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The transformation of JC Penney (NYSE:JCP) has taken a turn with the removal of CEO Ron Johnson and the reinstatement of Mike Ullman. The media has followed this story very closely, albeit from a rightly negative perspective. I will focus on what the media has overlooked by applying Howard Marks' second level thinking to JCP's current situation to attempt to understand why George Soros, Bill Ackman, Vornado and many other smart investors continue to support JC Penny.

Howard Marks, founder of Oak Tree Capital Management, has expounded on many useful mental models to be a better investor. One model called level two thinking is a way of thinking deeper into a situation. An example he gives is, "First-level thinking says, 'I think the company's earnings will fall; sell.' Second-level thinking says, 'I think the company's earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.'"

So first-level thinking with JC Penney says, "In Q4 2012 Penney's had a revenue decline 25% YOY, Q1 2013 lost 16% YOY and will continue to lose at double digit rates. Customers were shunned and will not be back; sell." Second-level thinking says, "JC Penney's Q4 was atrocious but changes in promotions, reintroduced product and a reinvigorated home section could make sales fall less than expected and the pleasant surprise will lift the stock; buy." JCP has changed from the everyday low prices with sales and bringing back core brands.

I think an estimated apples to apples comparison between Q1 2012 and Q1 2013 shows how the media is focusing on the wrong metrics. To compare the two years I am going to make adjustments to the 2012 numbers. To do this we have to think what are the differences between 2012 and 2013:

  1. No St. John's Bay Women line in Q1 2013 so direct loss of revenue and indirect loss of foot traffic for other purchases.
  2. Approximately 30% of 500 stores were under construction a majority of Q1 2013 for Home, 700 stores were under construction for Joe Fresh, Bijoux Bar, etc,. Direct loss of revenue to $0 sq ft. for a large part of busiest stores.

*Note: These are rough guesses that are not deemed to be accurate but should help us to utilize second-level thinking.

What we do know:

1104 stores = 111.6 million sq ft retail space

Roughly 500 stores under-construction / 1104 = 45% of total retail space

2012 Revenue/sq ft = $116 however Home was stated to be worst performing at $80

Approximations

111.6 million sq ft x .45 = Ballpark 50.22 million sq ft attributable to 500 stores

50.22 million sq ft x .3 = Ballpark 15.06 million sq ft under-construction for most of Q1

We'll round down to 15 million for the sake of ease. Because a majority of renovation is Home, we'll use $80 as our revenue lost.

15 million sq ft x $80 = $1.2 billion in one year / 4 = -$300 million in lost sales due to renovation

2012 Q1 sales were $3.152 billion

$3.152 billion - $300 million = $2.852 billion

Let's also adjust 2012 for lost sales from St. John's Bay: Management stated in Q1 2013 call that SJB was $1 billion in revenue. Anyone who knows clothing retail knows sales are skewed more toward Q4, however, because SJB removal seemed to decrease traffic I'll take 25% of annual revenues.

$2.852 billion - 250 million = $2.602 billion

I have not included an adjustment for the weather. Last year's spring had uncommonly high temperatures while 2013's spring was uncommonly colder, hurting sales of all retailers.

Looking at an adjusted 2012 to 2013 we see,

  • 2013 $2.635 billion
  • 2012 $2.602 billion

What this could imply is:

  1. A milder winter/spring in 2014 could make 2013 comparison easier to beat.
  2. A sales environment with more coupons throughout all of Q1 2014 could make comparison with 2013 easier to beat.
  3. All of home space finished or less space under-construction during spring 2014 could make comparison with 2013 easier to beat.
  4. Re-introduction of core brands for full duration of quarter could drive higher traffic and increase sales in the next year.
  5. Atrocious 2012 Q4 could be easily beaten with promotions, new home section, reintroduction of core brands, etc,.

Some anecdotal evidence that things are shaping up for JCP:

  1. A double vote of confidence from Goldman Sachs with $2.25 billion and investors who oversubscribed the issue. Bond prices are only slightly under par implying the market believes there is a low probability of JCP going out of business.
  2. The Michael Graves Teapot debacle has been good for business. JCP Facebook likes have grown roughly by 300,000 in a few weeks and teapots have sold out. Teapots are selling for $150 a pop on Ebay (275% premium).
  3. Whitney Tilson of Kase Capital and Langer Research Associates performed a telephone survey showing that core customers are willing to come back with the right changes.
  4. Thomas Stanley, author of The Millionaire Next Door book series, conducted surveys showing that 30.4% of millionaires were JC Penney card holders and 36% of millionaires with a house valued at under $400,000 were Penney's shoppers. Stanley often notes how many of the millionaires he surveys are value conscious and that Ullman's return to JCP's coupon roots could bring back shoppers. He says "From what I know about the value, value, value orientation of the millionaire next door types I'll bet my drawerful of J.C. Penney Stafford undershirts that the company will once again prosper!"

Risks that Penney still faces:

  1. Large debt load albeit starting to become due in a few years' time.
  2. Higher price points in the home section could discourage core customers.
  3. Could have problems winning back core customers and gaining new ones.
  4. Where the plan goes from here.

Conclusion

The market has priced in all of the negative data that has happened in the past year to JC Penney. Long term investors can gain an edge by thinking differently than the rest of the crowd via two level thinking. As the market says, "Sales in JC Penney have gone down 16% this past quarter. That will continue; sell." I have shown that with an adjustment to 2012, 2013 numbers are not that bad. Sales are actually slightly higher. Second level thinking says, "Many catalysts such as: promotions, reconstructed home space, new products and a re-introduction of core brands will make next year's comparisons quite possibly easy to beat; buy." With this second level thinking we can understand why George Soros, Bill Ackman, Dodge and Cox, Michael Price, and many other successful investors are invested in JC Penney.

Source: Second Level Thinking: J.C. Penney