An Inside Look at the New Retail Strategy at J.C. Penney (Part 2)

As was discussed yesterday, the much-talked about turnaround strategy at J.C. Penney (JCP), being led by Ron Johnson, is going to take a lot longer than many initially thought. Renovating two-thirds of their store base will take 3-4 years. Getting customers to understand and appreciate their new pricing model will take time, if it happens at all. If you contemplate the finished product in 2015, as Johnson has outlined it, the new JCP is likely to be very unique and intriguing for a large subset of shoppers. One hundred specialty shops, with large well-known brands such as Nike and Martha Stewart, connected by a “street” complete with food and beverage stations, comfy couches, free wi-fi, seasonal services such as Santa and gingerbread cookies for the kids in December or yoga classes and smoothies for moms to kick off the new year… it sounds great in theory. And that’s just it, in theory.

The end product won’t be completed for three more years. Until then, the stores will constantly have areas being boarded up and redone. With so many other choices in the typical mall, will shoppers leave JCP and have little reason to come back, even if the store in 2015 looks cool? And that’s another problem… the cool factor. It was obvious when I was at JCP on Monday that a large chunk of their core customers are women 50 years and over. Is that customer going to care that there is free wi-fi or nice couches in the store? Will they shop for denim fits and dyes at an iPad station? Are they going to warm to the RFID-enabled self-checkout kiosks that Johnson is planning? Sure, placing your shopping bag on the table and having the checkout station automatically read its contents and ring up the purchase is nice (all you have to do is swipe your card, no bar code scanning required), but is that too tech-heavy for the older generation? Can’t you envision the line at the cashier backing up pretty quickly if there is only one actual human operating it?

It seems this new prototype JCP store is geared towards a younger audience and I am not sure that crowd will head over to JCP even if it is designed for them. Again, you might have 100 shops in your JCP, but there are at least that many in the mall itself, and that is where most of these people already loyally shop. He won’t say it directly, but Ron Johnson probably knows that he really is launching a completely new store here, and will have to market it heavily so people know it exists and will give it a try.

Which brings us to the timing aspect of the investment story for JCP shares. The stock went from the high 20’s to the low 40’s when Johnson was hired, merely based on his previous retail successes. After Q1 2012 same-store sales dropped nearly 20%, the shares cratered to below $20 each. They have since rebounded to the mid 20’s, as investors hope for a rebound as more newly renovated shops are added. Second quarter comps fell by more than 20%. I don’t think an IZOD shop and a JCP house brand shop are going to move the needle in Q3, so I would expect similar results again this quarter. Whether they are down 16%, 20%, or 24%, though, is anyone’s guess.

When we get to the holiday season, then it really gets interesting. Wall Street analysts are an overly optimistic bunch, and typically project sales improvement slowly over time, regardless of the situation. The same is true of JCP today. Fourth quarter sales estimates right now are for a drop of 11% year-over-year, so the consensus is that revenue losses will be cut in half within a couple of months from now. Possible? Sure, maybe better sell-through of Levi’s jeans, from the new, fresh shop design, will offset a lot of the negatives from the older areas of the store.

But what if the holiday season for JCP actually gets worse? After all, they are trying to cut down on sales and offer everyday low prices. If customers balked at buying full priced items (regardless of the actual price level) over Memorial Day, why would their buying patterns change in November and December? In fact, would they not be even more inclined to look for sales over the holidays? JCP cutting back on sales should hurt them the most when everybody else is running Black Friday doorbusters. JCP already had a TV commercial making fun of long lines outside stores at 4am. Now they will be competing against them. How will sales be on Cyber Monday at Probably worse than and, right?

I know it is not the consensus view, but one of the reasons I have not bought a single share of JCP is that I think it is reasonable to think sales could get worse, not better, during the fourth quarter. If the first nine months of 2012 see sales declines of 20%, on average, why couldn’t a lack of Black Friday and Cyber Monday doorbuster specials result in a 30% decline during the ever-important holiday shopping season? Seems possible, in which case investors are in for a rude surprise when Q4 sales results come out early in 2013. Another round of selling may very well occur.

