There’s been a lot of talk about Bill Ackman’s interview on CNBC Tuesday morning with Andrew Ross Sorkin and the crew at Squawk Box; it was setup to be a “debate” of sorts between Ackman and Sorkin, who recently penned a piece about J.C. Penney (JCP) on the DealBook blog called “A Dose of Realism for the Chief of J.C. Penney.” It’s appropriate to address the points raised in this article. First, a reprint of that piece:
“You should know you have a problem when sales at your stores fall 26.1 percent in one quarter.
That was the surprising decline J.C. Penney reported last week, when it disclosed that it had lost $123 million in the previous three months.
Inside the fantasy world that is the executive suite of J.C. Penney, however, apparently it was just part of the plan. Ronald B. Johnson, a former head of Apple’s retail business who was handpicked to turn around J.C. Penney a little over a year ago, was in full spin mode, brushing off the challenges and promoting the success of the company’s store renovation plan as “gaining traction with customers every day and is surpassing our own expectations in terms of sales productivity, which continues to give us confidence in our long-term business model.”
To gain a more realistic view of J.C. Penney’s prospects, however, here is the Deutsche Bank analyst Charles Grom: 'Trends at J.C. Penney are obviously getting worse, not better, and we are becoming more and more convinced that sales in 2013 will also decline, which could lead to a going-concern problem next year.'
The company’s stock has fallen nearly 50 percent since the beginning of the year. Even its online sales, through jcp.com, fell 37.3 percent last quarter from a year ago.
Yet Mr. Johnson, a well-regarded and charismatic retailer who worked at Target before his meteoric rise at Apple, appears to be trying to mimic Steve Jobs and create what Mr. Jobs biographer, Walter Isaacson, called a 'reality distortion field.'
Mr. Johnson has spent the last several months trying to persuade investors that his transformation of J.C. Penney was the equivalent of Mr. Jobs’s efforts to turn around Apple a decade ago.
'You know, I watched this movie before. When I joined Apple in 2000, Apple was a company dwindling. Everyone said to me, ‘What are you doing there?’ Mr. Johnson told investors in September. 'Apple wept through 2002 and I think sales were down 38 percent as we dreamed about becoming a digital device company. But Apple invested during that downturn. That’s when Apple built, started to build its chain of stores. That’s when Apple transitioned to Intel. That’s when Apple started its app division. That’s when Apple imagined and built the first iPod.'
O.K., Mr. Johnson, but that was Apple. And J.C. Penney is not Apple — and let’s be honest, it can never be Apple. The company doesn’t make its own magical, revolutionary products that bring tears of joy to its customers. It is a low-end department store that Mr. Johnson is hoping to turn into a slightly higher-end department store that sells clothing made mostly by other manufacturers.
Still, Mr. Johnson has sought to remake the company quickly, perhaps too quickly, by eliminating promotions and discounts, moving the stores more upscale, rebranding the company as JCP and putting in place a “fair and square” pricing model. (J.C. Penney is, however, putting on a special sale for the holidays.)
Yet the renovations are hardly finished — or in some cases even started. Only 11 percent of its stores’ floor space has been remodeled with his successful specialty-store-within-a-store concept, in which he has opened up outposts for brands like Levi’s, Izod, Liz Claiborne and the Original Arizona Jean Company.
J.C. Penney may have been dying a slow death before Mr. Johnson’s arrival — some rivals used call it “death by coupon,” given the retailer’s penchant for discounts — but the company’s decline has only accelerated.
But the lessons, and successes, of the rollout of Apple stores are proving that they do not apply to Penney. While the customer experience at Apple is in a class by itself, and Mr. Johnson should rightly receive credit for that, the success of the stores was in large part a function of stunning products with a fan base that would stand outside stores for days in the rain to get their hands on them without any chance of a discount. Do you think there are customers who will ever stand outside J.C. Penney overnight for the next Liz Claiborne sweater? (J.C. Penney bought the Liz Claiborne brand last year.)
'Ron Johnson’s remake of JCP has assumed the consumer — the only one who matters — is the one who shops at Target or Macy’s or Nordstrom’s. Instead of pivoting on and strengthening the historic JCP brand, Johnson’s decided to recreate the Target and Apple wheel, a move akin to Toyota suddenly deciding it’s Porsche. In short, a ridiculous and condescending move,' Margaret Bogenrief, a partner at ACM Partners, a boutique crisis management and distressed investing firm, recently wrote.
There is something romantic about watching Mr. Johnson try to remake a dying classic icon. At some gut level, you have to root for him. He’s making a bold bet. Transitions are inherently painful. And everyone loves a great comeback story.
Here’s the good news: In the stores that have been transformed, J.C. Penney is making $269 in sales a square foot, versus $134 in sales a square foot in the older stores. So the model itself is working. And Mr. Johnson has the support of the company’s largest shareholder, Pershing Square’s Bill Ackman, who personally recruited Mr. Johnson. If Mr. Johnson were starting with a blank slate, it might be a great business.
Mr. Ackman declined to comment. J.C. Penney did not make Mr. Johnson available.
Now here’s the bad news. Mr. Johnson still has to convert nearly 90 percent of his square feet of shopping space. That will very likely take $1 billion and as long as three years. If the sales decline that occurred last quarter accelerates, the company could run out of money. It now has about a half-billion in cash and access to a credit line for as much as $1.5 billion.
Of course, it remains possible that Mr. Johnson, who people close to him say is a realist, could always decide that the transformation is not working and change course to return to the old model of J.C. Penney and save all that money remodeling. But that would be a huge setback.
The question Mr. Johnson may be asking himself now is: What would Steve do?”
As always, it is a well-researched piece. Let us start at the top:
In regards to Johnson being in spin mode, I think management’s enthusiasm as expressed on the call was 100% related to the success of the shops (which had a solid first quarter) – considering comparable sales for these shops were collectively up 33%, I certainly think that’s well deserved.
When discussing traditional J.C. Penney, there’s no doubt that Johnson tried to remain upbeat – whether this is warranted must be considered in the context that this is standard procedure for CEOs going through difficult periods. However, he was also clear about some of the company’s failures, such as the following (transcript):
“The post-Labor Day through Thanksgiving is the longest period in retail without a natural retail event to draw. And quite frankly, what we learned is that our former promotional model with couponing was able to bring people into the store during a period when they naturally wouldn't come. And so we are establishing a new base in business. Now we have got to figure out how do we bring people into the store during those kind of periods.” To be clear, Johnson said these exact words – “jcpenney has performed tougher than we expected.”
Moving on to the replication of Apple’s strategy, Sorkin’s argument is neatly summed up in this statement: “J.C. Penney is not Apple — and let’s be honest, it can never be Apple. The company doesn’t make its own magical, revolutionary products that bring tears of joy to its customers. It is a low-end department store that Mr. Johnson is hoping to turn into a slightly higher-end department store that sells clothing made mostly by other manufacturers.”
The second sentence is key – first off, Penney’s strategy isn’t to move from a low-end to a slightly higher-end department store: An imperative part of the strategy is selling differentiated products to consumers, not higher end products. The purpose of the strategy is to get away from selling cheap towels and socks that you can buy online at Amazon (AMZN) or at your local Wal-Mart (WMT). In regard to the second point, Sorkin seems to be suggesting that Apple has some sort of monopoly on the sale of iProducts, a status that JCP will never attain by selling the creations of others. The reality is that Apple products can be found at Best Buy (BBY), Target (TGT), Wal-Mart and online at Amazon and countless other places, often for less than the price at the Apple stores.
The next few paragraphs are simple factual statements (no debating that only 11% is completed at this point). Here’s where Sorkin makes another leap: “But the lessons, and successes, of the rollout of Apple stores are proving that they do not apply to Penney. While the customer experience at Apple is in a class by itself, and Mr. Johnson should rightly receive credit for that, the success of the stores was in large part a function of stunning products with a fan base that would stand outside stores for days in the rain to get their hands on them without any chance of a discount.” In the second sentence, I essentially derive the following: “the stores looked good, and Johnson should get his accolades – but the success was largely (and I think he feels close to entirely) due to the products.”
This essentially says that the product presentation is meaningless (at least not able to be measured, but implying relatively small), so I would simply wonder the following: When JCP’s productivity per square foot for brands they have sold prior to this transformation suddenly increased 33% in the most recent quarter, what drove that? Are these shops creating brand equity around this merchandise, and could the pricing strategy suggest something about these products that is difficult to say when you’re in a perpetual cycle of discounts? I think that’s happening slowly but surely, but maybe others see it differently.
Later on, Sorkin says the following: “Now here’s the bad news. Mr. Johnson still has to convert nearly 90 percent of his square feet of shopping space. That will very likely take $1 billion and as long as three years. If the sales decline that occurred last quarter accelerates, the company could run out of money.”
I agree with this statement 100% (hard to disagree – its math). Of course, this loses a bit of ist sting when “run out of money” isn’t quantified – at all. As I noted yesterday, I perceive this is a big misconception about JCP. I think that the financials could support another 12 months of comparable struggles to the first nine months of this year; when you consider that 40% of the store will be shops by that point (presumable selling at a comparable improved rate to the first ten), this looks like a long, long time.
In the conclusion, Sorkin admits that “the model itself is working,” as seen in the productivity numbers I just discussed - yet a few sentences later, he says this: “Of course, it remains possible that Mr. Johnson, who people close to him say is a realist, could always decide that the transformation is not working and change course to return to the old model of J.C. Penney and save all that money remodeling.” The transformation, the model, is working; the shops are the future of J.C. Penney. Dealing with the legacy JCP space is up for debate, and is priority number one for management – but the shops model is undoubtedly here to stay.
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of my portfolio (currently two). In the eyes of a businessman, I believe this is adequate diversification.