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JCP: 10-K
Posted by: The Science of Hitting (IP Logged)
Date: April 2, 2013 10:48AM

No need for an introduction – let’s jump right in.

I called “Home” an unmitigated disaster in a recent article about J.C. Penney (JCP); a look at sales by segment (percentage of total) shows just how bad the section has been for the company:

Segment 2009 2010 2011 2012
Women’s Apparel 24% 24% 25% 23%
Men’s Apparel/Accessories 19% 20% 20% 21%
Home 19% 18% 15% 12%
Women’s Accessories (+ Sephora) 11% 12% 12% 13%
Children’s Apparel 11% 11% 12% 12%
Family Footwear 7% 7% 7% 7%
Fine Jewelry 4% 4% 4% 7%
Services & Other 5% 4% 5% 5%
TOTAL 100% 100% 100% 100%


As well as in dollar terms:

Segment 2009 2010 2011 2012
Women’s Apparel $4.21B $4.26B $4.32B $2.99B
Men’s Apparel/Accessories $3.34B $3.55B $3.45B $2.73B
Home $3.34B $3.20B $2.59B $1.56B
Women’s Accessories (+ Sephora) $1.93B $2.13B $2.07B $1.69B
Children’s Apparel $1.93B $1.95B $2.07B $1.56B
Family Footwear $1.23B $1.24B $1.21B $909M
Fine Jewelry $702M $710M $690M $909M
Services & Other $878M $710M $863M $649M
TOTAL $17.56B $17.76B $17.26B $12.99B


Here’s the change in sales (cumulatively) from 2009 to 2012, by segment:

Segment 2009 2012 Change
Women’s Apparel $4.21B $2.99B -29%
Men’s Apparel/Accessories $3.34B $2.73B -18%
Home $3.34B $1.56B -53%
Women’s Accessories (+ Sephora) $1.93B $1.69B -12%
Children’s Apparel $1.93B $1.56B -19%
Family Footwear $1.23B $909M -26%
Fine Jewelry $702M $909M +29%
Services & Other $878M $649M -26%
TOTAL $17.56B $12.99B -26%


The press has clung onto the importance of the “Joe Fresh” shops, but the real game changer will be “Home” (we’ve started to see a shift in their focus as time has passed). As anybody who has been in a store lately knows (as of late March), the company is currently engaged in a material transformation of that department; shelves are essentially empty, and much of the floor space is marked off for construction. At completion in May, JCP anticipates opening close to 20 shops in 505 stores with brand partners such as Michael Graves, Jonathan Adler and Sir Terence Conran, among others. Upon completion, just under 40% of the stores will have been transitioned to the “shops” model.

It seems fitting that this section, the epitome of a department store clinging to the past, will likely prove to be Ron Johnson’s ultimate test; in my mind, his vision to transform J.C. Penney will live or die by the transition of “Home.”

Business Strategy

In last year’s 10-K, the company laid out its pricing strategy and other key changes in the “Business Strategy” section; in regards to pricing, here’s how the section reads this year:

“Our pricing strategy is founded on providing merchandise at low everyday prices and delivering even more exciting value through sales, promotions and rewards.” We saw a small example of this in each of the past two weeks; I’ll be thoroughly disappointed if this type of activity doesn’t ramp up substantially in the near future (again, I’m hoping Mr. Zyman’s experience helps here).

RISK FACTORS

In last year’s filing, the company jumped out of the gates with boiler plate commentary on macroeconomic (“Our Company’s growth and profitability depend on the level of consumer confidence and spending.”) and competitive (“The retail industry is highly competitive, which could adversely impact our sales and profitability.”) risks. This year, the company immediately noted – with the 2012 operating results as “Exhibit A” – that the success of the transformation is the company’s primary risk. Notably, the company added some key wording to the competitive risk this year (emphasis added) – “We operate in a highly competitive industry that includes significant promotional activity, which could adversely impact our sales and profitability.” The section continues as follows: “During the first year of our transformation, we discontinued our former promotional strategy and encountered difficulties in communicating our value proposition. Although we have re-introduced certain promotional activities, there can be no assurance that increased promotional activity will result in increased sales and profitability.”

In another section, which focuses on the importance of traffic in driving sales, the company again references their return to a promotional strategy: “There can be no assurance that our efforts to increase customer traffic and visit time in our stores will be successful or will result in increased sales. We may need to respond to any declines in customer traffic by increasing markdowns or changing marketing strategies to attract customers to our stores, which could adversely impact our gross margins, operating results and cash flows from operating activities.” I’ve said this before and will repeat myself again – I consider this to be critical; the company needs to stand up and say “we were wrong” – and give consumers the markup/markdown strategy they love so much. JCP has started to move back this direction – and needs to speed up.

