(Adds executive comments, new online initiative)

By Nathan Layne

May 13 (Reuters) - J.C. Penney Co Inc reported a smaller-than-expected quarterly loss on the back of solid demand for apparel and women's handbags, and lifted its annual margin target in a sign the department store chain is getting a better grip on costs.

The company also said it would start selling Sephora beauty products online this month in an expansion of that partnership. J.C. Penney currently has more than 500 Sephora outlets within its stores and plans to add more.

Marvin Ellison, who is due to take over as chief executive in August, talked up a handful of initiatives that included expanding the women's shoe section and investments in technology to make the supply chain more efficient.

"I've had the opportunity to go through a transformation like this in a past life and I would say we are a fourth of the way through," the former Home Depot executive said on an earnings call. "We hope to see benefits in the fall but more benefits starting in 2016."

The company posted a loss of $167 million, or 55 cents per share, in the first quarter ended May 2, compared with a net loss of $352 million, or $1.15 per share, a year earlier. Excluding items, the loss was 57 cents per share.

Analysts on average were expecting a loss of 76 cents per share, according to Thomson Reuters I/B/E/S.

The retailer said sales at stores open more than a year rose 3.4 percent in the quarter, just below guidance. But it raised its annual forecast to a range of 4 to 5 percent from 3 to 5 percent.

J.C. Penney's sales have been on the mend since the company abandoned an ill-fated attempt to move upmarket in 2013, reintroducing traditional discounts and focusing on a narrower set of products. However, profitability has proved elusive.

The company said its gross margin improved 330 basis points in the first quarter to 36.4 percent of sales, reflecting strong sales of private brand items which fetch relatively high margins. Selling, general and administrative expenses dropped $44 million, helped by lower advertising costs.

The better cost picture was achieved despite wage pressure that reflected merit-based pay increases last year and efforts generally to stay competitive on wages, outgoing CEO Mike Ullman said.

The company said it now expects gross margin to improve 100 to 150 basis points for 2015, up from a 50 to 100 basis points boost under a prior forecast.

(Reporting by Nathan Layne in Chicago; Editing by Chris Reese, Alan Crosby and Frances Kerry)