No need for an introduction – let’s jump right in.
I called “Home” an unmitigated disaster in a recent article about J.C. Penney (NYSE:JCP); a look at sales by segment (percentage of total) shows just how bad the section has been for the company:
|Women’s Accessories (+ Sephora)||11%||12%||12%||13%|
|Services & Other||5%||4%||5%||5%|
As well as in dollar terms:
|Women’s Accessories (+ Sephora)||$1.93B||$2.13B||$2.07B||$1.69B|
|Services & Other||$878M||$710M||$863M||$649M|
Here’s the change in sales (cumulatively) from 2009 to 2012, by segment:
|Women’s Accessories (+ Sephora)||$1.93B||$1.69B||-12%|
|Services & Other||$878M||$649M||-26%|
The press has clung onto the importance of the “Joe Fresh” shops, but the real game changer will be “Home” (we’ve started to see a shift in their focus as time has passed). As anybody who has been in a store lately knows (as of late March), the company is currently engaged in a material transformation of that department; shelves are essentially empty, and much of the floor space is marked off for construction. At completion in May, JCP anticipates opening close to 20 shops in 505 stores with brand partners such as Michael Graves, Jonathan Adler and Sir Terence Conran, among others. Upon completion, just under 40% of the stores will have been transitioned to the “shops” model.
It seems fitting that this section, the epitome of a department store clinging to the past, will likely prove to be Ron Johnson’s ultimate test; in my mind, his vision to transform J.C. Penney will live or die by the transition of “Home.”
In last year’s 10-K, the company laid out its pricing strategy and other key changes in the “Business Strategy” section; in regards to pricing, here’s how the section reads this year:
“Our pricing strategy is founded on providing merchandise at low everyday prices and delivering even more exciting value through sales, promotions and rewards.” We saw a small example of this in each of the past two weeks; I’ll be thoroughly disappointed if this type of activity doesn’t ramp up substantially in the near future (again, I’m hoping Mr. Zyman’s experience helps here).
In last year’s filing, the company jumped out of the gates with boiler plate commentary on macroeconomic (“Our Company’s growth and profitability depend on the level of consumer confidence and spending.”) and competitive (“The retail industry is highly competitive, which could adversely impact our sales and profitability.”) risks. This year, the company immediately noted – with the 2012 operating results as “Exhibit A” – that the success of the transformation is the company’s primary risk. Notably, the company added some key wording to the competitive risk this year (emphasis added) – “We operate in a highly competitive industry that includes significant promotional activity, which could adversely impact our sales and profitability.” The section continues as follows: “During the first year of our transformation, we discontinued our former promotional strategy and encountered difficulties in communicating our value proposition. Although we have re-introduced certain promotional activities, there can be no assurance that increased promotional activity will result in increased sales and profitability.”
In another section, which focuses on the importance of traffic in driving sales, the company again references their return to a promotional strategy: “There can be no assurance that our efforts to increase customer traffic and visit time in our stores will be successful or will result in increased sales. We may need to respond to any declines in customer traffic by increasing markdowns or changing marketing strategies to attract customers to our stores, which could adversely impact our gross margins, operating results and cash flows from operating activities.” I’ve said this before and will repeat myself again – I consider this to be critical; the company needs to stand up and say “we were wrong” – and give consumers the markup/markdown strategy they love so much. JCP has started to move back this direction – and needs to speed up.
At year-end, JCP operated just over 1,100 stores as of Feb. 2, with total square feet at 111.6 million; of those stores, 429 are owned, including 123 located on ground leases. In addition, the company has a supply chain network (merchandise distribution, jcp.com fulfillment, etc.) that operates 24 facilities; JCP owns 11.7 million of the 14.5illion square feet associated with the supply chain network. Finally, JCP owns their home office facility in Plano, Texas (about 20 minutes north of Dallas) – as well as 240 acres of adjacent property.
|Year||Gross Selling Space||Sales Per Gross Square Foot|
As we can see, the recent recession hit JCP pretty hard – four years after sales per square foot had peaked around $177, they were still off double digits from the peak; 2012 was a move in the wrong direction, and highlights just how material the impact of the pricing strategy truly was.
In 2013, the company is targeting capital expenditures in line with 2012, around $800 million; this spend will relate primarily to investment in shops and technology improvements. While still a sizable investment, it includes the addition of an estimated 30 shops, which lends support to Mr. Hannah’s commentary during a recent investor event suggesting that previous management teams had woefully underspent (on things such as lighting, etc) “for a number of years” – spend that the current team considered necessary. With that said, $800 million is a big number for a company with a similar amount in cash on hand (before considering sizable net outflows that will also occur during the year); I’m increasingly certain – despite the fact that it gets no play in the financial press – that JCP will make some big moves towards liquidating non-core assets (and pick up the pace of closures where it makes sense) in the coming months; as I’ll show below, we’ve got clear visibility into a couple hundred million dollars – from sources that can be tapped without affecting JCP’s core business.
