From Pershing Square's first-quarter letter:
J.C. Penney Company, Inc. (NYSE:JCP) The transformation of JCP is rapidly underway. On January 25th, Ron Johnson, JCP’s new CEO, launched a new strategy which includes new branding, marketing, and, most significantly, a dramatic change in the Company’s pricing and promotional strategies. Over the last 20 years, JCP had implemented an extremely promotional strategy with more than 500 promotional ‘events’ last year. The result of this strategy had been declining sales, reduced margins, and an inability to attract high quality, proprietary merchandise in the stores because the most desirable brands are not interested in selling product within a highly discount-oriented store environment.
The ability to offer proprietary, well-presented products in the stores is critically important in a world in which bricks-and-mortar retailers compete with internet retailers which can conveniently offer commodity products at lower prices. Prior to the change in strategy, JCP’s business was deteriorating and was at risk of further declines because the company offered largely undifferentiated products and competed principally on price.
By changing the pricing and promotional strategy of the business and updating the JCP brand, Ron has been able to attract a large number of new vendors and brands that were previously unwilling to sell in a JCP store. By allowing these vendors to open their own ‘boutiques,’ ‘shops,’ and ‘stores’ – essentially small, medium and large stores within a JCP store – they can control their selling environment, presentation and the customer experience. Some of these new stores within a store will begin to open this August.
Previously, the only alternative for these vendors to control their store environment would be to open specialty stores in a mall, pay high rents, invest materially more capital, and train and employ a large sales force to sell their products. By partnering with JCP, the vendor avoids these additional business complications and the capital costs of building out their own mall-based store portfolio, while gaining an overnight national presence.
JCP’s new business model allows it to leverage one of the Company’s important competitive advantages, i.e., its ownership of 49% of its real estate with the balance leased at about four dollars per square foot. This low cost real estate is an enormous competitive advantage when compared with specialty store rents which average approximately $40 per square foot in malls where JCP is located.
JCP’s store-within-a-store experience with Sephora has proven that non-discounted high quality brands can achieve high sales per square foot in a JCP store. Sephora stores inside JCP currently generate sales of more than $600 per square foot compared with an average of about $150 per square foot for the rest of the JCP store. By building out new shops which generate substantially higher sales per square foot, JCP should be able to greatly increase its overall sales per square foot and profitability.
There is more to the strategy than just opening up new stores within the store. Ron is an expert at creating store environments that are extremely appealing to consumers and in using technology to improve the shopping experience. The public will learn more about the new JCP selling environment when the company opens 10 stores within a store beginning this August.
The long-term value of the property depends on the mall attracting higher quality tenants that will generate larger sales volume. The tenants that have been recruited to date have a proven ability to generate large sales volumes and are going to attract a larger base of customers than the property’s current tenants. The mall manager is confident in the property’s turnaround based on the tenant roster that will open stores beginning in August, but for competitive reasons he has not yet disclosed the identity of the new tenants to the public. The mall’s traditional customers are puzzled as to why their coupons have been taken away, which has reduced customer traffic. While the mall manager has done his best to clean up the property, the property won’t show well until the new stores are open.
The mall has two large owners on his management committee and a highly dispersed group of smaller owners. The mall manager talks on a regular basis with the large owners and is able to share with them all of the details of the property’s weekly sales progress, the identity of new tenants, and the detailed plans for the mall renovation and marketing program. The larger group of smaller owners receives less information because it would be a competitive disadvantage for the mall to share this information broadly.
While the property used to make quarterly distributions to its owners, the mall manager has decided to stop making distributions to preserve capital to accelerate the transformation of the mall, and to maintain maximum balance sheet strength during the transformation. The reported financials are complicated by the inclusion of substantial expenses related to the repositioning of the mall and its management. As a result of the complexity of the financials, the limited amount of information available, and the cancellation of distributions, a number of the smaller owners have panicked and are selling their interests in the mall. The press and public commentators are having a field day. They too have limited information and have written articles that are short on facts and long on speculation.
The good news is that it is only a few more months before the first new stores open. With time and some changes, the marketing message for the property will be better understood, old customers who left will return, and a large base of new customers, who hadn’t shopped at the property before, will start shopping because they are attracted by the new tenants and the more attractive and compelling shopping experience. The mall will become the most attractive place to shop in the market because each month two to three new stores will be opening which will create news and a reason for existing and new customers to shop in the mall.
When we first announced our stake in JCP, the stock price increased to the low $30s per share. Shortly after announcing our stake, we were approached by one of the most well-respected private equity funds in the world who expressed an interest in acquiring the company at a substantial premium. While we welcomed this fund as an owner of the stock, we had no interest in selling the company for a quick premium because we believe in the long-term value creation opportunity.
We also believe that public market investors benefit by being able to participate in the value created from a business transformation, rather than being forced to sell out. While there will likely continue to be a high degree of stock price volatility during the course of our JCP transformation, we believe that long-term investors will benefit greatly from the outcome.
By the beginning of the company’s next fiscal year in February, we expect the most challenging year of the turnaround will have been completed. Sales should rise from the current low levels as the current JCP consumer comes to better understand the pricing strategy, and as new product is introduced with a new store presentation that attracts both new and traditional JCP customers.
JCP is currently operating at a fraction of its potential. While a stronger economy is a positive for nearly every business, the macro environment is unlikely to have a substantial effect on the performance of JCP. Rather, management’s degree of success in transforming the company will be the principal driver of the profitability of our investment.
Despite the fact that the company has stated that it will take about four years to complete the transformation, we do not believe that investors will need to wait long to see substantial stock price appreciation from current levels. As the company makes operational, strategic, and financial progress over the next 12 months, we expect the stock price to reflect that progress. We believe JCP stock is extremely cheap at current prices and that it offers one of the best potential opportunities we have seen for long-term profit when compared with the risk of a permanent decline in value from today’s share price.
From Pershing Square's first-quarter letter: