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A Dose of Realism for the Chief of J.C. Penney

November 14, 2012 | About:
The Science of Hitting

The Science of Hitting

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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:

The Science of Hitting
I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

Rating: 4.1/5 (20 votes)

Comments

rafaelscremin
Rafaelscremin - 1 year ago
"I'm a value investor, with a focus on patience, I wait for great companys that are suffering from short term issues, and load up when those opportunities become present". Investors are selling with panic, they are losing money.
The Science of Hitting
The Science of Hitting premium member - 1 year ago
Rafael,

Not too sure what you mean? Time will tell if this is a short term issue - but I think that the risk/reward balance is skewed in a big way to the benefit of people looking to go long.
ramands123
Ramands123 - 1 year ago


Either ways you can't loose at this price.

First of all at 18-20 $ share you are basically paying for thier strategy to not work.

Second, CFO had already said if thier is any liquidty issue or transformation cannot be funded by cash flow from operations or sale of non core assets, they can always slows it down.

Third, If it doesnt work does anyone think Bill Achman and Ron are going to bring JCP down. They will reverse the course. They both have huge sums of personal net worth invested in it.

The Science of Hitting
The Science of Hitting premium member - 1 year ago
Ramands,

I certainly agree with your general idea; as I noted in the article, a lot comes down to what you're looking for (some people simply cannot "invest" - they buy and sell in the anticipation of guessing what will happen next quarter or what will happen to the P/E ratio short term). Thanks for the comment!
swnyc2
Swnyc2 - 1 year ago
Science,

I liked your articles on JCP so much that I decided to open a long position this week, but I kept it small because I think in the near term the risk is high that the stock will move lower. (I'm trying to learn from your experience with SPLS!)

Analysts are calling for a price target of as low as $10/share. Given the accelerating decrease in sales, I have to admit it's likely the stock will go substantially lower in the short term, especially because of a likely disappointing upcoming holiday season.

Compared to other stocks I've purchased (such as SPLS, MSFT, and TSCDY), I'm having a much harder time deciding at what price I would be interested in buying more JCP. I'm also having a difficult time determining what the maximum amount of JCP shares I'd be willing to hold. With all the big box downsizing we will be seeing (e.g. BBY, SPLS, etc), how confident can we be that JCP's real estate value is really ~$15 per share??

The Science of Hitting
The Science of Hitting premium member - 1 year ago
Swnyc2,

Thanks for the comment! And that was likely smart of you: as we've seen - and I still think the fundamentals support their reversal - JCP, SPLS, and MSFT, to name a few, have all lagged since I recommended them (granted JCP gave the traders a nice 30-40% boost for a while). In terms of short term price movements, I don't have the slightest idea where JCP or any other stock is going - I can simply assess the financials and attempt to conservatively estimate the intrinsic value of the company in question.

In terms of $10/share, I would love to hear what they were saying three months ago, six months ago, and a year ago - if any of them were at that level the whole time (or even below $20), I would be very, very surprised; for a long term investors, their opinion has proven to be noise time and time again...

In terms of real estate, I don't have an exact answer for you; Michael Price estimates $15/share, and Bill Ackman thinks something materially higher (let me remind you, he wrote in his Q2 letter that a private equity buyer had shown interest in JCP in the mid-30's per share). On the other hand, lets think about the upside for one second - imagine this is working in 24 months; how will somebody replicate this strategy?

What CEO will be willing to suffer many very difficult quarters, as JCP's management has? In addition, will they be able to find brands to fill their shops (like Joe Fresh, etc), or will these players (or at least the top 100 of them, by JCP's analysis) already have been snatched up, potentially under deals where their product cannot be sold in other stores in the same mall? When you start thinking about these types of things, I think it starts to become apparent that if this works (not saying it will, but if it does), JCP will have a multi-year head start on the competition, and will continue to expand the model (as they noted, can match Macy's and others who have hundreds of more stores than they do). When this is all put in the context of Bill Ackman's original thesis, it appears that the upside potential is huge (5x or so on the current valuation in 3-4 years time); even if one assumes that the real estate is worth just $10/share (to choose a number materially lower than Price's), and a 20% chance of success (quite lower considering we've seen the model WORKS), this still looks like a steal at roughly $16-17. Thanks for the comment!

WildaBeast
WildaBeast - 1 year ago
Science,

Have you considered JCP bonds? It looks like the August 2016 issue trades below par with a yield to maturity of almost 9%. Do you have any thoughts on JCP's ability to make it through 2016 without bankruptcy?
ttony
Ttony premium member - 1 year ago
Some notes:

1. Interesting comment; the bk reference. JCP has had a severe sales decline but its cash flow has been pretty good underneath that sales decline. Last quarter, the AWFUL last quarter, they had a $48 million operating deficit of cash. Overall they had a $363 million cash drain. They sold some excess assets which produced some cash but also paid off a like amount of debt. The deficit therefore was almost entirely made of of capital expenditures. And their net debt went down.

