For some reason Pershing Square’s Bill Ackman decided to bail on his near-20% stake in struggling retailer JC Penney (NYSE: JCP) at a 50% loss after being instrumental in the company’s recent troubles. Classic buying high and selling low (when the pain becomes too great) case here. As has been the trend lately, hedge funds are coming in and buying what Ackman is selling (Herbalife being the most recent example). Glenview Capital and Hayman Capital have announced large stakes in recent days and now a handful of hedge funds (adding in Soros Fund Management and Perry Capital) own about a third of the company’s common stock. At $14 per share, JCP’s equity is worth about $3 billion, excluding net debt of more than $4 billion.
I have written quite a bit about JC Penney over the last year or two, since Ron Johnson was hired as CEO and then fired after implementing a disastrous plan, and I am baffled as to why these hedge funds are so bullish on JCP at this point in time. The seeds for a turnaround have certainly been planted with Mike Ullman’s return as CEO, but from what I can tell from the numbers, it is going to take a while before they really start to grow. Perhaps these funds are playing JCP for a quick trade to the upside, which would make sense given that Ackman’s sale represents capitulation at its best (or worst, depending on your perspective), but it appears premature to bet on a sure-thing turnaround at JCP longer term. Let’s look at the numbers.
Thanks to Ron Johnson’s blunders, JCP’s sales this year should come in around $12 billion, down from $17 billion a few years ago. Operating costs (SG&A) for the prior four quarters came in at $4.4 billion, and have been slashed lately to preserve cash. Although the company’s gross margins are nowhere near their historical average of 37% today, CEO Mike Ullman is making the right moves to reach those levels again, in 2014 if you are optimistic.
Retail companies are not that hard to analyze and from these few figures we can figure out what level of sales JCP needs to reach cash break-even again, a crucial goal post if you are going to see a prolonged turnaround in the company’s share price performance. With 37% gross margins and $4.4 billion in annual SG&A costs, JCP’s operating break-even point is $12 billion at first glance, but the company is losing lots of money right now due to elevated capital expenditures and a huge debt load, which has only risen as the company’s sales have plummeted. Throw in $300 million of annual capital expenditures going forward (guidance from management) and $500 million of annual interest costs, and JCP actual cash break-even level is $14 billion of annual revenue. That means sales would have to rise 15% from here just to reach break-even. Could that happen in 2014? It could, but that seems quite optimistic. 2015 is probably more likely.
But even if you assume that sales rebound and the company stops bleeding cash, I don’t think JCP shares are that exciting at today’s $14 price. Macy’s and Kohl’s are very good department store comps for JCP. Both trade at about 6 times cash flow. Let’s assume JCP’s sales continue climbing and reach $15 billion by 2016. Assuming margins hold steady, JCP will have annual cash flow of about $1.1 billion. Multiply that number by 6 times and net out $4.3 billion of net debt and the equity would be worth about $2.3 billion, or $10 per share. In order for JCP stock to zoom back into the 20’s and stay there, the company has to be cash flow positive and begin paying down some debt (every $100 million of debt repayment would boost that $10 fair value price by 50 cents). Given that it will take a year or two for JCP to reach break-even, it looks to me like these hedge funds might be too early to the JCP stock turnaround party.
Full Disclosure: Long JCP senior notes maturing in 2018 at the time of writing, but positions may change at any time