J.C. Penney (JCP) is a struggling retailer, searching for answers of a potential turnaround. Last year they introduced new CEO, Ron Johnson, in hopes that he holds the answers that will solve the questions J.C. Penney has. In the past he headed he created the Apple retail store concept, and he was Vice President of Merchandising for Target Corporations. Those qualifications make him seem like the ideal candidate to lead a turnaround for this troubled retailer, but most of the results to date have been negative, with many investors fearing that J.C. Penney's turnaround will not be successful and may even head towards a default. I disagree, and here is why.
J.C. Penney's transformation involves the company trying to find a new identity for itself. They have gone from essentially being a discount boutique for the discount shopper, who is trying to find the biggest bargains, to a retailer that provides high quality products at a low price. They are attempting to do this by completely changing the concept of its stores.
They started this transformation by first changing the items that they carry at their stores. Instead of carrying inventory that is deemed unfashionable and out of date they have gone the route of hiring fashionable designers and major brands to design products that are exclusively available at J.C. Penney stores.
To showcase their new designers, they are using the concept of store-in-store. In each sub store they are giving floor space to each of their designers and allowing the consumers to get a feel for the products and the experience that each designer gives. This enables the consumers to really experience the products and styles they are buying into, just as if they were to walk into a brand specific store.
Let's start with the good. J.C. Penney in the last year has managed to create around $900 million in permanent cost reductions since Johnson took over. These reductions were the result of increase operating efficiency, as well as, eliminating the legacy systems. Also, the company has gone ahead with its plan to start the conversion of its stores into the new mini boutique system. This would require massive capital expenditures, but so far they have already converted 11% of store space without adding more debt. To date, the transformation efforts have been completely funded by the cash the store has carried.
The most important figure for any retailer has to be the sales and throughout the first three quarters of last year, they have been dismal. The company's sales have declined by 20.1% in the first quarter, 22.6% in the second quarter and 26% in the third quarter. The performance of these three quarters have caused many to lose faith in Johnson's ability to lead this company and inevitably causing a massive decline in its stock price.
New Concept Validation
They have only converted 11% of their store space to this new concept, but sales in these stores have been dramatically higher. In the new concept stores sales have been at $269 per square foot, whereas in the traditional stores sales per square foot have only reached $134. This concept has been part of what has increased these sales by slightly more than 100%. Any way you look at this sales increase, it is a very dramatic change and provides evidence that the new concept developed is pushing the retailer in the right direction. Also, the early results are especially promising because it hasn't even been completed yet. The eventual plan of the transformation is to have 100 of these mini boutiques within one store. Right now, they are in the early stages and are not even close to this number. As of November 9th 2012, they have a total of ten boutiques opened. The plan is that by November of 2013 they would have 40 shops open, and by November 2014, 70 shops. As they increase the number of mini boutiques, they will be able to serve a wider range of customers and once again become the preferred destination for shoppers.
Potential Bias in Transformation Data
Most of the bulls on J.C. Penney cite the fact that per square foot sales have increased in these newly modeled boutiques but I believe although it may be good news, there is a certain amount of bias in that piece of information. This is because the ten stores that have opened within J.C. Penney are already very popular brands and the sales increase may not be a show that the concept works, but that the inventory from these particular brands are more popular than the inventory in the traditional parts of the store. Another question remains; can the boutiques that open following the initial ten provide as much zest and appeal? I ask this not because I don't believe in the concept, but in the fact that I know that the final target is 100, which means they must find 90 more brands who are able to provide products that are as high quality as those made by the initial 10. Also, we have to note that the figure that indicates that the sales per square foot in the old parts of the store are $134 could be skewed to be lower as well. As part of the process of the J.C. Penney transformation is to find higher quality products they are also completely changing their merchandising to induce better sales. It may be safe to assume that a higher portion of this merchandise in the new boutiques are of this new higher quality compared to what would be a lower percentage in the traditional store space. So here's my question how much of the increase in sales per square foot was really due to the concept and how much of it was due to the higher quality merchandise present in these areas? However, these questions may remain irrelevant if the company is able to bring in a large stream of high quality products that the consumers want, sales will spike regardless of what the sales experience provides.
Transformation Follow Through
Now that they have proof of concept, their focus shifts into doing three things. First, they need to convert the rest of their stores space into this new concept design. Second, they need to continue to secure designers to continue to design exclusive products for them. Lastly, they need to continue their advertising campaign to promote and changing their brand image.