Property

At year-end, JCP operated just over 1,100 stores as of Feb. 2, with total square feet at 111.6 million; of those stores, 429 are owned, including 123 located on ground leases. In addition, the company has a supply chain network (merchandise distribution, jcp.com fulfillment, etc.) that operates 24 facilities; JCP owns 11.7 million of the 14.5illion square feet associated with the supply chain network. Finally, JCP owns their home office facility in Plano, Texas (about 20 minutes north of Dallas) – as well as 240 acres of adjacent property.

Operating Results

Year Gross Selling Space Sales Per Gross Square Foot
2003 101.1M $150
2004 101.3M $159
2005 101.4M $167
2006 103.1M $176
2007 106.6M $177
2008 109.9M $160
2009 111.7M $149
2010 111.6M $153
2011 111.2M $154
2012 111.6M $116


As we can see, the recent recession hit JCP pretty hard – four years after sales per square foot had peaked around $177, they were still off double digits from the peak; 2012 was a move in the wrong direction, and highlights just how material the impact of the pricing strategy truly was.

Cash Flows

In 2013, the company is targeting capital expenditures in line with 2012, around $800 million; this spend will relate primarily to investment in shops and technology improvements. While still a sizable investment, it includes the addition of an estimated 30 shops, which lends support to Mr. Hannah’s commentary during a recent investor event suggesting that previous management teams had woefully underspent (on things such as lighting, etc) “for a number of years” – spend that the current team considered necessary. With that said, $800 million is a big number for a company with a similar amount in cash on hand (before considering sizable net outflows that will also occur during the year); I’m increasingly certain – despite the fact that it gets no play in the financial press – that JCP will make some big moves towards liquidating non-core assets (and pick up the pace of closures where it makes sense) in the coming months; as I’ll show below, we’ve got clear visibility into a couple hundred million dollars – from sources that can be tapped without affecting JCP’s core business.

In 2012, after adjusting for the repayment of long term debt and the (now discontinued) dividend – which totaled roughly $320 million - the company’s net decrease in cash, INCLUDING capital expenditures, were roughly $250 million. We certainly can’t expect the same amount of help from changes in working capital, but hopefully will see a similar bump from asset monetization (management has continually said “a couple hundred million”) and improved operating results; considering that the company’s transformation will be 38% complete in the coming months (and address the weakest section of the store), we’re getting closer to the point where the impact of the transformation can become a meaningful part of the business.

Balance Sheet

Here are some often overlooked assets that may be liquidated in the near future:

JCP continues to own 205,000 units of SPG after selling 2 million in July 2012; at Monday’s close, those 205,000 units are worth roughly $32.5 million (cost basis around $7 million, but carried at fair value under GAAP – listed under “other assets”).

The company sold four investments in four joint ventures that own regional mall properties for $90 million; because the net book value of the JV’s were -$61 million (distributions related to refinancing transactions in prior periods reduced the carrying amount of the investments), the company booked net gains totaling $151 million on the sale. At the time the 10-K was filed, JCP continued to hold investments in nine joint ventures that own regional mall properties; at a 20% discount to the other JV’s, the nine still on the books would be worth $162 million to JCP (while not specifically noted in the 10-K, my estimate is that these JV’s account for the majority of the $33 million “other” piece reported in “other liabilities”).

In 2011, JCP bought 11 million shares of common stock of Martha Stewart Living Omnimedia. I certainly wouldn’t expect the company to hold onto this stake if the result of mediation is unsatisfactory; at Thursday’s close, the market value of this position was roughly $27.5 million.

Finally, the “other assets” account lists $36 million in cost investments, described as such: “The cost investment is for equity securities that are not registered and freely tradable shares and their fair values are not readily determinable; however, we believe the carrying value approximates or is less than the fair value.” I’m not positive what this is in reference to (if anybody has any clues I would love to hear them), but the language suggests the carrying value is a good proxy.

In total, JCP's balance sheet shows $745 million in other assets as of yearend 2012, down roughly $400 million from the prior year. The few examples presented – none of which include owned stores, long term leases well below market rates, owned real estate in the supply chain network, or the company’s home office and adjacent property in Texas – will likely bring $200 million to $250 million to JCP if liquidated.

At a higher level, the current ratio stands at 1.42X, with the net current asset position around $1.1 billion. The long term debt on the company’s books is just that – long term; the weighted average maturity is 24 years, with the nearest maturity (for $200 million) coming in 2015.

Conclusion

There certainly isn’t much love for Bill Ackman, Ron Johnson, or J.C. Penney these days; the same can be said for Best Buy (BBY) a few months ago, or Research In Motion (BBRY) before that (you don’t have to look back very far to find a case of fearful analyst group-think; as usual, that group-think coincided with the point where the common stock was increasingly attractive).

