A Conservative Way To Play The Disappointing Yet Undervalued J.C. Penney

| About: J.C. Penney (JCP)

Business and retail in particular, is all about focusing on your customers first and then growing from there. J.C. Penney (NYSE:JCP) CEO Ron Johnson seems to have lost track of who ultimately generates the revenue to pay his salary, as exhibited in his complete alienation of what used to be existing J.C. Penney customers. I understand that a big part of the JCP turnaround strategy is to reduce the overly promotional aspect of the business, and I get that national brands aren't interested in seeing their products severely discounted. The problem is that Ron Johnson cut these traffic driving enterprises cold-turkey, which has severely impacted the company's finances during this critical time that the company is investing heavily to recreate the JCP experience. Sometimes our egos get in the way of our execution and there is no doubt that the JCP turnaround has drastically underperformed even the most conservative expectations. With this said, I believe the stock price overly discounts the dismal performance of both the CEO and the company, primarily due to the vast real estate holdings that give the company optionality to create shareholder value. I believe things will turnaround, but it didn't have to be an "all or nothing" proposition, and Johnson's reluctance to admit to making serious mistakes in his plan until four quarters of nearly 30% same store sales declines, is highly unattractive from an investor's point of view.

While the industries are different, J.C. Penney and Hewlett-Packard (NYSE:HPQ) have some things in common. Both companies are in the midst of dramatic change forced on them by evolving technological transitions. Both companies are forced to deal with the problems brought upon them by poor prior management. Both companies in essence, are dealing with a semi-runoff business, and a potential growth and higher margin business. Meg Whitman and Ron Johnson have chosen to deal with these issues very differently. Meg Whitman resisted the temptation to spin-off its cash flow generating P.C. business, and instead is determined to milk the cash flow to help fund investments in the more lucrative enterprise services business, and to pay-off debt. Ron Johnson decided to terminate the vast majority of promotion, which drew traffic and cash flow to J.C. Penney, during the same time that he was investing heavily to remodel the stores, and adjust the merchandise. J.C. Penney's dramatic cash losses and huge future spending requirements, made much more difficult due to a lack of traffic, limit the speed at which the company can transform its existing stores into the new model. Both companies are aggressively cutting costs, but when sales are down nearly 30% like they are for J.C. Penney, these cost cutting measures are only so impressive, because the margins are absolutely horrible for the underlying business.

There is no doubt that the new J.C. Penney stores look much better, and I believe that Ron Johnson's efforts in improving the merchandise will boost both sales and margins into the future. He may not have been given the 1927 Yankees' lineup, but when an average baseball team still needs to draw fans to the stadium, it doesn't make sense to bench all of the starting players while at the same time to only play the farm system squad. If a manager were to do that he would risk alienating the paying fans, and that is exactly what Ron Johnson did. Long-time, loyal, J.C. Penney customers were ignored in favor of the hypothetical iPhone-carrying hipster customer that has yet to show up in the stores. While investors might have been aware that a transformation was occurring, where was the education for existing customers? It didn't exist therefore it is difficult to argue that they were not alienated. Apple (NASDAQ:AAPL) was a start-up retail franchise, so decisive and contrary moves didn't risk alienating an existing customer base. J.C. Penney wasn't a start-up, so parlaying the cash flow to provide the investment funds for Johnson's "new JCP" startup would have made a lot of sense.

I believe the "stores-within-a-store" concept will ultimately optimize JCP's vast real estate footprint. Sephora, Joe Fresh and Levi's are likely to obtain much higher sales per square foot than legacy J.C. Penney offerings. Now that the inventory overhang is supposedly rectified with the $600MM reduction in 2012, JCP should be generating higher margins on its sales moving forward. It is imperative that the company drives traffic to its stores, so that customers can experience the new shopping experience. Johnson has had promotions such as free haircuts for children to drive traffic, but I believe the company must go much further. The company has only built-out a small fraction of its stores thus far so much of the work and financial commitments are ahead of it. As an investor I'm extremely patient and I understand this is a multi-year turnaround. I just don't get why the company would so aggressively turn-off its existing customers when the store footprint is not ready to showcase the "new JCP" concept fully. The company wisely increased its credit line and its accordion financing instrument, so unless sales stay on the same current trajectory, I don't expect the company to run into serious financial difficulties.

