I first wrote about J.C. Penney (NYSE:JCP) in November and December of 2012. Back then, the stock was at $17 and I argued it was a good buy based on a number of factors, chief among them the fact that the new stores could significantly improve the results of the company, which combined with its operating leverage, could double or triple the stock.
Recently I sold my shares of J.C. Penney (though I still own some long-term calls), and in this article, I'm going to explain why.
When Ron Johnson was fired a few months ago, I had some mixed feelings about the move. On the one hand, he was already aware that Fair and Square pricing had been a mistake and was on its way to bringing back all kinds of promotions and pricing tricks to entice buyers, so to get somebody else to do that same thing made no sense to me. He was also the chief architect of the new store model and customer experience -- a new CEO would be unlikely to do as good a job there as he would. On the other hand, employee morale is important and so is having confidence and trust from suppliers, partners and creditors, so firing him would be the right move if those things were impossible without a new CEO. I don't have access to insiders or what happened behind the scenes, so I won't ever know what really occurred.
I do know, however, that a significant part of the upside in an optimistic forecasting scenario was removed when Ron was fired because the new store model is unlikely to ever be fully completed without him. Now, downside could also have been cut as a result of the new CEO and credit arrangements, so I'm not saying it was not the right move if you are thinking solely about company survival (as opposed to mathematical expectation), but the minute the company changed the CEO, one of my first thoughts was "the upside now is limited."
That was one of the reasons that lead me to sell. Among the others were:
-The significant increase in borrowing that was and is likely to be done in the future will increase interest costs to a point that it will be difficult for the company to operate profitably. This makes expansion of the new store model even more unlikely.
-Those interest costs also make the company extremely vulnerable. I believe the company is one recession away from having to undertake a large equity offering. Even without a recession, it is possible it will have to raise equity, e.g., if the company doesn't get its customers back fast enough to cover its bills and interest.
-The CFO talked about "several hundred million dollars" of opportunity in sales of non-core assets but never followed through (this was after the sale of $500M or so in non-core assets in 2012). Instead he tapped credit lines and expanded access to them.
-New store construction hurts current sales. "One reason why J.C. Penney's revenues have taken such a hit over the last year is [because] former CEO Ron Johnson's plan to redesign the chain so it contains individual branded "shops" requires entire stores, or large sections of them, be shut down for weeks-long refurbishments." - Business Insider
-In my quantifiable analysis article, I wrote:
"If he fails to show any meaningful improvement at a time that cash flow is under pressure (due to capex and underperforming old stores) we believe it's safe to assume that Ron Johnson would be removed. The new CEO would have to go back to the old model or perhaps some kind of hybrid model that uses discounts/coupons plus whatever part of the Johnson strategy that worked. Our assumption in that scenario is that sales will begin to go back to the old levels from the years before the transformation."
I forecasted that it would take until 2015 to get most of its customers back. I might have to reassess how long its going to take to get customers back, as 2015 might not be the correct year. Given the limited data on the new CEO plans and the "apology tour," there is significant uncertainty in this front, which makes it attractive to wait on the sidelines until there is clarity.
-It's quite possible I will get to buy the stock cheaper at some point over the next year or two. Given my macro view that the U.S. economy is likely to remain weak, combined with difficulties on the operating side, at some point, people will get pessimistic again and the stock is likely to drop significantly.
Given all of this, why do I still own some calls in the stock? The bid-ask spreads in these options are significant, so liquidating will carry large costs. Furthermore, they dropped a lot in price, so any type of good news or a short squeeze, and they can quickly double. They would also become more active, allowing me to sell in a more liquid market closer to their fair value, but it's hard to get excited about a sustainable rally in the stock in the near term.
Given the several reasons I explained in this article, I decided to sell my stake in J.C. Penney. I would like to see more data on the company and client trends before I can asses if the company can come back. The new interest costs (which are likely to rise as the company borrows more) and the probability of a recession adds more risk to the position, which makes me want to play it safe and stay on the sidelines.
Additional disclosure: I'm long JCP calls. I am not a registered investment advisor and do not provide specific investment advice. The information contained herein is for informational purposes only and I can't guarantee the accuracy of all the information presented in this article. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion. It is up to investors to make the correct decision after necessary research. Investing and trading includes risks, including loss of principal.