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Department store chain J.C. Penney (NYSE:JCP) and its CEO Ron Johnson have been under tremendous scrutiny since Johnson took the reins in November of 2011. Johnson, independently wealthy from his days leading the retail push at Apple (NASDAQ:AAPL), came in looking to revamp the retailer and ignore the Street in the process.

Sales declines have been staggering. Same-store sales fell 26.1% during the third quarter and internet sales, in a secular uptrend, declined 37%, leading to a 26.6% decline in total sales. Earnings, on a non-GAAP basis, fell from $0.18 per share to a loss of $0.93 per share. The company also generated negative $389 million in free cash flow, though the majority was due to cash used for capital expenditures. With the firm's cash balance declining to $525 million from just over $1 billion a year ago, credit agencies have begun to downgrade J.C. Penney's credit rating.

We've been staying away from shares since the leadership change, and we continue to find them unattractive. Please click here to read our February 2012 article on how we used a DCF process to avoid the J.C. Penney investment hype. However, the recent sell-side downgrades calling for Johnson's head are baffling, in our view. The company's cash burn in the third quarter of 2011 (pre-Johnson) was worse than it was during this most recent quarter, as it built tons of inventory. Further, we think the market is completely missing the obvious in this situation: J.C. Penney was on its way to a slow, Sears-like (NASDAQ:SHLD) decline. Management was underinvesting in stores, not innovating, and slowly but surely, killing the business.

The Fallacy That JC Penney's Was Thriving

Some may think pre-Johnson J.C. Penney was a thriving company, but that clearly wasn't the case. Aside from a sparse capital expenditure budget in 2009, the company has struggled to generate much profit at all. Even more telling, year-to-date, SG&A is actually down 12.5% thanks to several cost savings initiatives (though it doesn't look good given the terrible sales decline).

Considering the company is in the midst of completely changing its business model, we don't think the cash burn is that bad (at least at this point). In fact, it simply underscores how much the company wasted on marketing and capital expenditures prior to Johnson's tenure. With Penney's reporting that sales are much stronger in the remodeled parts of the store, we believe the company could recapture some of its lost sales once the transformation is complete.

Of course, there's a chance the strategy doesn't work out, and the once-legendary department store fails. However, we think a strategy failure will simply accelerate an inevitable decline rather than be the cause of it. We'd rather J.C. Penney go down swinging rather than take the Sears, slow-death and "hope some financial engineering works out" approach. Given that the fourth quarter generates the lion's share of profits for retailers, there's a chance free cash flow for 2012 is roughly in-line with Penney's peak year of 2007. In this context, the same-store sales decline doesn't seem nearly as negative.

We think the risk/reward for the retailer remains unfavorable, and we think a wait-and-see approach is warranted at this time.

Source: Why J.C. Penney's Strategy Change Was - And Is - Necessary