Value investors live by a simple mantra – focus on the separation between price and intrinsic value; when the market becomes overly pessimistic or optimistic – and you can objectively state that you believe you’re capable of spotting that disparity – act accordingly. Of the three larger scenarios that I see as likely for JCP in the next few years (success, failure with Johnson out and the strategy abandoned within the next year, or failure with Johnson taking the ship under), I continue to believe that one presents material upside, while the other two aren’t nearly as dire – or likely – as the market currently seems to believe. Real estate valuation is a critical part of that calculation, but difficult to assess. The stock recently jumped on a note from ISI suggesting that the company’s top 300 stores under a new strategy could justify a valuation around $40 – or about 2x the current book value of JCP’s land and buildings (net). I’m not advocating their strategy – but I think it presents an interesting thought exercise on the potential scenarios that would unlock the company’s real estate value and make the current valuation look grossly inadequate – even while assuming the current strategy is a failure (which, by the way, doesn't mesh with early shops sales data).

The next quarterly results will likely be atrocious; the home department is essentially closed at this point in time, and accounts for material amount of floor space in most locations. I’m very focused on the continued push for a more promotional strategy, as well as the company’s efforts to liquidate non-core assets in the coming months. For the investor who is capable of blocking out all the noise – and their certainly is plenty - I think buying JCP at the current valuation is a sound decision once each of these scenarios is considered (I’ll leave it to the reader to form their own judgment on the likelihood of those scenarios and the expected value in each situation – and those uncomfortable making even rough calculations should not buy on my recommendation).

In the next few months, we will be at 38% shops, and 40% by year end (assuming all goes as planned); this is a far cry from the 10% reached to date, and will start to have a material impact on the combined (old & new) sales data. I’ve hashed out my thinking for readers in prior articles, so I’ll simply conclude with the following - I will likely add to my stake in the next 90 days.


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JCP 10-K
Posted by: cdubey (IP Logged)
Date: April 2, 2013 12:06PM

Good luck. Definitely going to be a tough ride. I am planning to look at JCP though in a more serious fashion.


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JCP 10-K
Posted by: aagold (IP Logged)
Date: April 2, 2013 12:45PM

Science,

Thanks for taking the time to write up your observations on JCP's 10K, but I wish you had made at least some attempt to estimate an intrinsic value range given the information now available. I have no idea why you say, "I think buying JCP at the current valuation is a sound decision once each of these scenarios is considered"... do you have any arithmetic to back this up?

As I mentioned in your previous article, I used to own JCP stock because I bought into Ackman's analysis that pegged $70/share as the mid-point of its intrinsic value range. I think it's pretty obvious now that Ackman's analysis can no longer be considered a reasonable conservative estimate of future outcomes, but I haven't seen any analysis to replace it. I was hoping you would provide that, but I guess I'm just being lazy. I guess if I want that analysis I'll just have to do it myself, and I may publish a GuruFocus article if I do that. My approach would be to assume 2013 revenue is the low point... maybe a 15% decline from 2012 (as horrendous as that sounds I think it may be reasonable). One can then assume some reasonable same-store sales growth rate.. maybe 5-8% per year?... from the trough for several years thereafter and see what earnings and cash flow look like under this model. Although I haven't done the analysis (yet), I suspect the company would go bankrupt under those assumptions before sales improved sufficiently because fixed costs are too high. So they'll probably need to close a significant number of underperforming stores in order to make it through the transition, which means the trough revenue will end up being even lower. My guess is that JCP may be a buy if it gets into the single digits, but without a solid intrinsic value analysis I'm just guessing.

- aagold


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JCP 10-K
Posted by: mocheng (IP Logged)
Date: April 2, 2013 02:19PM

i listened to ackman and bought into JCP in the low 20s. I have been to JCP recently and I am quite impress with what I see. So I am sticking with it.


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JCP 10-K
Posted by: The Science of Hitting (IP Logged)
Date: April 2, 2013 04:26PM


Cdubey,

Been pretty tough so far - time will tell...

Aagold,

I purposely left out a firm number for that reason alone - I don't want anybody acting based solely upon what I have to say; it's safe to say that my estimate of intrinsic value is meaningfully higher than the current valuation. With that said, I sold 50% of my stake in early 2012 in the low 40's, so I've certainly never pegged it near $70 either.

As I've noted, I think management will be able to fund this year's transformation, partly through non-core asset sales (and possibly via a sizable real estate transaction - in what form is unclear); in addition, I think the success of the early shops - in a horrible traffic environment - is more than a fluke; as a result, I believe that long term, the shops strategy has a good chance of being successful. You can model that as you see fit - but my math suggests that JCP is worth well over $15 per share.

Thanks for the comment!

Mocheng,

The opening of the "Home" shops will be interesting - the pictures I've seen to date look pretty good. Thanks for the comment!


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