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 jcp.com? Probably worse than macys.com and kohls.com, 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. 

An Inside Look at the New Retail Strategy at J.C. Penney (Part 1)

On September 1st, J.C. Penney (JCP) debuted more new "shops," bringing it about 10% of the way through a transformation plan aimed at having 700 of the chain's 1100 department stores offer shoppers 100 distinct "store within a store" experiences by 2015. My wife and I used part of our Labor Day holiday to do some market research at a local Portland mall and check out the progress at one of these renovated JCP locations.

I have been doing a fair amount of work on JCP lately, trying to figure out if it is a turnaround story I want to play or not. For me, there are three essential questions to ask when making this kind of investment decision. One, do I want to make a bullish bet on a JCP turnaround under new CEO Ron Johnson? Two, at what share price do I feel the risk-reward is attractive enough for the stock? And three, since this is a multi-year turnaround story (renovating 700 stores while they remain open is not easy), at what point in the process would it make the most sense to start buying?

With much of the valuation work done already from my office, my in-person store visit on Monday was more about checking out how the renovations looked and how shoppers were responding to them. I went to one location, in the morning, on a holiday, so this is by no means enough observation to draw strong conclusions about customer traffic, but it was enough to get an idea of where these stores are heading over the next few years.As soon as you walk into the store, you see the original "store within a store" concept, Sephora, that JCP introduced even before Ron Johnson took over as CEO:

The Sephora stores inside J.C. Penney have done very well. They look identical to actual Sephora stores, just with fewer square feet. The successes JCP has seen so far are often cited as a reason why the concept of converting the entire JCP store into dozens of specialty shops has huge potential. I would agree with that assessment, but it completely depends on what products you are selling. Sephora is very popular right now, so it would be hard for it to do poorly. What about other brands? That is the big question mark at this point.

Which brings us to the new shops JCP unveiled this month; IZOD, Liz Claiborne, and JCP (a generic house brand for basics). These are in addition to those already in place; Sephora, iJeans by Buffalo, Levi's, The Original Arizona Jean Co, and MNG by Mango. You may have noticed something odd about that list already, but we'll get to that shortly. For those who have not been in a JCP lately, here is what these new shops look like:

Notice there is nothing earth-shattering or particularly new here in terms of product. What they have essentially done is group product by brand and install upgraded fixtures and displays, so you feel like you are shopping at a smaller Gap or J Crew store within the mall, not at the enormous J.C. Penney anchor location. For instance, here is what most of the store's floor at JCP still looks like:

Obviously, cleaning up the stores by making them less cluttered, adding better lighting, and displaying the clothes more effectively is probably an investment worth making, if you are trying to revamp a department store and position it for long-term survival. Still, the early response by customers has been poor. Making the stores look nicer has not counteracted the negative impact from JCP's decision to reduce the number of sales they run and opt instead for everyday low prices on most items. Rather than paying $25 for a sweater originally marked $75 or $80 (although nobody ever paid that price), JCP has faith that shoppers will make the same purchase, even if it is marked $25 from the start with no discount. Shoppers are balking. The first quarter after the change (Q1 2012), sales dropped 19%. Last quarter they fell by 22%. I don't think there is reason to think the current quarter will be much different.

The pricing issue was something I made a point to watch for during my store visit. Again, it was before noon on Labor Day, so there was not much traffic in the stores. However, you may have noticed that there weren't any shoppers in the photos above. I was not the only one in the store, and I did not ask anyone to get out of the shots. So where were they? Well, look at that, there they are:

The clearance rack. Despite JCP's goal of getting 80%+ of their sales from full price merchandise with their new everyday low price strategy, the store still has product it needs to move quickly, so the clearance racks have not gone away. Interestingly, the signs on these racks do not simply say "clearance" but rather "clearance - $5 and up." Why put "$5" on the sign, which just signals you have really cheap sale merchandise (and gets you thinking that full price may be overpriced)? I don't know. It seems counter-productive. My wife even mentioned that she saw a $20 sweater that she liked, but since it was positioned close to the sale racks, she instinctively looked up to see if it was on sale. When it wasn't, she questioned whether people would think $20 was a good enough price (even though a $20 sweater, on its own, is quite inexpensive). This is what JCP is facing with their new strategy.

