back to profit: Penney expects to post a break-even profit this year and post a profit of $400 million to $500 million, or $1.40 to $1.50 a share by 2019, CFO Ed Record said at the analyst meeting. And the company is targeting earnings before interest, taxes, depreciation and amortization (EBITDA, a key performance metric used by its debtors) of $1.2 billion in 2017 (on sales slightly more than $13 billion), to improve its credit rating, a top priority.

Still, launching brands can cost hundreds of millions, with no guarantees a brand will catch on, particularly for apparel where there is a glut of offerings.

At the same time, Ellison seemed to recognize that there is a limit to how much new revenue this will bring, seeming to emphasize higher profits. The CEO said that getting back to $18 billion in annual revenue right before the botched 2012 transformation was not an “overarching” priority compared to raising profitability. Indeed, Penney said to expect sales between $13.8 billion and $14.3 billion in three years time, on the expectation of 3% annual growth in comparable sales.

“The landscape has dramatically changed,” he said of when Penney’s annual sales were $18 billion.

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