Will a border tax crush J.C. Penney?

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Congressional Republicans have been touting a corporate tax reform plan that would exempt exports from taxation while preventing companies from deducting the cost of imports when calculating their taxes. The plan would also reduce the baseline corporate tax rate from 35% to 20%. After initially criticizing this proposal, President Trump has more recently shown tentative support for this so-called border tax, increasing the chances that it will be implemented.

Economists and Wall Street analysts have noted that department stores could be big losers if the U.S. implements a border tax. Nearly everything they sell is imported.

J.C. Penney(NYSE: JCP) has been cited as a company that is particularly vulnerable because of its weak profitability. However, paradoxically, its accumulated losses could actually be an advantage in this case vis-a-vis rivals like Kohl’s(NYSE: KSS) and Macy’s(NYSE: M).

What the border tax would do

The current border tax proposal is designed to encourage domestic production. It conveys a big tax benefit to companies that export goods and services, while penalizing importers.

Department stores like J.C. Penney, Kohl’s, and Macy’s all spend more than half of their revenue on buying inventory. While they do sell some products that are made in the U.S., the vast majority of their merchandise is imported. Thus, a significant amount of their costs would be hit by the border tax in one way or another.

For example, suppose J.C. Penney currently spends $5 billion a year — roughly 40% of its revenue — on imported inventory, with half being directly sourced by the company (for its own private brands), and the rest being supplied by vendors. J.C. Penney wouldn’t be able to treat the $2.5 billion it spent on direct imports as an expense, making its profit appear to be $2.5 billion higher for tax purposes. At a 20% rate, this would put it on the hook for $500 million in taxes.

Meanwhile, its vendors would face a similar increase in their tax bills. They would presumably try to pass most of these costs through to J.C. Penney.

Given that J.C. Penney is barely profitable, it can’t afford to bear any extra costs. However, if it tries to pass these cost increases on to customers, J.C. Penney’s working-class and middle-class clientele would probably just buy fewer items.

J. Crew

The apparel retailer has had a difficult few years.

J. Crew announced in November that sales at stores open at least a year dropped 8%, following a decrease of 11% in the same period last year.

Now, the company is attempting to change things up. In November, the retailer axed its popular bridal line. A month earlier, J. Crew launched an athleisure line with New Balance — a collection that Business Insider felt failed to live up to competitors’ standards.

Sears

Sears’ sales continued to plunge in 2016. In the most recent quarter, revenue fell 13% to $5 billion, with losses widening to $748 million from $454 million in the third quarter last year.

The retailer is closing hundreds of stores, with more than 170 Sears and Kmart locations shuttering this year. 

And, things are only getting worse — many analysts say 2017 is likely the year that Sears goes bankrupt.

Macy’s

In August, Macy’s revealed plans to close down 100 stores in early 2017 as the retailer looks for a solution to slowing sales and the growth of online competitors.

In November, the retailer reported that net income for the third quarter fell by 87% to $15 million, following a 46% decline over the same period last year. Same-store sales at stores open at least a year fell 3.3%.

“These figures show a company grappling with what looks like terminal decline,” Neil Saunders, CEO of the consulting firm Conlumino, wrote in a note to clients.

Hugo Boss

Huge Boss simply isn’t cool any more.

In a UBS report released in Decemberonly 20% of people surveyed said that Hugo Boss was a cool and fashionable brand, compared to nearly 40% a year ago.

Being off-trend is seriously impacting sales. In November, the company adjusted its sales prediction for 2016, saying sales could decline up to 3% in the year.

Coach

The handbag maker stopped selling merch at more than 250 department stores in 2016 in an effort to regain its premium, luxury status.

However, the move hasn’t paid off yet — in November, when reporting the company’s the most recent quarter, Coach said it had its slowest growth in four quarters.

Nasty Gal

A decade after it was founded by then 22-year-old Sophia Amoruso in 2006, Nasty Gal filed for bankruptcy in November.

“Filing for bankruptcy is actually the most responsible decision for the business,” Amoruso said at an event in Sydney, Australia when the news broke, the Independent reported.

The trendy fashion retailer had been through some tumultuous times in recent years. Amoruso stepped down as CEO in 2015. In her absence, the retailer laid off employees and former workers complained of a toxic environment.

It looks like Nasty Gal could get a fresh start in 2017. On Wednesday, British online fast-fashion retailer Boohoo.com announced it was bidding $20 million for Nasty Gal’s brand and customer list. 