In 2012, after adjusting for the repayment of long term debt and the (now discontinued) dividend – which totaled roughly $320 million - the company’s net decrease in cash, INCLUDING capital expenditures, were roughly $250 million. We certainly can’t expect the same amount of help from changes in working capital, but hopefully will see a similar bump from asset monetization (management has continually said “a couple hundred million”) and improved operating results; considering that the company’s transformation will be 38% complete in the coming months (and address the weakest section of the store), we’re getting closer to the point where the impact of the transformation can become a meaningful part of the business.
Here are some often overlooked assets that may be liquidated in the near future:
JCP continues to own 205,000 units of SPG after selling 2 million in July 2012; at Monday’s close, those 205,000 units are worth roughly $32.5 million (cost basis around $7 million, but carried at fair value under GAAP – listed under “other assets”).
The company sold four investments in four joint ventures that own regional mall properties for $90 million; because the net book value of the JV’s were -$61 million (distributions related to refinancing transactions in prior periods reduced the carrying amount of the investments), the company booked net gains totaling $151 million on the sale. At the time the 10-K was filed, JCP continued to hold investments in nine joint ventures that own regional mall properties; at a 20% discount to the other JV’s, the nine still on the books would be worth $162 million to JCP (while not specifically noted in the 10-K, my estimate is that these JV’s account for the majority of the $33 million “other” piece reported in “other liabilities”).
In 2011, JCP bought 11 million shares of common stock of Martha Stewart Living Omnimedia. I certainly wouldn’t expect the company to hold onto this stake if the result of mediation is unsatisfactory; at Thursday’s close, the market value of this position was roughly $27.5 million.
Finally, the “other assets” account lists $36 million in cost investments, described as such: “The cost investment is for equity securities that are not registered and freely tradable shares and their fair values are not readily determinable; however, we believe the carrying value approximates or is less than the fair value.” I’m not positive what this is in reference to (if anybody has any clues I would love to hear them), but the language suggests the carrying value is a good proxy.
In total, JCP's balance sheet shows $745 million in other assets as of yearend 2012, down roughly $400 million from the prior year. The few examples presented – none of which include owned stores, long term leases well below market rates, owned real estate in the supply chain network, or the company’s home office and adjacent property in Texas – will likely bring $200 million to $250 million to JCP if liquidated.
At a higher level, the current ratio stands at 1.42X, with the net current asset position around $1.1 billion. The long term debt on the company’s books is just that – long term; the weighted average maturity is 24 years, with the nearest maturity (for $200 million) coming in 2015.
There certainly isn’t much love for Bill Ackman, Ron Johnson, or J.C. Penney these days; the same can be said for Best Buy (NYSE:BBY) a few months ago, or Research In Motion (NASDAQ:BBRY) before that (you don’t have to look back very far to find a case of fearful analyst group-think; as usual, that group-think coincided with the point where the common stock was increasingly attractive).
Value investors live by a simple mantra – focus on the separation between price and intrinsic value; when the market becomes overly pessimistic or optimistic – and you can objectively state that you believe you’re capable of spotting that disparity – act accordingly. Of the three larger scenarios that I see as likely for JCP in the next few years (success, failure with Johnson out and the strategy abandoned within the next year, or failure with Johnson taking the ship under), I continue to believe that one presents material upside, while the other two aren’t nearly as dire – or likely – as the market currently seems to believe. Real estate valuation is a critical part of that calculation, but difficult to assess. The stock recently jumped on a note from ISI suggesting that the company’s top 300 stores under a new strategy could justify a valuation around $40 – or about 2x the current book value of JCP’s land and buildings (net). I’m not advocating their strategy – but I think it presents an interesting thought exercise on the potential scenarios that would unlock the company’s real estate value and make the current valuation look grossly inadequate – even while assuming the current strategy is a failure (which, by the way, doesn't mesh with early shops sales data).
The next quarterly results will likely be atrocious; the home department is essentially closed at this point in time, and accounts for material amount of floor space in most locations. I’m very focused on the continued push for a more promotional strategy, as well as the company’s efforts to liquidate non-core assets in the coming months. For the investor who is capable of blocking out all the noise – and their certainly is plenty - I think buying JCP at the current valuation is a sound decision once each of these scenarios is considered (I’ll leave it to the reader to form their own judgment on the likelihood of those scenarios and the expected value in each situation – and those uncomfortable making even rough calculations should not buy on my recommendation).
In the next few months, we will be at 38% shops, and 40% by year end (assuming all goes as planned); this is a far cry from the 10% reached to date, and will start to have a material impact on the combined (old & new) sales data. I’ve hashed out my thinking for readers in prior articles, so I’ll simply conclude with the following - I will likely add to my stake in the next 90 days.
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About the author:
I think Charlie Munger has the right idea: "Patience followed by pretty aggressive conduct."
I run a fairly concentrated portfolio, with a handful of positions accounting for the majority of the total. From the perspective of a businessman, I believe this is sufficient diversification.