In my investing experience, I've learned that GAAP accounting causes material distortions in stock prices due to its inherent limitations. Accounting will never be a perfect science or even close to it, but the accounting on real estate is truly prehistoric. Most real estate is valued at cost minus depreciation. Land is never depreciated of course, but buildings and fixtures are. J.C. Penney has one of the larger retail real estate portfolios in the country, which is a primary reason in my opinion, why Bill Ackman and Vornado (NYSE:VNO) bought close to a 30% stake in the company in the first place. J.C. Penney has irreplaceable positions in malls across the country, and with mall real estate being valued extremely richly in today's low interest rate environment, the company can easily divest some of these assets to improve its financial position. Market participants tend to overly discount real estate as an asset due to the perceived lack of liquidity, but barring a 2008-2009 environment, deals get done and it is foolish to think that there isn't huge realizable value in JCP's real estate portfolio. The company owns approximately 39% of its real estate and has another 10% with ground leases. In addition the company benefits from below market value leases, which can be monetized. The store-within-a-store concept could potentially open the door for JCP to act as a landlord of sorts, where the company collects rents from operators' that are seeking smaller amounts of square footage in J.C. Penney's large square footage footprint within malls. J.C. Penney also owns 60% of its national distribution centers, which are likely, quite valuable and that I imagine could potentially be used for other uses, such as data centers where they may even be more valuable.

J.C. Penney could certainly explore turning its real estate into a REIT where the tax benefits would add considerable value to the company. I don't think this is likely at this stage of the transition so instead I believe that the company will slowly monetize locations through smaller sales. This will help unlock the apparently hidden value of the real estate, while providing capital for Johnson to continue building upon his vision. I t is very difficult to do a completely comprehensive analysis of the real estate without researching each location, but my own conservatively derived calculations on the real estate value put it well in excess of $15 per share, and I believe that if it were divested at today's robust prices in a bulk transaction, that the realized value could be quite a bit higher. It doesn't take much with the stock so depressed to move the needle and the only benefit of JCP's struggles are that it might force their hand a bit in terms of monetizing non-core assets while pricing is attractive. My investment thesis on J.C. Penney has always been predicated on the real estate and the benefits of cutting the fat out of a bloated operating structure. Management has delivered on the cost cuts as expected, and is also investing in technology to optimize the efficiency of the organization. This creates a situation where any retail sales growth could potentially add multiples on the value of the stock, from recent prices. I must say that I certainly didn't expect Johnson to handle the transition this poorly and I'd bet dollars to donuts that behind closed doors, Ackman and Vornado are pretty sick about the missed opportunity.

On February 27th, J.C. Penney reported the mother of terrible earnings reports. It is important to keep in mind that this is the essential Christmas holiday 4th quarter, so the huge losses must be put into that dreary context. For the 4th quarter, the company reported a loss of $552MM or $2.51 per share. Adjusted for restructuring and management transition charges and non-cash primary pension plan expense, JCP's adjusted net loss for the quarter was a whopping $427MM or $1.95 per share. For the year, JPM reported a net loss of $985MM or $4.49 per share. If you were to exclude markdowns related to the alignment of inventory with JCP's new strategy, restructuring and management transition charges, non-cash primary pension plan expense and the net gain on the sale or redemption of non-operating assets, JCP's adjusted net loss for the year was $766MM or $3.49. Make no mistake; this has been one of the worst restructuring jobs in recent memory.

4th quarter sales were so bad that even including $163MM of sales from the 53rd week, sales still decreased 28.4% to $3.884 billion. Comparable store sales excluding the 53rd week were down 31.7%. While traffic has been down at the stores due to the alienation of the existing customer base, it really is alarming how bad internet sales are doing. Internet sales through jcp.com were $315MM in the 4th quarter, which is a decline of 34.4% from the same time last year. Ron Johnson blamed the change in sales mix from household goods, which previously accounted for a large percentage of internet sales for the disappointing performance, but you'd think a CEO coming from Apple would have had a little better internet strategy to help offset some of that loss. SG&A expenses decreased $134MM YoY, while operating cash flow dropped $645MM from $953MM the prior year. The company cut down on its investing in the quarter with an investing cash use of $229MM, from $455MM the prior year.

