Value Idea Contest Submission: J.C. Penney

In June 2011, nearly one year ago to the day, J.C. Penney (NYSE:JCP) announced a change that would move the 110 year old retailer into the purview of Wall Street and Main Street alike: the company had recruited Ron Johnson to step in as the company’s CEO. The market responded with excitement, sending shares of JCP up 17.5% to over $35, and adding more than $1.2 billion to the company’s market value.

Since that time, shares of JCP have been on a roller coaster ride: by mid-August the shares were back below $24, before climbing more than 75% over the next six months. From there, JCP slowly trended down until the company reported a weak Q1, causing shares to plummet; they are down nearly 40% since the start of May, and as of Tuesday afternoon trade for just over $22 per share (the market cap is equal to $4.85B).

THE BASICS

J.C. Penney’s sells a wide assortment of products (with a roughly balance between private label and national brands), with the breakdown for 2011 as follows:

Of Penney’s 1,100 stores (covering a total of 112M square feet), there are three separate formats:



Real estate is one area where Penney’s has a distinct advantage over competitors: the company owns 49% of their retail square footage, with the remainder being leased at an average $4 per square foot. In addition, certain locations (particularly “Legacy” stores) benefit from limited competition and generate high free cash flow for the company.

While Penney’s put up good numbers in the middle of the decade (average net income from 2006 – 2008 was more than $1B annually), the company has been on a downward trend in recent years, with poor performance being exacerbated by the busting of the housing bubble: revenue has fallen, margins have collapsed, and total shareholder return is last among its peer group. Looking over the past ten years, the company has averaged annually net income of roughly $560 million, equal to roughly $2.57 per share (218M shares out as of the end of Q1).

KEY INVESTORS

Bill Ackman, the activist hedge fund manager of Pershing Square, revealed in an October 2010 filing that his fund had taken a 16.5% stake in J.C. Penney equal to 39 million shares (including roughly 4 million options). In addition, Vornado Realty Trust, one of the largest owner/managers of commercial real estate in the United States, filed a 13D disclosing a stake of 9.9% in Penney’s. Three months later, Penney’s announced that Ackman and Steve Roth, the Chairman of Vornado, were joining the board of directors (as they had requested).

In August of 2011, an agreement was made with the company that would allow Pershing to acquire an economic interest in the company (via synthetic long positions) equal to 26.1% of its outstanding stock in exchange for reducing their voting interest to just 15% of the outstanding shares; such was Ackman’s interest in having exposure to JCP at the attractive valuation.

A Barron’s article from May highlighted Ackman’s comments from the Ira Sohn conference, where he said his average cost per share was $26, or 18% higher than the current stock price.

MANAGEMENT

Ron Johnson was born in Minnesota in 1959, and was the son of an executive at General Mills and a nurse turned homemaker. He received a degree in economics from Stanford University, and after a short stint as an accountant, received an MBA from Harvard Business School in 1984. As retold in a recent Fortune interview, Johnson turned down offers from places like Salomon Brothers and Goldman Sachs (GS) to work at Mervyn’s, a middle scale department store chain that was owned by Dayton Hudson (the present day Target) - "I thought, I want to be really good at something…I want to run a company one day, and I need to learn the business from the ground up."

Six years later, Johnson was moved to Target (Mervyn’s was run as a separate subsidiary) and was put in charge of housewares; his prominence began to rise after he hired architect Michael Graves to create low-cost versions of his designer products (140 of them). As noted in the Fortune article, the impact was sizeable, practically redefining the Target brand as a “chic discounter” – “The Graves line was such a smash that Target's image changed from a ho-hum discounter to a store that sells stylish but affordable products”. It’s important to recognize that the transformation at Target was similar to what Johnson is implementing today – he ran the Home area for Target from 1995-2000; over that period, the number of products sold that were on sale dropped from 40% to 3%.

