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The Science of Hitting
The Science of Hitting
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JCP - Contest Submission Update

September 05, 2012 | About:

As some readers may remember, I presented my thesis for an investment in J.C. Penney (JCP) in late June; I plan on continually updating my thoughts on GuruFocus and will highlight key events as they come along. On Tuesday, CFO Ken Hannah presented at the Goldman Sachs (GS) 2012 Global Retail Conference; here are some of the important notes from the call:

“We’re very excited about the early read on the events that have happened in the store recently,” with specific mention of the free haircuts for back to school (1.8 million kids).

Shops were opened across 700 stores on August 1, with additional shops in those same 700 stores on September 1, all one month’s time (this is just the start, and the pace of change will continue to be rapid); the plan is still for $850 million in capex for the year, with the majority being spent on the store transformation.

“We saw enough in the August shop performance to remain committed to this strategy… we believe we’ll have around 40 shops in our stores next year with the goal of eventually moving to 100 shops inside our [each] store.” Mr. Hannah also added that if results start to come in better than expected, the company could accelerate the rollout – the only real constraint is capital.

When asked why he took the job, Mr. Hannah specifically mentioned that Ron Johnson is open to debate and transparent, and is someone he wants to work with on a daily basis – for me, a big relief after some concern about the “resignation” of Michael Francis back in June.

The cost-cutting target of $900 million on an annual (run rate) basis is still the target – the company was at $194 million year over year in the second quarter, and Mr. Hannah says you can expect that to accelerate in the back half.

In terms of the pricing strategy, an analyst commented that he doesn’t believe it was necessary to do in order to access quality brands (a key issue for JCP) – as he noted, look at Macy’s (M), which has quality brands but still offers discounts/coupons. Mr. Hannah responded that “time will tell,” and that the access JCP has to certain brands as a result of their actions will be apparent with time (presumably as shops and brands continue to be showcased one by one in the store).

There are 700 stores with roughly 100,000 square feet, and 400 stores with anywhere up to 50,000 square feet; the 400 stores are generating strong cash flow, and the company is “very pleased” with the performance in those small stores (limited competition) and with leaving those locations as-is for the time being.

The agreements for the vendor and JCP are generally targeted for multi-year relationships; “we want an everyday low cost from them as a partner,” while minimizing the need to push goods through clearance (around 10% selling margin on average, compared to roughly 50% for everyday pricing).

The shares held in the Simon REIT were redeemed at a 20% discount to the market price – partly because management felt the time to monetize that asset (which was selling near all-time highs) while also being able to defer the tax by going directly through Simon was a much better value than by going through the sale on the open market (a question I’ve long been waiting to hear asked – and glad to hear answered!)

On a funny (sad?) note, Mr. Hannah mentioned that he often ends one-on-one talks with analysts by asking them if they’ve actually been into the store and seen the JCP shops, and he is surprised by how few have. Clearly, these are people who have an active interest in the companies that they’re following!

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct". I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 4.4/5 (24 votes)


Aagold - 5 years ago    Report SPAM

I'm a JCP shareholder and am hopeful about the prospects of their transformation succeeding, but I remain skeptical about their decision to eliminate coupons and discounts. That didn't stop me from buying JCP shares because I figured that they could always reverse course later. I was just curious what your thoughts were on that. Is there really any evidence that it was necessary to take such a dramatic step as eliminating coupons and discounts? I sure hope they don't stick with their decision too long solely to "save face". I certainly would not think any less of Ron Johnson if he reverses that decision.

- aagold
The Science of Hitting
The Science of Hitting - 5 years ago    Report SPAM

That's a good question - and management's answer would be that it was necessary in order to secure brands that were tired of seeing their products marked up only to be slashed 30%+ on the majority of transactions. I tend to be a bit agnostic on this - while I see the merit for some clearance sections in the store (as management has now implemented), I also think this idea that nobody has a reason to shop unless they are using a coupon is absurd (particularly from the same people who talk about Amazon's push to price transparency and how it will destroy brick-and-mortar retail - is it really that hard to compare an everyday price with a competitors marked-up product plus a 20% coupon?).

While most people are laser-focused on the effectiveness of the pricing strategy, I care about store presentation (which drives traffic) and quality products (which turns traffic into sales) in addition to reasonable prices; I believe management is clearly focused on this, and has laid-out a plan that has the potential to be a big winner over time from my view (and research). Whether or not I am right is yet to be seen, but I think the real estate portfolio tips the risk-reward scale in my favor in a big way.

