JCPenney (JCP) reported fourth quarter earnings after the close on Wednesday, and it’s safe to say that management and investors are happy to see 2012 is finally complete. For the full year, sales declined by nearly one-quarter (even when including a 53rd week) to just shy of $13 billion; we’ll take a closer look at the income statement in a second, but it’s safe to say that the financials were utterly atrocious. As we can see (here), Bill Ackman’s original expectation – that sales would start to turn positive by August 2012 with the addition of the first shops – clearly doesn’t mesh with today’s reality; in fact, comps worsened throughout 2012.
Management’s pricing strategy, one that I fully supported in hope of better customer service (less time spent changing signage) and in fear of increased price transparency due to Smartphones, has been disappointing; this year was largely a test of that strategy – and resulted in demonstrable damage to the company’s financial position heading into 2013.
With that said, let me be clear about something: the real target, in my view, is differentiation in the store. Partnering with brands like Joe Fresh, Disney, Michael Graves, and others, was always the goal; the pricing strategy was, in a lot of ways (at least as told by management), the only way to appeal to – and land – these brand-conscious suppliers. Despite management’s decision to revert to a more promotional model, there’s no indication that any national brand partners have an interest in backing out of their shop plans with JCP; the company’s pricing strategy targets promotion in JCP’s own private label brands (“going to promote them more aggressively to get customers in the store”), with national brand partners able to run their business as they see fit.
HOME: AN UNMITIGATED DISASTER
The company’s troubles for the year were most apparent in the home department. As I noted in an article from last October (“JCP – A Consumer Perspective”), it really didn’t seem like it could have been otherwise:
“Once I got out of the apparel sections and into the areas selling kitchen appliances and home goods, I noticed that a lot of the products being sold didn’t really mesh with what I envision as the future of JCP. A great example of this was a rack of 50 to 100 boxes of K-cups and Nespresso pods. I simply cannot imagine who comes to JCPenney to load up capsules for their single-serve coffee machine (and after looking at the rapidly approaching expiration date on many of the boxes, the answer might be that not many people do). Thinking about the strategy as presented by Johnson, it is about product quality, with a focus on differentiated experiences and offerings. What the company will do in sections like kitchen to eliminate the plethora of cheap appliances and other trinkets that have no real place in the store and face direct competition with the Walmart’s (WMT) and Amazon’s (AMZN) of the world is still a bit unclear to me.”
On the Q4 call, management provided some commentary that perfectly encapsulates the problem facing the company in home – a problem that will hopefully turn and start heading in the right direction in the coming months (emphasis added):
"But the biggest change of all is coming in May. As you know, we are undertaking a complete makeover of our home department with an average of 19,000 square feet per store under construction as we speak. Home has been one of the worst performing categories in our stores for years and in particular this past year and we’re going to get the business back. Home formerly ran nearly 20% of J. C. Penney store sales and over the years it has declined to a mere 10%. Sales per square foot in home which formerly ran at $185 per foot have dropped through the years to under $80 per square foot. It’s an incredible opportunity and a great place to launch the new JCP.
When we unveil our new home department in May, we will have created the most exciting place to buy home products in America. With new partners such as Martha Stewart, Michael Graves, Jonathan Adler, Sir Terence Conran and more and great brands such as Bodum and Calphalon, and OXO and Keurig, we will have the most sought after products for Americans to update their homes and we will introduce a shopping environment unlike any other. We will roll out nearly 20 new shops, create a street in our stores filled with activities and some stores will even include a kitchen where people can learn and get help.”
Even if the company is able to include products from Martha Stewart in the coming months (far from certain), I’m still questionable about this business (I’ll believe it when I see it); considering that home accounts for more than 10% of the average square feet in JCP’s on-mall locations (19,000/145,000), success here is vital. The one thing going for this section of the store is the atrocious comparison – by my back of the envelope math, pulling same store sales to even $125-130 per square foot would add about $800 million – or +6% - to JCP’s top line results in 2013.
Success in home is also critical because it will result in material CapEx for JCP, and will need to partially fund continued expansion through the end of 2013; as noted on the call, continued additions will transition the stores from a handful of shops towards increased saturation: “When home is completed in May, we will have transformed over 30% of the floor space in over 500 stores and we’ll move from having a few islands of improved space to critical mass and we expect this to provide synergy between the new JCP and J.C. Penney. As customers come in to shop for home, they’ll discover Joe Fresh and Sephora and MNG by Mango and more and many will see for the first time the irresistible style and unmatched value we deliver through our great own brands such as Arizona, Liz Claiborne, Worthington, JCP and St. John's Bay.”