At that point, though, maybe it will be a better time to dip one’s toe in, if in fact you want to place a wager on the long-term future of JCP. Next year the company will be lapping an absolutely horrible financial performance from 2012. The bar will be low and expectations will be uninspiring. Even if 2013 brings more of the same; more renovations and little in the way of increased customer excitement, it is hard to imagine sales falling another 20% from 2012 levels. While a meaningful turn might be a ways off, 2012 might still mark the bottom for sales losses, and for the stock. And we all know the stock market is forward-looking, so even if we won’t see material improvement until 2014 or 2015, investors will bid up the stock ahead of time, just like they have in recent weeks on hopes that things will get better very soon.

Full Disclosure: No position in any of the companies mentioned at the time of writing, but positions may change at any time.


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12 Thoughts on “An Inside Look at the New Retail Strategy at J.C. Penney (Part 2)

  1. Let’s argue that the current fair pricing strategy fails. What does JCP do? JCP goes back to its promotional strategy. My belief is that the customer is not alienated, that the customer is not permanently lost. JCP will be able to win back that customer.

    Let’s take FY2011 earnings, JCP lost 152MM but included in those numbers are 451MM in restructuring costs. Real earnings power is 300MM per year. In 2010 earnings were 378MM and 2009 earnings were 251MM making 300MM per year a reasonable if not low number.

    In 2012, JCP is on track to cut 900MM+ in expenses. Some of these expenses are reduced employee hours as less changing of signs and marking down of prices are not needed. For example, Ron Johnson talked about how there were 500 sales per year, quite a bit of signage changing and marking down of prices. Moving back to a promotional strategy, I would argue that half of the savings could be lost.

    Adding back 450MM to real earnings power (on 219M shares outstanding) would lead to 750MM in earnings power, or about $3.42 in EPS.

    Buying at today’s prices leaves little downside (at 8x EPS) with multitudes of scenarios to win.

    Long JCP

  2. Chad Brand on September 5, 2012 at 3:01 PM said:


    I would only take issue with 2 things.

    First, I do not think it is reasonable to think they would be able to regain 100% of the lost customers. After a sales drop of 20% you need a 25% increase to get back to even. They might be able to get a majority, but probably not all as people are going elsewhere and some may really like it there.

    Second, using a multiple of EPS instead of EV/EBITDA paints a brighter picture than one might think. Remember, JCP has $2 billion of net debt (1/3 of its market value). Macys and Kohls both trade at 6x trailing cash flow. Even under your rosy scenario with respect to regaining lost sales, JCP would earn about $1 billion in annual EBITDA. At a peer multiple of 6x, the equity would only be worth $4 billion (because of the debt). That gets you to a share price of $18.00, if my math is right, or about 1/3 off from here.

  3. Chad, I agree with you, it might not be reasonable to say that JCP will regain all of its customers. I probably was too simplistic in explaining my view there.

    I am willing to make the assumption of regaining sales because I am decreasing other items in the scenario such as only keeping half of the savings. Maybe I argue instead that 2/3 of the savings are kept but sales only come back by x amount offsetting.

    I also argue that the store look will be improved from before (regardless of pricing strategy) which will increase sales. Because of lead times, we have not seen merchandise come in that is handled by Ron Johnson and team (also increasing sales). I think in the bear scenario those two items still hold up.

    Why choose EBITDA in this case? I am not a fan of EBITDA unless CapEx is high. I look at the amount of debt more as a function of how risky a company is in a downturn.