In 1999, his career took a change in direction - a recruiter invited him to meet with Steve Jobs about building the retail operation for Apple; Jobs asked headhunters to bring him the best retailer they could find – with Johnson’s name topping the list. At the time, Apple was just a few years past a near collapse (Microsoft invested $150M in the company in a move many experts called an antitrust insurance policy), but Johnson left Target and accepted Jobs offer: “I wanted to help him fulfill his dream, which was to change people’s lives.” Johnson was the architect behind store designs and the Genius Bar, taking Apple retail from infancy to $18 billion in sales; today, Apple stores average roughly $6,000 of sales per square foot.

When Johnson decided to come to JCP, he made a financial commitment that aligned his long term interests with shareholders: he invested $50 million in warrants at market value with a seven and a half year maturity period (and he can’t hedge/sell for six years) – meaning that if JCP is trading at or below $29.92 in 2017, he loses every last penny.

Over the past 12 months, Johnson has surrounded himself with a balance of 41 former colleagues and legacy JCP employees, bringing with them experience as executives from places like Abercrombie & Fitch, GE, Apple, Gap, Boeing, Nike, Disney, Home Depot, and PepsiCo. While the result has been overwhelmingly positive, the recent departure of President Michael Francis (Johnson’s long time colleague from his Target days) after just eight months was a red flag that came with no explanation from the company.

As someone who has followed Mr. Ackman for years and has read multiple in-depth profiles on his life and career (including the recently published “The Alpha Masters” and the profile of his public fight with MBIA in “Confidence Game”), I’ve never found a single instance where I’ve doubted his credibility or his work ethics – this is someone I want representing my interests. While the media and the blogosphere speculate about the Francis incident (long on guesses and short on facts), I’ll stick with his opinion as a board member in the company: he told Bloomberg that he’s “100% behind the strategy” and “very comfortable” with Ron Johnson handling the marketing duties; for me, that is satisfactory until facts suggest otherwise.

Bill Ackman had this to say after Penney’s stock exploded upon the announcement of the CEO hire: “The market says the guy we hired is worth $1.2 billion…The market is wrong; he's worth way more than that.”

TIME FOR CHANGE

The mounting problems at JCP can be collectively summed up in two points: sales are too low (they’ve been essentially flat for eight years), and expenses are too high. J.C. Penney’s has backed itself into a corner with a strategy that is entirely dependent upon promotion; in 2011, more than 70% of all revenue was from products marked down by more than 50%, with just 0.2% (or 1 out of every 500 products) sold at the actual sticker price (compare this to Q1 of this year at 67%). Ron Johnson talked about the downward spiral JCP’s promotional strategy was on at a recent investor conference (bold added for emphasis):

“What's pretty clear to me is that for J.C. Penney, the promotional strategy had run its course. Let me tell you what that means to make sure you understand. From 2002 to 2012, a 10-year period, our price points went from $27, our average retail, to $36.We raised our price in a decade 40%.The revenue the customer gave us for every item went down $1 during that period from $15 to $14. So the average discount it took to get someone to buy a product went from 38% to 60% over a 10-year period. And if you look at what happened at Mervyns's, it was the same thing.

When all of the promotional department stores started, what did you do? You took moderate priced brands that Americans love and you offered them in a nice store environment with good service and you would promote them at the discounts that the market would let you, which is typically 25% off. And there was a good relationship between the everyday price and the sale price that gave some integrity, so if you needed the item, you could buy it, but if you wanted a little more value, you could come in for a sale. And that was kind of the model.

But as the stores got bigger - this happened to Mervyn's - they decided, well, we can make more money by sourcing some of this ourselves through private label, and so private label, which didn't exist, started to become something you'd buy, and it's 25% of the mix, 30%, 40%, 50%. Eventually, at Mervyn's, [private label was] 60% of the mix… And so over that time, you kind of lost your price integrity and the only way to beat a sale is what: A bigger sale.