YEAR END FINANCES
Looking at the financials, let’s start by counting the cash; starting with the cash flow statement, we see cash flow from operations was a use of $10 million for the year. This number was materially improved by +$748 million from working capital, a result that will not recur in the coming fiscal year. The net decrease in cash for the year was $577 million, with notable items being repayment of long term debt (use of $230M), CapEx (use of $810M, up from $634M in the prior fiscal year), a decrease in inventory and an increase in payables (collectively, +$715M), $526M from the proceeds on the sale of non-core assets, and finally a GAAP loss of $985M.
On the balance sheet, the company ended the year with $930 million in cash, and $845 million after adjusting for the deferral of select vendor payments in the fourth quarter – well below management’s target of $1 billion at year end; this is a target that I had a clear eye on, and a big miss in my book (should’ve been guiding very conservatively considering timing of estimate). Of course, cash isn’t the only asset we’re counting; as pointed out by CFO Ken Hannah during the call, “other assets” were a significant area of monetization for JCP in 2012, and they see continued opportunities in 2013: “All other assets are down $422M for the year. This was primarily driven by the monetization of the non-core assets early in the year for our REIT ownership interest, leverage leases, and regional mall partnerships. We still have several hundred million dollars of opportunity here.” The “other assets” account on the balance sheet was reported at $745 million as of February 2nd, 2013, yet rarely receives a single line in articles proclaiming cash troubles at JCP; I’ll discuss this key account further when we get the 10-K.
Another important item to touch on is the company’s credit facility, which was amended a few weeks ago; here again is Mr. Hannah, explaining the updated facility terms: “We increased the line of credit from $1.5 billion to $1.85 billion and increased the number of lenders. We also increased the accordion feature from $250 million to $400 million. We increased the flexibility for third-party financing and updated the representations and warranty section to acknowledge the business results in the first year of our transformation. There were no changes to the asset borrowing base, which were the company's receivables and inventories, nor the borrowing rates. There are no new financial covenants associated with this facility. We are very pleased with the support of our banking partners.”
If we look at the line of credit, including the accordion feature, in combination with the roughly $850M in cash on the books (adjusted for deferred vendor payment early in Q1), JCP has access to about $3 billion in short term capital. Thinking about this balance in addition to other assets and potential transactions with company-owned real estate (as noted in Section 6.06 of the credit agreement, the company is allowed to engage in Sale/Leaseback transactions if certain criteria are met), I still believe that financials will support shop construction throughout the full year, with much help from continued asset monetization (if we don’t see material sales per square foot improvements in departments like home, a lack of cash won’t be the only reason why the shop strategy will be abandoned by late 2013; management didn’t go into the level of detail given for Q3, but said shops “continued at the same exceptional rate during the fourth quarter”). As a remainder, the company’s next debt maturity isn’t until 2015 ($200M of 6.9% Notes); as noted above, I will provide a much more detailed discussion when we get the 10-K.
To close, I want to note something that I think is commonly overlooked (exaggerated may be a better word): some people believe that consumers will NEVER return after the pricing fiasco of 2012. I have a question: for the customer who stopped coming to JCP, solely because they stopped having sales and offering coupons, where was the loyalty to begin with? If that person ONLY came to the stores with a coupon in hand or when summoned by a TV or newspaper ad proclaiming “20% OFF!”, what would hinder his return when the same approach continued – albeit after a twelve month delay? Some people will undoubtedly feel scorn for the company and swear off ever returning again, and I’m certainly not predicting that sales regain all their lost ground when the sale spigot is reopened; I would simply point to a recent ad campaign the company ran that focused on cost savings, as noted on the call: “Three weeks ago we launched a campaign called “Compare” which establishes a great value of our everyday prices by comparing our key items with those you would find elsewhere. We saw an immediate jump in traffic and sales the moment these ads began.” How big of a jump is naturally up for question, but my point is this: as JCP returns to this space, I think many people could be surprised by the reemergence of the bargain shopper; couple this with the continuation of the proven shops strategy (granted, over a short period of time), and I think we're seeing a more likely iteration of what JCP could become.
I continue to view this as a multi-year transformation; I’m a bit reserved in my opinion until I have a chance to do a thorough reading of the 10-K (and am not looking for much improvement in near term results), but at this point I remain steadfast in my belief that the risk/reward balance favors the long term JCP investor at the current valuation. Until I get the annual report in hand, I will likely not add to my position in JCP; as always, I welcome your comments.
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.