  4. Chad Brand on September 5, 2012 at 4:19 PM said:

    Reasons for using cash flow multiples instead of reported earnings are the usual suspects… they ignore non-cash items, factor in the strength of the balance sheet, doesn’t allow companies to have serial restructuring plans that eat cash every year but are excluded from reported earnings, negates differing D+A rates for competitors, etc. It’s just more apples to apples (assuming you would value JCP like M, KSS, DDS, etc) and considers real cash flow, not non-cash accounting line items. Interestingly, those 3 peers all trade at 6x EV/EBITDA so to me that is the target valuation I would assign to JCP, in any/all of the possible scenarios going forward.

  5. Very valid points. One company might depreciate equipment at 10 years, another at 20 years etc.

    Other then 2011, the restructuring and ‘discontinued’ operations have been light. I looked at the 10-K’s from 2006-2011 quickly.

    If you take EBITDA for 2011, it is 500MM. How much of the restructuring/management transition of 451MM would you take away, the whole thing? + half of the 900MM cost savings I estimated. I come up with a higher number of 1B EBITDA.

  6. Chad Brand on September 6, 2012 at 8:43 AM said:

    I think we’ll get clarity on these items in 2H 2012. Restructuring charges ($150M in Q2) will continue for awhile (hopefully not too long) and SG&A levels should stabilize and give us a good idea of where operating margins are at the current sales pace and gross margin level. I think people will disagree on how quickly sales pick up (I am not going to take management at its word until it proves it has a handle on the business), but the CFO yesterday said 2H 2012 will be similar to 1H 2012, which is in-line with my observations. I think Q4 results will be VERY telling.

  7. Just read your posting. Since I bought some JCP stocks, naturally will try to read anything JPC related.

    I have been in JCP stores before, many times. And I never saw any of them crowded, or was a popular place with people fighting for merchandises. So in your Part 1’s photos, which shows a kinda deserted store, I was wondering ‘what is the big deal?’.

    My point of bringing this up is that, with all the ’empty’ stores, JPC still have generated $15 annual sales. And that is profitable and enabled JCP to even issue dividend.

    BTW, a often quited reserach result says: average JCP shopers only go there 4 times a year. I would guess most time those shoppers go are around big holiday seasons: Back-to-school, Xmas time, and two more personalized picks.

    Labor Day does not seem to be one of those 4 ‘big event day’ for avg JCP shoppers.

    Now back to those big sales comp drops – Q1 has 19% yoy and Q2 has 20% drop. I am so amused that so many people (supposedly smart people) running around like headless chicken, yielding that ‘sky is falling’. Is the reason obvious, people? If not, open your eyes and go to a store – do you see the boarded up places? Stores are under renovations (building Shops within Store). Of course comps figures are dropping. They should be. Otherwise, what do you think?

    Then let’s talk perspective.

    In the old JCPenny stores, you can get $15 Bn a year. Then look around and see all those bright, contemporary displays, does anyone in his right mind think the future full-scale sales of the same JCP store groups will be 18% lower than the lousy, old environment?

    If you do, you must be really dim-witted, or don’t have a brain at all.

    So the conclusion is pretty obvious to me. And I believe to a lot of smart people as well.

    That’s why I am still building up JCP position.

  8. Most interesting analysis and discussion of jcp I’ve read thus far…

    I’d be interested to hear your thoughts about management’s continued assertion of 1b cash balance by year end.

  9. It is unclear to me why any thoughtful analysis of the future prospects of JCP would focus on the results of the past quarter or the next few quarters. This would be very short term thinking, and as the likes of Warren Buffett will tell you, the stock market is not about the last quarters performance or the next few quarters performance.

    There are some key issues that any thoughtful investors should be focusing on, which I really don’t see being mentioned in these notes. Firstly, one needs to assess earning power of the company. This should not be assessed based on the last quarter or the next few quarters for that matter. One should ask what will this company earn in the next few years, say in the 2014-2015 range. With as business model that is focused on 40% gross margins and cutting a bloated cost structure, i would think that it is very likely the earnings will be well in excess of the current levels.

