Part of the legacy of J.C. Penney (NYSE:JCP)’s 110-year history is that over time it has purchased an enormous amount of real estate. In total, J.C. Penney has 1,100 stores or 111 million square feet of floor space, and J.C. Penney owns 49% of this real estate. The remainder is rented at just $4 per square foot or 90% less than what an average retail tenant would pay.
This real estate provides J.C. Penney with a competitive advantage over other retailers who need to buy or lease new real estate to grow.
Additionally, this real estate is recorded on J.C. Penney’s books at its written-down value, and it is recorded at historical cost. The replacement value of the stores is significantly more than the reported values in J.C. Penney’s balance sheet.
New Management with a New Strategy
Ron Johnson joined J.C. Penney as CEO in November 2011 with a wealth of experience in the retail world. At Apple Inc. he was the senior vice president of retail operations and spearheaded Apple’s successful rollout of its retail branches. Prior to this he had an extremely successful career at Target as vice president of merchandising.
Bill Ackman, whose Pershing Capital fund owns a 25.1% economic stake in J.C. Penney, was instrumental in bringing Johnson and his management team in to transform J.C. Penney and improve its declining sales and bottom line.
The strategy being implemented by J.C. Penney under Johnson is to move J.C. Penney away from being a price-driven retailer to a retailer that is offering a better customer experience than other department stores.
A key plank of this strategy is to transform J.C. Penney into a specialty retailer by installing 80 to 100 specialty retail brand-name shops in 700 of its stores by November 2015.
The other plank has been to move J.C. Penney to a “fair and square” pricing strategy and away from using price promotions and coupons. This strategy has been controversial and led to a 26% decline in sales in the fiscal third quarter and 27% decline in Internet sales. The reality is that Johnson and management made a mistake and tried to push too hard on being price disciplined. Finding the right balance over time between offering targeted sales promotions as well as providing a better shopping experience for customers, is the key challenge being faced.
Will the Turnaround Strategy Work?
There is a tendency to cringe when a CEO talks about a “turnaround strategy.” Further, J.C. Penney’s turnaround results so far have been disappointing while promising as well.
Warren Buffett once remarked that the problem with turnarounds is that they seldom turn. I believe the J.C. Penney “turnaround strategy” will ultimately be successful. Why? The retail brands that J.C. Penney is bringing in-store have already been proven and are already successful in the marketplace. This is not a punt on a new line of clothing or new untested products.
Further, J.C. Penney is leveraging its best asset (real estate) with these retail brands' best asset (brand equity). The early evidence is the strategy is working as we discuss further below.
Finally, J.C. Penney has a number of very successful investors with significant shareholdings, including Pershing Square Capital and Vornado Realty. These shareholders have demonstrated a long-term commitment for Ron Johnson and his management team to get the job done. Further, Johnson has personally invested $50 million in stock warrants in J.C. Penney, so he personally has a big financial stake in J.C. Penney’s success.
Specialty “Shop-in-Shop” Transformation – 34 Months to Go!
Under Johnson and management’s new specialty retail shop vision, J.C. Penney will transform 64 million square feet out of 111 million square feet. The remaining square footage comprises 13 million square feet of small stores and 34 million square feet of backroom offices and services.
The company will install 80 to 100 shops in 700 stores (out of 1,100 stores) represented by 100 top-selling retail brands including Sephora, Levis, Izod and Mango. In 2013, J.C. Penney has planned new shops to open including Joe Fresh, Cosabella, Martha Stewart, Jonathan Adler, Disney and Carter’s.
The process will take place over the next 34 months, with 40 out of 100 shops in each location completed by November 2013, 70 out of 100 shops completed in each location by November 2014 and 100 out of 100 shops completed in each location by November 2015.
J.C. Penney is providing these specialty retail franchises with a compelling opportunity to roll out their brands across the U.S. in a way that is cost effective. Further, it enables these brands to reach a wide audience quickly and control their “in store” customer and brand experience.
Early evidence suggests this is a “win-win” strategy for J.C. Penney and these retail franchise brands. Take PVH-owned Izod for example. PVH Corp.’s Investor Day presentation in October 2012 showed initial sales at its Izod shop-in-shop outlets are strong, with sales up 40% since installation of the shops and Average Unit Retail (AUR) up in the double digits.
As of Oct. 27, 2012, J.C. Penney had installed the first 7.2 million square feet of the new stores or just over 11% of the 64 million square feet that will be eventually converted.
The results from the new shops have been excellent. In the third fiscal quarter 2012, the new shop sales averaged $269 a square foot or nearly double the $134 per square foot of the old shops.
J.C. Penney’s profitability looking forward
Assuming J.C. Penney’s new shops generate $269 per square foot in net sales and the old shops generate $134 per square foot, we can project J.C. Penney’s profitability at different stages of the transformation process in the spreadsheet below.