Even bigger than pricing strategy is that shoppers are still gravitating to the sale racks, even with these new, upgraded specialty shops. That is where the customers were on Monday, which jives with the trend they have seen so far this year; less traffic, fewer sales, and lower gross margin on each sale. Shoppers are still fixated on sales, and if you don't have as many, they will either leave the store, or only buy the cheaper stuff. Not a good recipe for a retail turnaround (given that JCP is trying to do the exact opposite).

After my in-store visit to JCP this week I was hoping to shed some light on the first of three questions I mentioned at the outset of this post; do I want to make a bullish bet on a JCP turnaround? When you listen to Ron Johnson articulate the ideas he has, they make sense and you can't help but be inclined to think he just might make it work. And he might. However, I had mixed feelings after seeing the store. The shops look nice, but so far customers have not responded, in large part due to pricing. They still flock to the sale racks.

I think JCP can fix this problem to a large degree by offering unique product (like Sephora) in order to differentiate themselves from other stores like Sears, Kohls, and Macys. I am not sure that the Levi's, Arizona Jean Co, and JCP brands do that. Even Liz Claiborne, which is exclusive to JCP, might not be different enough from other similar brands found in competing stores to make people want to go to JCP first.

Not only that, but did you notice the odd choice for the initial set of new specialty shops? Levi's, the Original Arizona Jeans Co, and iJeans by Buffalo are all among the first eight shops. How many choices of jeans does one need? And is that really the best way to use their concept, by duplicating product so much? And you know there are other brands of jeans in the store already (I saw Lee jeans right next to the Levi's shop, for instance). In fact, while we were there my wife overheard a female shopper ask for some help finding a pair of new jeans. The employee walked her over to the Levi's shop, but then told her, unfortunately, that there were jeans scattered around the store, so although this was the best place to start, she would have to walk the entire floor to see everything they had.

That type of shopping experience is exactly what you would expect from a large, disorganized department store; the exact model JCP is trying to get away from. If you are aiming for a wonderful shopping experience (Ron Johnson is aiming low --- trying to becoming "America's favorite store"), you probably don't need three denim brands in your first eight shops. And if you do, at least put them close together and remove the other jeans from the rest of the store. First impressions are everything, as new shops are going to be added periodically over the next three years.

As you can see, this is still very much a work in progress. So, I remain skeptical and will likely want to see some proof of changing customer behavior in future quarters before I take a bullish stance. Right now it is more about the potential for success (if executed better in the future) and less about solid progress thus far.

More thoughts on JCP are coming shortly, so stay tuned.

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

Consumer Debt Paydown Crimps GDP Growth

It's election season so both candidates would love for you to think that the POTUS has a lot of control over economic growth, but this week we got a report that sheds light on one of the major reasons the U. S. economy is growing at around 2%, down from its long-term average of around 3% per year. The New York Federal Reserve reported that credit card debt balances last quarter dropped a $672 billion, a level not seen since 2002. It also marks a 22.4% decline from the peak we saw in the fourth quarter of 2008.

So how exactly has this de-leveraging trend negatively impacted GDP growth? Well, consumer spending represents about 70% of GDP, so a drop in credit card balances of $200 billion over the last few years represents a lot of money that was sent off to pay bills, not spent on goods and services. Toss in another $100 billion of spending that would normally be incremental over that time period due to overall growth in the underlying economy, and you can see that about $300 billion of consumer spending has been absent from the system, compared to what would have been normal.