And so if you look at Penney's over the course of 2002 to 2012, what happened was we increased our private label percent, kept raising our retails and offering bigger and bigger sales. But during that time, the volume didn't grow, right? That model wasn't working…

And toward the end of the era we concluded that our promotional strategy hit the point where there is only diminishing return from further promotions. You can't raise the price more and discount more. And there is no way out of the puzzle. And so we made the courageous bet that we are going to go through a year of transformation to get to the other side.

When I joined [Penney’s] the Company largely had a very significant promotional model, 590 events a year - that's two a day - 60% off onaverage on the products with merchandise that was largely undifferentiated. It was private label…it's essentially the kind of products you'd find anywhere where private label is sold. The brands we had access to were highly limited because of how we promoted because great brands don't want to be devalued in the marketplace… And so the brands we had access to, except for Sephora, were largely not differentiated… we did our best effort to create great products, but at the end of the day, the customer voted because they wouldn't buy it until we got it to 60% off.”

THE PROBLEM WITH PROMOTIONS

This promotional strategy has two huge detriments: one, it hurt the brand and caused suppliers to resist putting their product in the store for fear of destroying their brand; importantly, this strategy of selling commodity private label brands has lead JCP into a heads-on price war with companies like Costco, Wal-Mart, Target, and low cost online merchants like Amazon.com, a strategy that would surely spell disaster in a battle of price alone.

Ron Johnson said it best – “If we didn't change our pricing, we'd just continue to make a no-name private label and put it in the store and market it better. And that's not a business model we think is going to win in the long run.”

The second issue with an environment of constant promotions is that employees spent their time in a cycle of marking product due to nearly 600 “events” a year, which meant increased store work hours (despite less time focusing on product) and unproductive advertising that outpaced peers; at 6% of revenues, JCP’s advertising spend is 90 basis points higher than Kohl’s and 170 basis points higher than Macy’s.

CLOSING THE GAP

Simply catching up to peers will materially improve profitability: Penney’s SG&A (percentage of sales, excluding depreciation/amortization and rent) was 31% of 2011 revenues, compared to just 21% for Kohl’s, equal to a $1.8B cost reduction if JCP closes the gap.

Some of the anecdotal cost structure issues are truly shocking: for example, Penney’s has been spending 2x what benchmarks are paying on IT; upon arrival, the new vice president of IT was able to reduce the run rate budget for 2012 by 25% in just six weeks. The new management team (led by Michael Kramer) has brought the axe to cut the bloated cost structure, with estimated run rate savings of more than $900 million ($200M from Home Office, $400M from Stores, and $300M from Advertising) by year end 2012; this level of savings would be equal to 120% of the company’s 2011 operating income (EBIT).

THE STRATEGIC SHIFT

The new management team came in and revealed a new strategy, outlined here from the 10-K:

“On January 25-26, 2012, we announced our plans to become America’s favorite store. As of February 1, 2012, we introduced a new pricing and promotional strategy as well as a new personality for jcpenney and we began implementation of the remaining three pillars of our strategy. Our transformational strategy is based on 6 P’s of retail – price, promotion, personality, product, presentation and place – as outlined below:

Price. Our new pricing strategy is called Fair and Square and includes three types of prices: (1) everyday, (2) month-long and (3) best or our lowest prices.

Promotion. Our new brand marketing campaign showcases our products, highlights our new pricing strategy and focuses on 12 promotional events each year corresponding and themed to each calendar month.

Personality. We are revitalizing our brand to honor our century-old legacy and introduced a new logo that is evocative of everything we stand for: Fair and Square.

Product. We are making substantial changes in our merchandise and plan to add more global brands into our merchandise assortment.

Presentation and Place. We plan to re-organize our department stores into separately curated stores, shops and boutiques known as The Shopsthat will align a pathway through our stores known as The Street, which will surround The Square, a re-imagined center core experience offering attractions and services.”

The Presentation & Place portion of the shift is what I believe will be the catalyst for change at Penney’s; starting in August of this year, the company will introduce 10 new shops (including Nike, Martha Home, Michael Graves Design, William Rast, and others), followed by 2-3 new shops monthly through the end of 2015 (with national brand sales increasing from a current level of 45% over time). The interesting thing is that this shop idea has already been tried at JCP with great success – Sephora shops generate sales of $600+ per square foot, or roughly 4x the average sales per square feet across JCP as a whole.