They are already doing all those tasks, but to continue doing all those tasks the company needs more capital in the next year. There is only one question left to ask. Will J.C. Penney have enough capital to follow through with this transformation? Well on January 31st J.C. Penney's credit line on its assets based loans and receivables were increased from $1.50 billion to $1.75 billion. On November 9th, 2012 Ken Hannah, the CFO, stated that by the end of the fiscal year J.C. Penney should have around $1 billion in cash. Also, J.C. Penney is now allowed to borrow an additional 1.75 billion dollars on its fixed assets . This means that J.C. Penney will have an additional $2 billion available in credit and $1 billion in cash. Furthermore, on February 12th, J.C. Penney filed with the SEC a borrowing agreement that would allow them to raise more cash through stock offerings. All of this means that J.C. Penney will remain well capitalized and can more aggressively pursue their transformation plans.
Why the results of last quarter further prove that J.C. Penney is headed in the right direction?
In the fourth quarter, they lost money again and not only did they lose money they surpassed everyone's expectation at how fast they can lose money. Typically, we want companies to make money and find ways to make more and more money each quarter. Although, it is tough to see, last quarter and last year was a step in the right direction for the company to return to profitability. This is why.
The key numbers that everyone focuses on are the revenue plunge (28.4%), the drop in same store sales (31.7%) and sales decline of (32%). These are not the numbers we should be focusing on. Shareholders and potential investors should be focusing on the numbers that will make this company a great retailer in the future, not what makes it a great retailer now. If we focus on the future, it is easy to see, that this has been a good year. The three indicators we will focus on are the lowering of low quality inventory, the lowering of their bloated cost structure and the company remaining very liquid even with all the sales declines.
We must start by looking at the inventory numbers. The problem is that they were selling low quality products at low prices and they are transitioning to selling high quality products at low prices. The inventory number tells us how much of the past inventory they were able to clear and they cleared $600 million throughout the year. This clearance can also be evidenced by the lower gross margins over this fiscal year compared to the previous year (from 36% to 31.3%) because this means that a higher level of inventory is being put on clearance prices, so that they can be cleared. This is amazing news. For a retailer to succeed they must have great products that people love at great prices and getting rid of old inventory that does not hold the interest of the public is one of the key steps in this transformation.
Next, we look at the cost structure of the company. I believe this is the next key in looking at a turnaround. These numbers are important because it dictates how efficient the retailer can be. If its cost structure is too big and they are competing with a company with similar size and sales, they will always lag them in profits. Johnson has already taken many steps to lower the costs in running the company. Last year alone the company saved $800 million and going forward the company can save $900 million each year. For J.C. Penney to be competitive with other retailers they must have comparable cost structures and this cost cutting measure definitely puts them in the right direction.
In the section above we talked about the credits line that J.C. Penney has and I would like to further elaborate on this point with the news present in the most recent earnings report. As seen in the information above J.C. Penney should have no problems with its credit as it is well capitalized. The company expected to be holding around 1 billion in cash by the end of the fiscal year, today they announced they are holding $930 million in cash and cash equivalents. Also, throughout all this the company managed to reduce its debt by $250 million. This shows that even though sales seems to be getting worse and worse, they are finding ways to manage their money which allows them to have high levels of cash and continues to give them the ability to move forward with this transformation. If this was a bad year, with low quality products, antiquated systems, unappealing stores and confusing pricing systems, I 'd like to be part of this coming year where the products are of high quality, yet consistently low in price, with updated systems and stores that give amazing shopping experiences.
Is J.C. Penney a trade?
Now all of that sounds great, but what does it mean for me? Can I trade J.C. Penney? Is it undervalued at the moment? Well, currently J.C. Penney (JCP) is currently trading at $21.16 with a market cap of 4.64 billion dollars, with post market trading bring it down another 13%. Its stock price has been hammered in the past year falling from a high of 42.05 down to a low of 15.69. However, it is not logical to use these past numbers to gauge where the future price should be, since this is a new business model, how the old business model performed in the past is not relevant to us.
What we need to know is how drastic the change in sales will be, given this change in business model? As we have seen in the store space that was converted, there was a 100% jump in sales to $269 sales per square foot from the abysmal $134 per square foot. This is on the 11% of store space that have already been converted. The goal is for all the store space to be converted by 2015. This gives the company two more years to do this, which says that in the following two years they will need to convert 89 % of their store space. That means by the end of this year we should see that 55.5% of the store space is converted and performing at levels we have seen in the converted store space. I believe that $269 sales per square foot is not the peak and that this figure will further climb as more and more brands and designers sign up to put mini boutiques in the converted stores.
So where will the future stock price of J.C. Penney be? I do not know, but I do know that if the plans described above goes through (looks like it will), it is likely the company returns to profitability in 2014 and this will greatly increase the stock price from its current levels.
Note: This is not a trade for the short term trader; it is more fitting for those planning to hold on to the stock of this company long-term.
Disclosure: I am long JCP.