With annual U.S. GDP at around $15 trillion, this consumer credit card de-leveraging represents about 2% of GDP growth lost. Over 3-4 years, that comes out to about 0.5% GDP impact per year. In a world where GDP growth has dropped a full percentage point from its long-term normalized level, consumer debt repayments account for a major portion of that slowdown. You aren't likely to hear much about that on the campaign trail, but politicians rarely deal with facts and truths when it comes to hot-button issues like the economy.

Apple Sets Market Value Record As iPhone 5 Debut Nears

Earlier this week I wrote a piece on Seeking Alpha that outlined why I believe investors are likely to value Apple (AAPL) shares similarly to other blue chip consumer brands, which would mean a valuation of 10-12 times trailing cash flow (defined as EV/EBITDA). Bulls on the stock have a multitude of reasons why Apple should trade at a premium, but in recent quarters the market has disagreed. In fact, even as Apple stock has broken out to new highs, setting a new market value record in the process, AAPL shares fetch about 9 times trailing cash flow (at the current quote of $665), a discount to other superb consumer brands.

If fair value is somewhere in the 10-12 times cash flow range, that would equate to $725-$850 per share. That would mean fair value is somewhere between 10% and 25% above current levels. That is why I continue to hold the stock, despite its enormous run-up lately.

In terms of future potential, I continue to be intrigued by the possible launch of an Apple TV set. When I think of the large market opportunities for Apple, those that can really move the needle for a company worth more than $600 billion, the television market is the only one they have yet to target that has real appeal. Outside of desktop, laptop, and tablet computers, phones, music players, and televisions, I am not sure where else Apple could find significant future expansion potential (although I am sure they would disagree and are looking for some already). After launching a TV, I think Apple's strong growth days might fade. Assuming the stock traded in line with other blue chips at that point, I would likely look for an exit point.

I have not sold yet, mainly because a TV is still not here (some are even arguing they aren't going to make one, just a set-top box) and the stock's valuation on current products, at 9 times cash flow, is still below that of other large cap blue chips. So while I am not as bullish as some, I still see room to run for the stock.

Full Disclosure: Long Apple at the time of writing, but positions may change at any time

Bubble Bursting 2.0 (Part 2): Isn't Groupon Worth Something?

Last November, in a post entitled "Numbers Behind Groupon's Business Warrant Caution After First Day Pop", I cautioned investors that the IPO of daily deal leader Groupon (GRPN) looked sky-high at the initial offer price of $20 per share, which valued the company at an astounding $13 billion:

"It is not hard to understand why skeptics do not believe Groupon is worth nearly $13 billion today. To warrant a $425 per customer valuation, Groupon would have to sell far more Groupons to its customers than it does now, or make so much profit on each one that it negates the lower sales rate. The former scenario is unlikely to materialize as merchant growth slows. The latter could improve when the company stops spending so much money on marketing (currently more than half of net revenue is allocated there), but who knows when that will happen or how the daily deal industry landscape will evolve in the meantime over the next couple of years.

Buyer beware seems to definitely be warranted here."

A few things have happened since then. First, Groupon has cut back on marketing spending and is now making a profit (free cash flow of $50 million in the second quarter). Second, the post-IPO insider lockup period has expired, removing a negative catalyst that the market knew was coming. Third, and most importantly, Groupon's stock has plummeted from a high of $31 on the first day of trading ($20 billion valuation) to a new low today of $4.50 ($3 billion valuation).

Here is my question, as simply as I can put it; "Isn't Groupon worth something?" The stock market seems to be wondering if many of these Internet IPOs will exist in a few years. Today's 8% price drop for Groupon was prompted by an analyst downgrade to a "sell" and a $3 price target. Here is a company with $1.2 billion in cash, no debt, and a free cash flow positive business that will generate over $2 billion of revenue this year. That has to be worth something. How much is another story.