    In addition, other key issues of the JCP idea are being ignored such as the ‘alignment of interests’ issue. One of the most powerful aspects of this idea is the fact that you how investors that know something about retail that are not only significant equity owners (i.e. putting their money were there mouth is), but they have seats on the board, such that their valuable options and viewpoints will be heard. Importantly, the CEO took $50 million of his own money and purchased options on the company, which carry many restrictions. Furthermore, he doesn’t make a cent unless the company reaches a price in excess of $37/share. Any student of the history of corporate finance and management will tell you that it is very rare when a CEO tries to get rich by spending some of his own money (i.e. most CEO’s get rich by cashing in on options that were given to them, usually by a compensation committee that did not have the proper alignment of interests (i.e. they don’t care about the options being granted as much as the recipient (CEO) does). From my view, the alignment of interests issue, is one of the key drivers of the ultimate success of this idea.

    And yes I am long JCP

  10. @Sean:
    I certainly agree with your assertion that $15 billion in profitable sales trumps any picture a blogger could take. Where I would disagree is that the sales decline was prompted by the construction. It coincided with the elimination of deep discounting, which is a shopper psychology issue that no store redesign will change. I do think a turnaround can occur long term here, but if the financial results are not going to bottom out near term, and won’t grow for several years until the redesigns are completed, then the stock can go lower before it goes higher. That is what I am trying to determine… do I want to buy at some point, and if so, when and at what price. My conclusion was that it was simply too early.

    The cash flow dynamics around holiday seasons can diverge from the reported earnings, so I am not in a position to know the cash inflow/outflow situation. My guess would be they will either hit $1B or be very close. It might be quite predictable after they get their holiday inventory purchased and have those outflows out of the way, regardless of whether sales fall 15%, 20%, or 25% in Q4.

    You are right. Long term the stock price will converge to a level that matches 2014 or 2015 earnings. That is why the P/E on 2012 EPS looks absurd (investors don’t care about 2012 earnings). Still, if sales losses accelerate in Q4 due to lack of Black Friday type deals, and reach -25 or -30%, the stock will decline further because estimates are higher currently. If normalized earnings are 3 years away, we have plenty of time to buy and maybe could get a price of $20 or lower between now and then. Wall Street is so short term focused that the stock will not start to discount normalized earnings until it sees some signs of improvement. That may take a while…

    I would end with this… Despite my assertion in these posts that it is likely too early for me to want to buy JCP in the high 20’s as a turnaround play, at a certain price I would get interested. In fact, we are getting close to that type of level. So, it’s not that I hate JCP as an investment, or that I don’t think Johnson can make this work, I am just trying to nail down a logical entry point based on what is happening. It the JCP business stabilizes for a few quarters and the stock gets a bit cheaper, you may just read a bullish post on this blog…

    Best of luck everyone!

  11. calvin on October 5, 2012 at 2:07 PM said:

    The original analysis fails to account for any traffic driving measures mgmt will take for the holidays (similar to haircuts at BTS). Also, the second quarter comp came in uglier than expected because they went dark on advertising.

    I would love just one analysis to include the value of the real estate, it’s mentioned as an afterthought in some reports. It’s probably worth low-mid double digits/share.

  12. Chad Brand on October 5, 2012 at 2:21 PM said:

    Management has guided second half 2012 to be similar to the first half, so they clearly don’t think any traffic gains will be material.

    I would guess the reason people ignore the real estate value is because you can’t run JCP as a retailer AND liquidate it as a real estate company. It’s one or the other. Since they have said nothing to make anyone think they will liquidate and monetize real estate, it’s value is less relevant. It may be worth 10-15 per share as you say, but that is not a reason to buy the stock in the 20’s, it just means they won’t go bankrupt because they have hidden assets they could sell if needed (very similar to the situation at SHLD). If the stock dropped to 10 or 15, then you would see more talk about the underlying asset values. So far 19 or so was the bottom.

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