Description

Bear Thesis & Current Market Consensus:

JC Penney (JCP) is a third-class department store, which is a segment in decline.  While not capable of great returns, JCP did have some earnings power, but now that has been jeopardized by new management’s foolish attempt to reinvent the company.  JCP’s elimination of discounting will not work and has done permanent damage to the brand.  The changes instituted by management are eerily similar to what Eddie Lampert introduced to Sears (SHLD), a strategy that has not worked.

Variant Perception:

What JCP is doing is not as revolutionary as investors think; most of the moves are just simple and easy cost cuts.  JCP’s switch to everyday low pricing from discounting does not hurt customer experience or value. This is very different than SHLD’s strategy of cutting store capex, which yielded unappealing stores.  JCP could reverse this policy if need be, with little damage.  JCP actually has significant competitive advantages, including an estimated $11 billion of replacement value in real estate.  The strategies being employed by the new management make sense, and the upside potential is huge.  At the current stock price, we need very little of the strategy to work, just an avoidance of a complete disaster.  Right now with none of the more positive aspects of management’s new plan implemented, JCP should be at its absolute low point, and the stock price seems to reflect that reality.

You can find both good arguments for both the bull & bear case online:

Bear Case: Though Davidowitz is a little loud, I think this is basically the bear thesis in a nutshell: http://finance.yahoo.com/blogs/daily-ticker/j-c-penney-sears-ron-johnson-done-incalculable-160736591.html

Bull Case: Bill Ackman gives a much fuller story than I have. Here is his Ira Sohn presentation: http://www.scribd.com/doc/94429025/AckmanJCP.

JCP itself gives extremely full presentations, which you can access on their website.

Management’s Plan & Valuation:

Essentially JCP’s plans are very simple: cut the costs of a company, which over its 110-year history has grown to 170k employees and has become very bloated.  I believe these are the type of cost cuts that, quite frankly, could be assumed to be nearly 100% doable if done by merger or a new management team.  However, since JCP has wrapped these cuts as part of its pitch to revolutionize the department store, investors perceive them as much more difficult then they appear to be.  If JCP had pitched its story as cost cuts and then emphasized the possible upside of the new design of the stores, the stock would likely be much higher today.  Instead, JCP hyped up the transformation of the store, leading off its analyst day presentation with a comparison to Apple stores, which caused the cost cuts appear secondary.  While this approach wowed investors at first, their patience has become limited even before the plan has been rolled out.

We put the cost cuts into 4 buckets: home office, store efficiency, cash wrap cut, and the change in promotional policy.  The first three are pure cost cuts achieved by simple blocking and tackling. Remember, this is a company where the average employee made 1,000 clicks on YouTube per month, and 20% of corporate internet bandwidth is used on Netflix. All it really takes to analyze JCP is a simple smell test; go into a JCP store, and ask yourself is this a model of ultimate efficiency?  Clearly not.  You could really look at any department store and recognize that, but JCP is actually the worst of the bunch.  The numbers clearly bear that out.  JCP has 40% more supervisors per store, and 15% more employees per store than competitors.  It is clear that there is a lot of room for improvement.  Below, Exhibit 1 presents our valuation for JCP, with just part of the planned cost cuts.  Given where the stock price is, this seems to be what the market is pricing in. 

We think we are being extremely conservative in our estimates.  Often when companies set out cost-cutting programs like this, their results exceed their initial targets.  Additionally, the store efficiency number given by JCP actually excludes 400 smaller stores.  We also excluded $50 million of reduced costs from in-store costs (putting up sale signs) related to discounting practices from store efficiency and put that in place of the discounting practice.  Lastly, we used the already depressed FY2012 EPS.

The bearish answer to this is that JCP’s discounting policy has done irreversible damage to the company, making this analysis irrelevant.  We completely disagree.  If the policy does not work, JCP should be able to reverse course on the discounting policy with little or no long-term damage to the company.  After Macy’s (M) took over Marshall Field in August 2005, the company aggressively cut back on coupons, only to reverse the process.  M suffered no permanent damage from the policy shift.  It is quite logical to think that those customers, who go to JCP only when sent coupons or for supposed sales, would return when those come back.  In fact, one could make an argument that such customers may even spend more when the coupons return after a long disappearance.  We also could not think of a company that has gone out of business due to exorbitant pricing (note: this excludes companies which are forced to price highly because of a competitive disadvantage), with the exception of fraudulent companies. 