I would argue that it is too early to write off companies like Groupon as being "finished." It is far from assured that they will be around in 3-5 years, but many of them have huge cash hoards ($2 per share in Groupon's case), no debt, and a business that is making money today. My most recent blog post made the point that many of these Internet companies are going to survive, and in those cases bargain hunters are likely to make a lot of money. Will Groupon be one of them? I don't know, but if an investor wanted to make that bet, at $4.50 per share, they are paying about $1.8 billion ($3 billion market value less $1.2 billion of cash in the bank) for an operating business that is on track for more than $2 billion in sales and $200 million in free cash flow in 2012. And who knows, with this kind of negative momentum, the shares could certainly reach the analyst's $3 price target in a few more days.

Bottom line: these things are starting to get pretty darn cheap. If they make it, of course.

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

Bubble Bursting 2.0: Coming To A Dot-Com Stock Near You

By now you probably know the poster children for the bursting of the 2012 Internet bubble:

Facebook (FB) IPO price: $38.00, Current quote $21.75 (down 43%)

Zynga (ZNGA) IPO price: $10.00, Current quote: $2.95 (down 70%)

Groupon (GRPN) IPO price: $20.00, Current quote: $6.66 (down 67%)

And as was the case in 2000, we are seeing violent selling in most any Internet company that reports a less-than-impressive quarter as a public company. We are also likely to get a repeat scenario in terms of bargain basement prices, for a time anyway, even on those companies who are able to survive and grow with a profitable business model. I think it is time to start monitoring these dot-com IPOs in search of those that might be written off prematurely. After all, unlike the late 1990's, many of these companies do make a profit. The issue today is more that they don't always make enough to justify multi-billion dollar stock market valuations.

Today's disaster du jour is CafePress (PRSS), a profitable e-commerce site that has been around since, you guessed it, 1999. CafePress, which projects 2012 revenue of more than $200 million, went public in late March at $19 per share, giving it a market value at the time of about $325 million. In today's trading the stock is falling by nearly $6, or 42%, to a new low of under $8 per share. Loss since the IPO: 58%.

So why bring up CafePress? I think it is the kind of company (a viable, profitable, and growing Internet operation) that might fall into that "written off way too early" category as the air continues to flee from the 2012 Internet company bubble. Granted, I have only spent an hour or so looking at CafePress specifically, so this is by no means a huge ringing endorsement yet, but it is the kind of stock I think warrants a closer look.

Even with reduced financial guidance for 2012 (the reason for today's steep stock price decline), CafePress is predicting more than $20 million in EBITDA on more than $200 million in sales this year. With sales growing by about 20%, coupled with an 11% cash flow margin, PRSS is certainly a viable company. And yet, at under $8 per share, the stock price is indicating otherwise. The market value is now down to $135 million. PRSS has $60 million in cash on the balance sheet, so at current prices Wall Street is saying that the CafePress operating business is worth just $75 million, or 3 times EBITDA. That is the kind of valuation that Wall Street normally reserves for companies in a steep decline. As a value investor, numbers like these can't help but get my attention.

Comments on the Internet stocks in general, or CafePress specifically, are always welcomed.

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

Chipotle: A Lesson in High P/E Investing

Shares of Chipotle Mexican Grill (CMG) are falling more than 90 dollars today after reporting second quarter earnings last night. Revenue rose 21%, with earnings soaring 61%, beating estimates of $2.30 per share by an impressive 26 cents. However, light sales figures (same store sales of 8% versus expectations of double digits) are causing a huge sell-off today. This is a perfect example of what can go wrong when investors rush into stocks that are very expensive relative to their overall profitability. Any hiccup results in a violent decline. And this really isn't a hiccup except relative to lofty expectations. If you simply read the press release and ignored the analyst estimates, you would conclude the company is absolutely printing money at its restaurants. Unit-level margins approaching 30% are pretty much unheard of in the industry.

The problem is that prior to today's drop, CMG stock traded for a stunning 59 times trailing earnings. Even using this year's projections gets you to a P/E of 45x, more than 3x the S&P 500 multiple. Even a meaningful earnings beat can't help investors with the bar set so high. Today could very well be a buying opportunity if one believes in the long term growth story at CMG, however, with the P/E still sitting around 34 on 2012 earnings, it is definitely not cheap enough for value investors to get interested.