As expected, JCP had to start fixing the other issues (like the promotional pricing strategy and the cost structure) before it could get the new product and agreements needed to put the strategic plan into place. While I will review the year to date results momentarily, it’s critical to recognize that the transformation will be completed, not started, in 2015; by August of this year, 50% of the product on the shelves will be new or revamped brands.

FIRST QUARTER RESULTS

Sales in the most recent quarter came in at $3.15 billion, down 20% from the $3.9 billion reported last year; on a comp store basis that represented a decline of 18.9% (with modest improvement through the quarter).

It’s important to understand the decline; let’s look at the components of the comp figure:



The changes in conversion and average spend are relatively small, but let’s look at the traffic component. As noted on the call, there’s an interesting component within traffic – when broken down by days of the week, Monday-Thursday was down 6% while the weekend was down 12%.

The explanation for this is that Penney’s was hardest hit when coupon shoppers were out at the stores – which the weekend is known for. The comps are up against a period (2011) where 40% of all transactions were “double downs” – sales plus another coupon. This business model is not sustainable and was running heads on into technological innovation that would render this pricing strategy ineffective (transparency is increasing with the continued adoption of devices that offer real time access to competitor pricing); JCP’s continued markup/promotion strategy was not a viable long term strategy - and despite the near term pain, the band-aid needed to be removed.

It’s also important to show what businesses were most affected in Q1 – particularly basics -which shows that although it is painful today, the transformation is putting JCP in a position where promotion isn’t the only thing driving traffic: “It turns out if you give someone $10 for the first $10 spent and they have nothing to buy, they are going to fill their sock drawer, they fill their underwear drawer, they buy towels. That is what the coupon did. The coupon was like free money; it is a justification to shop. So our businesses that are down are the basic businesses in Home, in Men's, in Women's and Kids; the fashion is actually doing quite well. That is encouraging, because we are going to compete on products and presentation.”

Continuing down the P&L, gross margin declined 290 basis points year over year; again, let’s break this down by category to see the change from 2011:



The positive 1.5% from net markdown/other is a retail accounting convention that is due to the moving of fall merchandise into Q1, so let’s ignore that positive impact since it is not related to the underlying business; there’s not much to be said on freight & delivery – it is what it is. For the remaining two categories, let’s look at them individually:

Aged Inventory Reserve – this is old inventory that has been sitting on the balance sheet; management wants to convert this to cash rather than sit with 2-3 year old merchandise (will be marked down and sold in other channels), which resulted in a $53 million write-down to estimated net realizable value.



Selling Margin Impact – The 240 basis point decline in selling margin impact accounts for the majority of the 270 basis point decline in gross margin; yet when we look closer, we actually see that this is part of the transformation. In Q1, the gross margin on everyday/month-long products, which account for 80% of the company’s sales, was HIGHER by 270 basis points to 51.6%. The reconciliation back to the net figure is from clearance and deeper markdowns, which was a 590 basis point headwind; again, this is mostly product that was purchased before the new management team joined JCP, and before the strategy was laid out for implementation.

DEVELOPMENTS IN THE STRATEGY

While ripping off the band-aid clearly impacted Q1, it’s important to look behind the quarterly results and see the long term impact of the strategic changes being made at retail.

Here’s Ron Johnson take on the customer reaction to date – “We like how the customer loves what's happening in the store. If you've been to a Penney's store, you'll see how cleaned up they are and the customer votes every day with their survey. Everything we measure, and have measured for a decade, they find much more attractive than before. The store is cleaner. The employees provide better service. The pricing is easier to understand. The overall value they find is higher. And that's really encouraging because that builds that word of mouth.”