Lands’ End

In December, Lands’ End reported a 14.3% drop in same-store sales in the third quarter, with a 49% drop in apparel sales. That marked the ninth consecutive quarter of declining sales for the company.

To make matters worse, Lands’ End has also been dealing with problems in its executive suite.

In September, Federica Marchionni left her position as CEO. According to the Wall Street Journal, her departure was triggered by employees’ disagreements with Marchionni’s more high-fashion approach to the brand as well as the limited time she spent in the office — just one week every month.

Aeropostale

As teens’ interest in the brand waned, Aeropostale filed for Chapter 11 bankruptcy in May.

After declaring bankruptcy, the retailer announced it would close 154 stores in the US and Canada.

“Back in the day, all of the cool kids had trendy brand names plastered across the front (or back) of their clothing. The trend has changed, and style today, perhaps encouraged by social media, embraces individualism and uniqueness,” wrote Nicholas Rossolillo in finance publication The Motley Fool. “Online ordering and heavy discounting have also taken a toll on the industry, especially mall-based retailers. Aeropostale simply hasn’t been able to adapt.”

Kate Spade

Kate Spade’s sales have suffered in 2016 as tourists’ visits declined and discounting grew more popular, making it harder to sell items at full-price.

Now, the company is reportedly working with investment banks on a possible sale, the Wall Street Journal reported Wednesday.

The news comes six weeks after New York-based hedge fund Caerus Investors sent a letter to Kate Spade pushing the retailer’s board to consider a sale.

“We have become increasingly frustrated by management’s inability to achieve profit margins comparable to industry peers,” Caerus’ founder, Ward Davis, and managing partner, Brian Agnew, wrote.

Would a border tax have no impact at all?

Critics of the border tax proposal have said that any measure that taxes imports will drive up consumer prices. However, proponents of the border tax have argued that taxing imports while effectively subsidizing exports wouldn’t impact consumer prices.

The rationale is that the change in tax policy would drive a big increase in the dollar’s value, relative to other currencies. A strong dollar would allow importers to spend less money buying goods abroad. In theory, that savings could fully offset the tax due on imports, leading to zero net effect on consumer prices.

However, it could take years for exchange rates to fully adjust. Additionally, since so many commodities are traded in dollars, a strong dollar could spark inflation in emerging markets, driving up local-currency prices. Finally, department stores pay many overseas suppliers in dollars, so they wouldn’t see any savings until they renegotiated those contracts.

J.C. Penney’s trump card

In the long run, retailers will have to pass any cost or tax increases through to their customers. But in the short run, companies like Kohl’s and Macy’s might face more pressure to raise their prices than J.C. Penney.

Kohl’s and Macy’s have both experienced weak sales trends recently, which has translated to falling earnings. Nevertheless, they still pay hundreds of millions of dollars in income tax each year. By contrast, J.C. Penney pays no income tax, because it has racked up billions of dollars in losses over the past five years or so.

JCP Income Tax Paid Supplemental Data (TTM) Chart

JCP Income Tax Paid Supplemental Data (TTM), data by YCharts.

As a result, if a border tax were implemented, Macy’s and Kohl’s would have to immediately raise their prices — or reduce discounts — to protect their cash flow. The increase in their costs, either through higher tax bills or higher payments to suppliers, would likely exceed $1 billion annually.

J.C. Penney would face a similar increase in costs from vendors. But for private brand items that it sources directly from overseas, J.C. Penney wouldn’t face a tax increase — for now.

Returning to our earlier example, if J.C. Penney spent $2.5 billion in a year on direct imports, this amount would be treated as “profit” for tax purposes. However, J.C. Penney has $2.6 billion in loss carryforwards, reflecting its accumulated losses from the past few years. These tax credits would fully offset the tax bill from J.C. Penney’s $2.5 billion in imports.

In effect, this means J.C. Penney would be able to phase in any price increases over the course of a year without negatively affecting its profit or cash flow. Kohl’s and Macy’s wouldn’t have the same luxury.

A border tax would undoubtedly pose some long-term risk to J.C. Penney since the company would eventually have to pass through any cost increases to its price-sensitive customers. But in the short run, it could present an opportunity for J.C. Penney to use its tax shield to steal market share from Kohl’s and Macy’s.

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Adam Levine-Weinberg owns shares of J.C. Penney and Macy’s. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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