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

Values Abound in Enterprise Computing

With the European recession beginning to impact earnings guidance for U.S. companies in recent weeks, one of the sectors to really get hammered is enterprise-focused technology. While second quarter profit reports and forward guidance will likely be unimpressive this month, some of the current valuations on Wall Street make little sense even in that scenario. As a result, I would expect strategic mergers and private equity buyers to begin looking at some of these companies.

There are far too many ideas to list here, or buy for clients, so I will just point to one that looks intriguing; enterprise collaboration hardware maker Polycom (PLCM). Polycom earned $1.18 per share last year, but weakening demand has pushed forecasts for 2012 down to just $0.89 which has crushed the stock from $32 a year ago to a recent quote of just $9 per share. What really bulks up the bullish case for the stock is that Polycom has no debt and a whopping $600 million of cash in the bank, which equates to about $3.50 per share in net cash. Investors are getting the business for only $6 per share, or 5 times trailing earnings.

With such a pristine balance sheet, the odds of Polycom being acquired rises materially relative to the average hardware company. It would be a logical target for a Cisco, HP, or Dell, all of which are companies that either compete with PLCM or are looking to expand their product offerings to enterprise customers. Even without a deal, the stock should likely command at least a market multiple, which would put fair value in the high teens inclusive of cash. This is just one of many enterprise computing companies that have been decimated in recent months, which make them very attractive in my view.

Full Disclosure: Clients of Peridot Capital own shares of Polycom at the time of writing, but positions may change at any time.

JCP Follow-up: Ackman's Presentation

Following up yesterday's discussion about J.C. Penney (JCP), today the slides from Bill Ackman's recent presentation on JCP have been making their way around the Internet. Below is a link:

Bill Ackman of Pershing Square Capital Management: Bullish on J.C. Penney's Turnaround  

J.C. Penney Stock: Back to Earth

It has been less than four months since my bearish post on J.C. Penney (JCP). Since then the $42 stock has fallen nearly 40 percent to $26 per share. It turns out Ron Johnson does not have magical pixie dust to sprinkle on his 1,100 stores. As the retailer slashes prices on old merchandise, initiates an everyday low pricing strategy, and begins shifting towards its "stores-within-a-store" concept, sales and profits are plummeting. Same store sales fell 19% last quarter, a figure almost unheard-of in the retail sector. The stock is below its level on the day Ron Johnson was hired.

So what now? Well, the stock is no longer clearly overvalued, as it was four months ago. In the mid-twenties, it now has material upside if Johnson's plan bears fruit. It will still take a long time, so investors need not rush in if they still believe in the new management team. That said, it is probably time to start formulating a game plan if you want to get in. The first quarter results were really the first in what may be a series of bombs as the company right-sizes its inventory and pushes forward with its revamp. The year-over-year comparisons early next year will be very favorable for the company. And who knows, maybe Johnson can drum up some excitement over the holiday season. He does have another six months or so to make a strong push there.

For investors who want to get in on the Ron Johnson JCP experiment, it seems reasonable to scale in slowly with an understanding that Q4 2012 and Q1 2013 may be when we start to see the sales and profit figures turn around. Between now and then we really don't know how bad it will get. The stock could certainly drop to the low 20's or even high teens depending on how 2012 progresses and if the red ink continues short term.

Still, as Bill Ackman of Pershing Square Capital Management pointed out shortly after JCP's recent earnings miss, there is still a lot of potential here and we are really only in the first inning of the company's plan. Specifically, he pointed to sales of $600 per square foot in JCP's in-store Sephora boutiques. If Johnson can get exclusive merchandise in JCP and mimic the Sephora "store-within-a-store" concept, there is certainly upside here. Given that the stock was worth about this much before he was even hired, he would really have to screw up the entire brand and alienate his customers in order to destroy the stock permanently. As a result, JCP's turnaround remains a very interesting story to watch.

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