2. I would expect they are learning from their remodeling experience so there should be a slightly less expensive build out going forward. Also they are spending considerable amount of money on bringing technology to all parts of JCP. The majority of this excess spending should be done by the end of the first quarter of next year. Their overhead expenses have been pruned. This is a big savings.

3. They just haven't promoted the stores....The switch from sales and coupons strategy has not been replaced by anything. That is obviously changing. Under new prettier names used by Johnson but nevertheless, JCP is once again in the get them into the store with promotions.

4. The stores look great; better than their competition. Their prices are very, very competitive. Johnson has FINALLY admitted that shoppers not only want bargains but NEED TO SEE THE BARGAINS IN PRINT. So the $25 dollar pair of pants selling for $20 will now show both the prices.

5. There are certainly more excess assets to sell to help the fund the remodel process. There are the 400 small stores. It has never been explained how these will fit into the future of the new JCP. I don't see it. They are too small and will somehow be turned into cash. When a store is sold not only is there a realization of cash from the asset sale, but also there is cash from the sale of the inventory.

There are also " several hundreds of millions" of other assets, primarily minority ownership interests in malls, which can be realized. And finally there is the debt market. When one looks at what is currently being sold in the junk bond market, one has to assume that there would be a quick demand for JCP bonds. It would all be in the pricing. And they haven't touched their credit line which they say can be expanded. I just don't see the bk. And in a pinch they could raise equity.

6. While it is impossible to model with any certainty the cash flow from sales next year, there will be a much larger contribution from the new JCP stores. They expect it at 40% by November 1st. The line from the loss of sales from JC Penny and the new addition of sales from JCP stores should cross at some point next year. There really is no reason why JC Penny customers should continue to flee; the stores look good; the prices are excellent; technology additions will make it a quicker and more efficient place to shop; and there is a return to the more traditional method of showing the customer exactly how big a bargain they are getting while shopping there.

ONE THING WAS HUGELY APPARENT FROM THE LAST CONFERENCE CALL; Johnson gets it. He has waved the flag in surrender and will promote, promote, show discount prices, etc, etc, etc. to get the shoppers back into the stores.

Buzz; the next group of shops should create considerable media buzz. It will be new stuff with a new approach and the media loves NEW. This is free advertising and will be a welcome addition. It will also give JCP a reason to lure its customers in-to see the new stuff. And as each new shop is completed, the feeling of a store comprised with shops will become more and more apparent. Next year it appears that the home and children sections will be featured.

So I see the downside in the business model as limited. Worst case will be a return to a combo of the old JC Penny and a slow introduction of the new shops. With the lower overhead, the new technology and a reasonable ad/promotional spend, sales should stabilize. Technology is helping the company have a much better handle of the inventory so investment in inventory will be much less. With just a slight uptick in sales cash flow, without the huge capital investment in the new shops, could would turn positive. The current debt level is not a problem. The conversion to the shops idea would continue but at a much slower pace. The capital investment, ie cash drain, would be far less.

Good luck to all...

Who knows about the stock price. I have been more than surprised about this decline. It seems far overdone but Mr Market is usually far wiser than any of us. But Mr Market is also representative of the relatively short term vision of the majority of its voters. We JCP stockholders will have to experience more patience than originally anticipated.
windplayer13
Windplayer13 - 1 year ago
Take a look at the trading range of JCP's "third party trust preferreds," such as their CorTS, SATURNS, and CABCO Trusts: PFH HJV JBN JBR KTP. Quantumonline.com has a description of what these instruments are. PFH's historical trading range is the best to view. The next liquidity crisis may present another entry point.
The Science of Hitting
The Science of Hitting premium member - 1 year ago
WildaBeast,

I don't have anything in particular to add beyond what I've said throughout these articles; I personally think that a bankruptcy is unlikely only because of what can be done with the asset base if necessary, but wouldn't be surprised if that cash would simply be used to fund the transformation (unless they find a way to stabilize the 89% soon, the shift to 40/60 by Nov 2013 will become even more important - assuming they will not abandon the change, a move that I see as highly unlikely).

On the flip side, in the scenario where this works, the upside is certainly well beyond the 9% YTM; the difficulty of replicating the model with solid shops, as well as the time/pain to do so, suggests to me that this will be a true differentiation - copying it's diversity of brands and overall strategy via brick-and-mortar doesn't really seem feasible. As always, I could end up being wrong about that...

Ttony,

Number three is critically important, particularly when you consider the shop success with that in context and the poor traffic figures; I think the ability of this model is only starting to be seen.

Mr. Hannah's wording on the call increased my belief that the 400 are in play; I'm not sure what a deal would look like, but I certainly believe that any transaction involving these stores would provide a nice windfall for JCP.

Finally, I agree with you on the decline; it's simply amazing how volatile this stock has been in the past few quarters...

Windplayer13,

That's interesting - thanks for posting!

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