Upgrading J.C. Penney To Hold From Sell

Mar. 1.13 | About: J.C. Penney (JCP)

J.C. Penney (NYSE:JCP) shares tanked 17% Thursday on another very poor earnings result. Jim Cramer joked about it on CNBC and had me nodding my head as he said, "What do you have to do to get fired today?" Later, on his "Mad Money" program, he placed JCP's CEO Ron Johnson on his "Wall of Shame". I think criticism is understandable here considering the stock's current price trend. Into yesterday's close, JCP shares shed 59% of their value since the stock's February 9, 2012, closing high of $42.89. Of course, some of the reason for those highs came on enthusiasm about the new management. It was around the time when the company was "assembling its team of the industry's best".

JCP's market capitalization is approximately $3.85 billion today, so several billion dollars worth of market value have been destroyed in just a year's time. Given JCP's divergence from the SPDR S&P Retail (NYSEARCA:XRT), most of it appears to be clearly traceable to the strategic game plan implemented by new management. The company changed direction from the way its customers had gotten used to dealing with it. Some serious investors bought into that game plan, including Bill Ackman, so the shares rose into the changes as the market anticipated improvement. I was not a fan of the change, though, as documented by my report published last spring.

Investors may recall and wish they took heed of my suggestion in May of 2012, which in the form of its article title still resounds, "Sell J.C. Penney: Too Much Change Too Soon." The stock was in the mid-$20s at that point and had just slipped nearly overnight from the mid-$30s. At the close of trading Thursday, JCP traded at $17.60. A ton of capital could have been preserved or even made on the short side for those who might have followed along.

JCP just reported a 28.4% decrease in quarterly sales, driven by a 31.7% decline in same-store sales. Internet sales fell by 34.4%, so the issue is widespread and inherent in everything JCP is doing. The fact that the same decline is found in the Internet sales figures says something about the reason. Taking an operating company and shaving off sales, while at the same time shedding vast amounts of net income, is incomprehensible to me. JCP posted an adjusted net loss of $427 million or $1.95 per share, versus last year's adjusted earnings of $45 million or $0.21. If sales were declining while net income was slipping modestly with margins hopefully expanding and return on capital growing, then you might have an argument, but otherwise I cannot see a good reason to destroy so much capital so fast in the name of creating it over the longer term. Now, many investors and the JCP management team may still believe in the long-term gains they expected when they set out on this adventure, but putting shareholders through the value depreciating wringer to get there makes little sense to me.

Thus, it's not difficult to understand why demand for JCP shares has dissipated. I believe there were better ways to go about this experiment that would not have involved destroying so much value last year. If you want to create a new idea, you can start your own company or a new brand within the same company with a handful of test locations. As things stand now, cash flow is lower and debt costs are starting to concern some people because of the pace of sales deterioration. Anecdotally, all the negative media attention likely has managers distracted and perhaps losing confidence in the game plan.

As a result of the change in the tone of operating results and sinking shareholder value, JCP's executive team has been forced to reevaluate its move away from what J.C. Penney customers knew. That sale mentality and active relative marketing, and the brand value that JCP spent so much time and effort to create before new management came in, was sort of abandoned in my view. Introducing customers to the everyday low price model, despite the interesting store design, was sure to be slower in pulling in JCP's core deal-seeking customers, who had been trained to be sale-minded by the same company.

I feel like the significance of the change in operations in this case should have met resistance from within the company's management, its shareholders and its Board, but perhaps a yes-man mentality prevented that.

I applaud JCP's move to "reconnect" with its core customers, but I wonder if enough will be done. Jim Cramer said this morning that there's a short timeline for such a reconciliation to work and I agree. If I had more confidence that the JCP team might perfectly reinstate its old model and that it might work perfectly, I would be urged to change my sell call on JCP to a buy today. However, I am not.

Valuation does not matter so much when earnings are disintegrating, unless you're applying a model based on break-up value or the value of real estate. I'm not sure we want to go there just yet. In conclusion then, while I favor JCP's return to some of the company's old ways, I'm not sure how long it might take to get back to old share price values. You can close out shorts near-term. Long-time holders who are still aboard might benefit from shorts closing out positions and also from more developments over the near-term Thus, I would hold JCP here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.