This is spelled out in the in-store satisfaction scores compiled by the company in Q1 of 2012:



In addition to happier customers, the vendors are interested in what lies ahead. The company believes that they have room for about 100 shops (this includes shops that are already planned for rollout in August or shops with previously named designers like Martha Stewart) and posted a place online where vendors working with merchants could apply for shops in the middle of Q1; after just 45 days, management had received 110 applications. As noted by Mr. Johnson, the company is now in a position of having more choices for content than they have space for, meaning that the top prospects will be rolled out starting in 2013.

VALUATION

In Bill Ackman’s first quarter letter to Pershing Square investors, he wrote the following: “When we first announced our stake in JCP, the stock price increased to the low $30s per share. Shortly after announcing our stake, we were approached by one of the most well-respected private equity funds in the world who expressed an interest in acquiring the company at a substantial premium. While we welcomed this fund as an owner of the stock, we had no interest in selling the company for a quick premium because we believe in the long-term value creation opportunity.”

The valuation truly seems quirky based on what management has announced to date; looking at the excess that management has identified in the cost structure ($900M, or $2.50/share), investor’s could assume that the former operations were breakeven and still come to a value of $25-30 per share (10-12x earnings) simply based upon the value that opportunity presents. When we look at 2011 EPS of $1.49 and adjust for these cost savings, the stock trades at just 5.5x earnings; based on 10 year average earnings of roughly $2.55 per share, that multiple is even lower.

Looking at it another way, the real estate (by Mr. Ackman’s estimate) has a replacement value of more than $11B (compared to a GROSS book value of $4.8B; difficult to net out because accumulated depreciation is not split out between furniture/equipment and the buildings), which is more than 2x the current market capitalization of under $5B (remember, Ackman spent years on the board at General Growth Properties, which owns and manages shopping malls). As CFO Kenneth Hannah recently noted at an investor conference, the company feels very comfortable with the balance sheet not only due to the businesses ability to generate cash, butalso because there's a lot of non-strategic assets that have been on the balance sheet for a long time that management could monetize if necessary (analysis of the portfolio is currently being undertaken by Mr. Hannah and recent hire Ben Fay from Apple).

The ironic thing is that the market price of the company as a publicly traded going concern is a fraction of its value to a private owner or in liquidation (when PP&E is adjusted for the actual value of the buildings and the land, JCP is trading below book - even if inventory is written down to a fraction of its book value).

I think Mr. Ackman makes a strong case in his slide deck for JCP at the current price: his 2015 sales target is $177 per square foot, equal to peak sales per square foot hit in 2007 and 15% higher than 2011. As we move through the P&L, Ackman models 40% gross margins, which is equal to the low end of management’s target of 40%-plus. As I noted earlier on the gross margin, everyday/month-long products exceeded 50% gross margins in Q1; controlling inventory will be key, with management’s target inventory of 13 weeks being a good indicator of effectiveness.

The SG&A line assumes JCP realizes the $900M in cost savings guided; Mr. Kramer changed this to $900+ during the Q1 call, saying that he wouldn’t make the announcement if it was just $10-20M. Assuming these targets are hit, EPS will be equal to $6 per share in 2015; with a P/E of 10-12, shares would trade at $60-72, an increase in the stock of 140-190% by 2015.

CONCLUSION

Personally, I believe these estimates will be exceeded; I think the attractiveness of this strategy is clear (as shown by Sephora), and that this model will create a shopping experience that is different from any department store – however, I’m more than happy to pay a price that suggests Johnson is over his head and that Penney’s will not be successful.

The problem for the time being is that JCP is in limbo: the promotions and coupons aren’t there to attract the old customer base, but there are still few signs of any real change to the average consumer. I think there are clear catalysts on the horizon, particularly as shops enter the store starting in August and the media and Wall Street once again set their sights on Johnson & Co. Some people will feel the need to wait for assurance of success; I believe that the intelligent investor can look at the current variables (management’s track record, key shareholder’s track record, plausibility of the business strategy, difficulty to replicate, etc) and see that the current valuation is a steep discount to J.C. Penney’s intrinsic value.

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