Now we can look at JCP, adopting the assumption that it gets 100% of the in-store efficiencies and the $50 million from in-store savings on discount preparation.

As you can see JCP already has some upside, just off of simple cost cuts and continuing to run at a suboptimal sales rate.  This analysis does not include the changes to inventory ($500+ million opportunity), supply chain, and capital allocation.

Further Upside:

We would first point out that JCP’s switch to everyday low pricing makes sense.  The practice seems to have served Wal-Mart (WMT) well, and it appears that coupon- and promotion-driven models have underperformed fixed-price format stores. 

In addition to the $300 million in decreased advertising spent mostly within the new everyday low pricing strategy, JCP has a real opportunity to increase sales.  JCP pays $4.00 / sq. ft, while non-anchor tenant mall competitors pay an average of $40 / sq. ft.  JCP is essentially going to attempt to arbitrage the difference.  Up till now, JCP was primarily focused on its private label, but now the idea is to adopt a store within a store model (goal is to go from 45% national brands today to 75%-80% by 2015).  JCP will be opening up to 100 stores within a store by 2015 in a partnership with outside vendors.  Basically JCP will almost become a mall itself but at rents 90% cheaper than its competitors.  Even JCP bears seem to think this concept makes sense.  JCP has already received interest from 110 vendors for this concept, with the first ten shops to be completed by year end 2012.  Not only do we believe the store within a store idea will improve sales through better product, but we think consumers will find the layout much more enticing.  JCP will then complement this approach with a town square in the middle of the store (the idea is to walk through the rest of the store to get there) with amenities like free ice cream in the summer.  The town square could be a strong draw and a clear differentiating factor in comparison with other competitors.  The bar is set pretty low; the department store experience is one of the worst in retail, and JCP’s sales / sq. ft. are barely above what they were in 2009, and under 10% above what the company earned in the mid-1990s.  Just a 10% improvement in sales would still bring JCP sales to 5% below where the company was at the 2007 peak, but 30% incremental margins would bring a dramatic difference to the bottom line.  If JCP were to regain an upward trajectory in same-store sales, then a higher terminal multiple (we will use 15) is likely.

The amazing thing here is that we have not put in any heroic estimates, just simple cost cuts and an extremely modest rebound in sales. Within this paradigm, we get a current value that is 150% above today’s price, and a price in under 3 years that is more than triple today's mark.  With the elimination of JCP’s dividend, there should be some extra cash for JCP to allocate, which we did not factor in. 

If you look at the analyst day presentation and consider new CEO Ron Johnson’s vision for what JCP will be, it is easy to see an upside well above our estimates.  While we have not added value for Ron Johnson or Bill Ackman, it is easy to see a plus.  Ron Johnson clearly has merchandising expertise, which he demonstrated at Target (TGT), and he seems to have learned some design expertise while head of retail at Apple.  The management team that Johnson has assembled so far seems to be exceptional.  Ackman’s involvement should lead to an optimized capital structure, which could increase the upside once the turn-around is complete.

Point of Maximum Pessimism:

JCP has now done more than a round trip since Ron Johnson was named CEO (6/14/11).  Yet almost none of the plans Mr. Johnson has laid out have been implemented, with the exception of the switch in pricing strategy.  Customers now have the shock of the new pricing strategy but no additional reason to walk in or buy.  This is clearly the worst possible time for JCP, which may make it the best time to invest.  Clearly things have to get better from here.  In August, we will see the first few stores within a store, and 50% of product will represent new or revamped brands.  Being at the point of maximum pessimism should help us time our investment and allow for a better entry point.  The point of maximum pessimism combined with $11 billion in replacement cost for real estate and the fact that we only need some of the cost cuts to justify the current stock price, gives us our margin of safety.

Risks:

Switch to everyday low pricing may flop.

Management may lack the flexibility or the ability to change its plans, if they prove to be ineffective.

Management is planning on self-funding the transformation; if funds fall short, the cost of capital could be high.

The U.S. consumer may weaken, if the economy weakens.

Catalyst