Thanks for the comment!
Ttony premium member - 5 years ago
I also have wondered about the fixation with the pricing strategy. More to the point is their competitive position with their space cost and also the tremendous amount of expense reduction which is going on. Add that they seem to be assuming the technology lead with an owner who is willing to do what is best for later rather than bow to the usual pressure from the predominant short term expectation of results and we have a powerful package. Then their is Johnson who saw the transition marketing problem and ACTED. He didn't duck; he just acted and closed down the entire thing until a better strategy could be found. That to me is leadership.

I love the current shareholder's odds of making a tremendous return. And we can hold this for some time; the roll out and perfection of the new system will take years and hopefully continually add to the sales per square foot.

My question would be when Ackman will buy more.....as he has said, seldom does an opportunity present itself with a multiple of entry price return.

One factor not ever mentioned is that JCP will soon starting creating a buzz. As it rolls out new little section after new little section I would think both the media and shoppers will want to see what is THE LATEST. Also success will bring more success as vendors who do not have a major presence in the US market will see that they can immediately have their own, somewhat controlled world, immediately in 700 stores.

The September 19th show in Texas will win converts.

At some point they will address the 400 smaller stores and housewares.

This is going to be alot of fun and almost certainly very profitable for a long time.
The Science of Hitting
The Science of Hitting - 5 years ago    Report SPAM

You make good points; unfortunately, the financial media could care less about long term results, and has difficultly looking at financial statements and understanding what the $900M in cost reductions mean in terms of earnings power (as you know, it is material).

In terms of Ackman, my understanding is he cannot buy more; when he was building up his stake, they announced in August of last year that Pershing had increased their stake synthetically (via derivatives) but would hold their voting rights to 15% of shares outstanding and not increase their stake in the company without explicit permission from JCP.

In terms of September 19th, the story will only continue to improve with time (in my opinion); thanks for the comment!

Shb600 premium member - 5 years ago
Could you explain the Simon Properties transaction? How much cash after tax did the company receive? Why the 20% discount?
Ttony premium member - 5 years ago
one other point...all this talk about financial disaster appears to me to be silly. The first two quarterly results were littered with transition items; adjustment for inventory write down due to change in strategy; write down of inventory to adjust for 20% lower sales totals; less advertising spending than anticipated in second quarter; higher pension expense due to low interest rates; write down of fixtures no longer needed for new layouts; etc, etc, etc.

But one thing does stand out to me...they haven't lost much money aside froml the write downs. Usually when you lose 20% of your sales it is a financial disaster but this hasn't been. Why? Taking Value Line numbers for last year we see sales around $17,250 B. Lose 20% and it comes to $3,450 sales lost. Their gross margin last year was 36%.......but the 20% of lost sales this year almost certainly included a large majority of the most ambitious coupon clippers...very low margin type shoppers. So reducing that gross margin on that lost 20% of sales to 26% and we come up with $975million of lost profit. But we are reducing overhead at a year end rate of $950.....so the way I figure it the financial results are surprisingly good for this stage of a FAILED transition. Now we have stores with better technology, much better inventory control, much better ownership and management, and a new selling stage.
The Science of Hitting
The Science of Hitting - 5 years ago    Report SPAM

I'm certainly not someone to explain the tax implications of the transaction, but my understanding is that by going through Simon (as opposed to on the open market), the company was able to liquidate the stake quickly (to capitalize on market price run-up) and in a tax efficient manner; it's important to remember that they hold another 205,000 LP units, with an estimated value of roughly $25 million.


As always, you can't listen to the street or CNBC; as you point out, there are issues with inventory (the new management team explicitly stated that they took a charge on old inventory that previous executives had essentially swept aside), the pension (with the funded status significantly stronger than the vast majority of publicly traded companies), etc.

On the cost front (and how it correlates to lost sales), you are spot on: Ron Johnson talked about this on the Q1 conference call, discussing that product lines like towels, socks, etc had been the hardest hit in the quarter, because consumers with "$10 FREE" type promotions would come in and buy essentials - and then leave. The obsession with sales over profitability is comparable to EPS growth at all costs - people fail to understand that sales, much like EPS in a vacuum, does not necessarily signify value creation to the company's shareholders.

You'll notice that analyst reports and CNBC segments rarely focus on the actual strategy in question - they simply discuss the drop off in sales (without discussing cost cutting measures), never discuss key non-GAAP figures when they are relevant (yet let companies like CRM parade BS earnings numbers quarter after quarter), and cannot see beyond next quarter (or apparently read a balance sheet). As always, my grief comes with a shred of optimism - they are the people creating the inefficiencies that present investment opportunities like JCP below $20/share and Berkshire below book value; thanks for the comment!

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