Total net sales (note 1)
Cost of goods sold
Operating expenses (note 2)
Total operating expenses
Net interest expense
Income/(loss) before tax
Income tax expense (@37%)
Net income/(loss) after tax
Shares diluted (million)
PE 12 x
40 shops out of 100 shops complete
25.6 mil "new" sq ft @269
38.4 mil "old" sq ft @134
13 mil sq ft "small stores" @134
70 shops out of 100 shops complete
44.8 mil "new" sq ft @269
19.2 mil "old" sq ft @134
13 mil sq ft "small stores" @134
100 shops out of 100 shops complete
64 mil "new" sq ft @269
13 mil sq ft "small stores" @134
*restructuring & other non-recurring expenses are excluded from above calculations
As shown in the table above, by November 2015 I would estimate J.C. Penney’s net sales increasing to $18.9 billion and assuming management stick to their commitment of a 40% gross margin and operating expenses at 29% of net sales, J.C. Penney will have an earnings power of $5.33 per share. If we apply a normalized price-earnings multiple of 12 for a specialty retailer, we would expect J.C. Penney’s share price to increase to $64 per share by November 2015, triple its current share price of $20.63 as of Jan. 30, 2013.
Funding J.C. Penney’s Transformation
J.C. Penney has insisted it can subsidize the transformation by relying on operating cash flows alone, but the reality is it has needed to sell non-core assets. In the third fiscal quarter of 2012, $279 million of non-core real estate assets were sold to subsidize partly $341 million in capital expenditure. A further $250 million in capital expenditure is expected for the fourth fiscal quarter.
The fourth fiscal quarter is traditionally the strongest sales quarter for retailers such as J.C. Penney, and evidence from previous years supports this view. J.C. Penney’s CFO expects the retailer to generate an additional $500 million in cash in fourth quarter 2012, bringing its cash balance to $1 billion by Dec. 31, 2012.
Further, J.C. Penney has a $1.5 billion line of credit that is backed by its inventory and which could be raised to $2 billion. So J.C. Penney’s end of year liquidity will be $2.5 billion, with $1 billion in cash and $1.5 billion in a line of credit.
J.C. Penney has other non-operating assets that it can liquidate if it needs to generate cash to fund the build out of the new shops.
Further, the company has reduced its long-term debt by repaying a $230 million debt maturity in August 2011. The company has no further debt maturities owing until October 2015, by which time the new shop build up will be almost finished, assuming management stick to the time frame provided.
· There is a muted turnaround or none at all and J.C. Penney will have sold off large amounts of non-core assets to fund the new shop build-out.
· There is execution risk in bringing the new brands into the J.C. Penney stores. Nevertheless, if new brands such as Izod continue to flourish it will motivate other retail brands to become involved in the J.C. Penney transformation.
· The U.S. could go back into recession in the near future or Europe’s continuing economic problems could restrict growth globally including in the U.S. This could limit or restrict the amount of profit growth from J.C. Penney’s new shop build-out.
· There is the risk that online retail sales continue to pressure margins of bricks-and-mortar stores, such as J.C. Penney. The flip side to this risk is that as J.C. Penney “transforms” itself to a specialty retailer and destination of choice, J.C. Penney will be able to cross-promote its Internet online sales.
· The sales per square foot of the new shops in the third fiscal quarter of 2012 were $269 per square foot. If customers can find all of their favorite brands within one department store then it makes sense for them to do all their shopping in the one place. This has the potential to drive up the sales per square foot and could materially raise J.C. Penney’s bottom line and share price.
· The real estate that J.C. Penney owns could be spun off into a REIT and the new J.C. Penney retail chain could be traded as a separate entity. Investors would then be able to more properly evaluate these businesses, creating the opportunity for J.C. Penney’s share price to substantially increase.
· The completion of the new shop build-out will increase J.C. Penney’s EPS and share price (see above).
J.C. Penney has substantial real estate which is significantly undervalued on J.C. Penney’s balance sheet. This provides investors with a solid margin of safety if the J.C. Penney transformation is not a success. However, if the transformation is successful and we extrapolate the sales per square foot of the new shops built so far, we can expect J.C. Penney’s EPS will approximate $5.33 by November 2015 on an annualized basis. Applying a conservative PE ratio of 12, we would expect the share price to triple from its current levels over a period of less than three years.
As a result, J.C. Penney’s shares are a buy at the current price of $20.63 as of Jan. 30, 2013.
Tarn P. Crowe, Crowe Finance
Disclosure: I own JCP shares personally and for my company and super fund.
Disclaimer: This article represents the opinions of the author but it is not intended as investment advice and should not be relied upon as investment advice.