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J.C. Penney (NYSE:JCP) is back in the headlines as a result of another pricing change by the CEO Ron Johnson.

I believe these adjustments makes sense and the people who criticize him don't understand what he is doing and how the old JCP worked. In this article I'm going to explain why these changes represent a positive for the stock.

Thesis

It's a well-known fact that people are suckers for discounts, coupons, sales, etc. People might not buy a $40 item but turn around and buy that same item if it's priced at $55 but marked down to $40 in a "one day sale" or with a coupon. Retailers have been using tricks like these ever since they noticed it appeals to human nature.

Our DNA is programmed mainly to survive and replicate, saving money in shopping is attractive to us because it allows us to survive longer and better because we economize resources. We are wired to look for opportunities like these. Many people may fall for this trick even though they are aware that this is going on. I consider myself a rational person but even I will be tempted by retail tricks like these mainly because it creates a perception of value and scarcity in the item that is being discounted. It takes quite a lot of discipline not to fall for these methods and lots of people don't have it.

On the other hand there are issues with highly promotional strategies like these (and they are the main reason the old J.C. Penney was struggling). First, lots of brands won't provide products to your stores at attractive prices because they don't want to cheapen their brand. This was a big issue for the old JCP as the higher margin brands refused to sell in their stores because they didn't want to lose their premium appeal and become just another commoditized clothing provider. Second, you tend to attract value-oriented people looking for bargains and these clients tend to be lower margin (premium clients don't want to shop in "cheap" stores). Thirdly, you spend a lot on marketing, changing price tags and other operating costs in order to keep these illusions going. And finally, you sacrifice margins when you have to keep decreasing prices till someone buys.

There is no free lunch, in order to make use of these tricks there are trade-offs and it's a question of how much of these trade-offs you want. In economics people frequently used tools like curves in order to explain relationships, I believe in this case it can capture these trade-offs quite well. Here is a curve I built that I believe captures well how these relationships work:

The exact points of this curve are not important, it's a rough estimate. In 2012 he clearly went too much to the left, offering very little promotions, and as a result profits collapsed and clients revolted. Now he is trying to move to the right, increasing promotions and that is expected to increase customer interest in the company again and as a result, profits. The old JCP was too much to the right, he is trying to find the correct balance.

But what is even better than all of this is the price comparison that he is rolling out, he is not going back to the old strategy where 99% of products was being sold with a coupon or discount, instead he will use some of that combined with "suggested" prices from the manufacturer (which will be higher than the price JCP will sell at) and comparisons with the competition (thus triggering the perception of value in the client mind). The advantage of doing that is that its almost free, there is no need to spend heavily in marketing, you simply show two prices and let the client decide if there is value there or not. One reason to believe that this will work if the fact that they tested that on Izod men's merchandise last fall and the result was very good.

The reason why I believe he is the right man for the job is because he has shown so far no problem with admitting mistakes and making changes and he has being highly transparent about it. As a result I believe it's highly likely that he will either find the sweet spot or will get very close to it because he will keep adjusting. At the same time he is doing his store experience revolution (the new JCP, which according to the last data boosted sales by 33% on average, this is what he is good at and the main reason Apple Stores are so popular) and this year it is expected that another 30% of the stores will be changed (from the current 10%). I outlined in this article how that will affect EPS based on current trends. If he finds the sweet spot or gets close to it, that article will prove pessimistic as he will boost sales in the old stores as well (and the new stores will become even more profitable). $70 a share or more becomes a possibility.

Risks

The main risk that I'm concerned about is a recession. This could impact sales in a way that makes shareholders think it's all his fault and as a result he could be forced to step down. The new CEO might not be as flexible as him and be stuck in the wrong point of the profit curve and leave the company stagnant (he could also not do a good job in improving the client shopping experience). Another risk would be if the recession lead to a liquidity problem thus forcing an equity or hybrid security offering, thus diluting the stock in the low point of the cycle. I don't believe that is a concern for 2013 and outlined the reasons in this article. If in 2013 the company doesn't deliver I might close out my position or buy puts in order to protect myself from that risk but I do expect improvements in sales this year as the new stores roll out and pricing changes take place.

Conclusion

I believe JCP stock is substantially undervalued because it is essentially an option (from a risk to reward perspective) that is mispriced due people not understanding the new CEO strategy which I explained in this article. Other reasons for the mispricing are excessive negative media coverage, analyst pessimism, career risk by fund managers, overall uncertainty, underestimating the CEO capacity in order to feel superior or not be criticized by others, among other reasons. The high level of short interest should also provide a catalyst for a rise in the stock once it becomes clear to them that they are short an option that is substantially mispriced.

Source: Why J.C. Penney's Pricing Strategy Changes Are Great For The Stock