Including the extra week, total sales for fiscal year 2012, were down 24.8% to $12.985 billion. Comparable store sales, excluding the extra week, were down by 25.2% from 2011. Internet sales declined by 33% in 2012 from 2011, to $1.020 billion. Gross margin was 31.3% of sales, compared to 36% in 2011, as margins were negatively impacted by a higher level of clearance sales to clear excess inventory. For the full year, the company's SG&A expenses decreased $603MM compared to last year. While this savings is excellent in the context that management has met its targets for the year in that regard, when you factor in the staggering sales declines, it is little consolation. J.C. Penney reduced its debt load by $250MM in 2012, and end the year with $930MM in cash and cash equivalents.

On March 15th, Joe Fresh will be launched in JCP stores across the United States. Joe Fresh stores are under construction in nearly 700 stores so far and the company is optimistic that this along with the other merchandising initiatives can bolster sales. In the 4th quarter conference call, Ron Johnson alluded to the fact that Liz Claiborne had been the number one performing online brand, but in the one week that Joe Fresh has been available online, the brand has had seven times the visitors and conversion is 10% higher than Liz Claiborne. Average retail is nearly 20% higher and a full 61% of the buyers of Joe Fresh are first time JCP.com customers. The company is also launching its intimate apparel from Casa Bella, junior's fashions from Nanette Lepore, along with several other exciting brands. In May, the company is making over its home departments and the company has an average of 19,000 square feet under construction currently. Home used to generate 20% of store sales and over the years that number has been cut in half to 10% of sales. Sales per square foot in Home formerly ran at $185 per foot and have dropped to under $80 per square foot, which is truly terrible. It won't take the reinvention of the wheel to squeeze better production out of this segment. The company will be leveraging relationships with Martha Stewart, Michael Graves, Jonathan Adler and many other brands.

Management estimates that by the end of May, the company will have transformed over 30% of the floor space in over 500 stores and will attain a critical mass. We'll see if they can deliver on this, as I'm not too sure it will be enough to really move the needle materially from where things currently stand. Johnson is implementing weekly sales to attempt to win some former customers back so I do at least applaud that he is showing some flexibility. Management has made serious changes to its marketing approach, which will emphasize everyday low prices, and that will highlight the vastly improved merchandising. If the company can stop the bleeding and generate operating cash flow, which can be redeployed into the renovations than the company has a chance to achieve success.

After hours, J.C. Penney's stock was in free fall at a price around $18.30, down from a close of $21.16 on Wednesday the 27th. Based on 219.5MM diluted shares, the market capitalization is approximately $4 billion. Shareholders' equity is $3.171 billion and this number severely understates the value of the real estate. The company has $2.956 billion in long-term debt and capital leases, and $930MM of cash and equivalents. This equates to an enterprise value of just over $6 billion. J.C. Penney has about 1100 stores, with about 2/3rds of them being "on-mall." According to Bill Ackman's presentation, 80% of Penney's on mall stores are in shopping centers with sales> $300 per square foot, versus Macy's where this figure is roughly 75%. The company controls approximately 112MM sf of high quality real estate through long-dated leases at $4/sf, in addition to the real estate it owns. Because of the quality of J.C. Penney's locations, there is no doubt in my mind that much of this could be monetized to create value well in excess of that enterprise value, giving absolutely no credit to the underlying business. I'm willing to accept this low-downside opportunity where the risk is on realizing that value, for the benefit of any free cash flow that the retail operation produces over the long-term would equate to upside potential for the stock. For those of you that don't believe resource conversions on retailers can add value, I'd encourage you to do a case study on Dillards (NYSE:DDS) during the financial crisis. I believe there are a lot of parallels with J.C. Penney in terms of the real estate and the struggling retail operation. Volatility is extreme on J.C. Penney stock and I believe there is an underlying assumption that the company could face serious financial problems, which I disagree with. We've sold the $13 January 14 put options for prices in excess of $2.00 and it is very possible that after today's plunge, they might be trading in excess of that tomorrow. If you can sell the $13 for $200 a-piece, the target profit would be 18% in less than a year, on a maximum risk of $1100 per contract. Given my rationale on the real estate I see very little downside, and if Mr. Market goes crazy like it did with Sears Holdings (NASDAQ:SHLD) stock in December of 2011, then you might end up getting exercised with huge upside potential being long the stock.

Disclosure: I am long JCP, HPQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long Sears Holdings Bonds

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