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Is J.C. Penney (NYSE:JCP) a value trap?

Full Disclosure. I used to own a distressed retailer as an investor and managed the company through a bankruptcy filing/restructuring. Turning around a retail operation is no easy business.

Retail is a fairly straightforward business to understand. Most of the costs of the business are fixed. These would include line items like rent/leases, staffing, utilities, maintenance, etc.

Variable expenses might include things like advertising and promotion, company overhead, etc. For the most part retailers have very high levels of operating leverage.

Successful retailers typically require one of two things to be profitable.

1) They must turn their inventory quickly enough in order to have a healthy working capital cycle or

2) They must have very high gross margins to offset the lower velocity/turn rates of their inventory.

Contrast the businesses of Costco (NASDAQ:COST) and Tiffany (NYSE:TIF) for example. Costco realizes gross margins of 9-11% on inventory but it turns over its inventory so quickly that its vendors end up financing all of its working capital.

Tiffany turns its inventory much slower but can make up to 60% gross margin or more on many purchases. This higher level of gross margin/contribution margin allows TIF to cover its fixed costs even with lower inventory turns.

JCP has big problems. It is facing a cornucopia of negative metrics that have pressured liquidity. These include:

  • lower YOY traffic/store visits from customers
  • lower YOY conversion to sale activity
  • lower gross sales
  • lower realized gross margins (30% last quarter)

Operating leverage is a beautiful thing when volumes are growing but the company's balance sheet bleeds like a stuck pig once gross margin contribution drops below the company's fixed cost "nut." This is where JCP finds itself today.

New Management is pulling a number of levers in order to try to reverse the negative trends listed above. These include:

  • acquiring meaningful levels of inventory to support higher sales levels in the coming weeks
  • engaging in more promotion/couponing/discounting activity to drive store traffic and conversion
  • restocking trusted private label brands to repatriate former customers, etc.

Fixed Costs would appear to be as lean as they can get. Cap-ex has been dialed back too.

Yesterday I visited a local J.C. Penney store for the first time in my life. I had never shopped there before. I wanted to see first hand what I have been reading about in the headlines, 10Ks and 10Qs. As a former retailer, my observations were as follows. Noted: I only visited the one store.

Who is the Target Customer?

The store I visited struck me as a cross between a discounter and a Specialty retailer. Some of the areas of the store featured aggressively priced, basic merchandise. Other areas (most notably the Home section) featured many skus that featured designer names and higher price points. This merchandise mix struck me as both odd and perplexing. Is JCP about value or is it about premium? I candidly couldn't tell.

How "Money Good" is the Inventory?

The store I visited seemed chocked full of all kinds of inventory. My initial reaction as the store was largely empty was: "Who are they going to sell all of this stuff to?"

High inventory levels combined with low traffic counts is the quickest way to foreshadow inventory writedowns/markdowns. I did not feel optimistic that JCP was going to be able to turn the stock I saw on the floor without material discounting.

Are the refurbs "Lipstick" on a pig?"

Granted, I only visited the one store but the leasehold improvements/capital spending seemed to have been applied to a tired, old "Box." Flooring, carpet, lighting, etc. looked old and depreciated. I was impressed by the displays in the Levis area, the Joe Fresh area, the Home areas, etc. They certainly looked clean and inviting but my overall reaction was that the atmosphere in my local Target store seemed more upscale than the local JCP I visited. Again, was the decision to take JCP into more of a branded/premium merchandise mix the wrong direction to go?

Of late I have been reading articles/analyst pieces talking about how this quarter is the "turning point" for the company. Once the new CEO buys new inventory for back to school, revamps the promotions, etc. then the traffic will return and everything will be okay.

Candidly, this analysis strikes me as too simplistic. Based upon my first-hand observations of what I saw at JCP I think the company has some very troubling issues it has to deal with.

  1. I submit that some material % of the inventory carried on JCPs books is "dead stock" that is unlikely to be liquidated at a positive gross margin. JCP doesn't publish an aging report for its wares, but there seemed to be a decent amount of high-ticket/low turn goods on display that need to be flushed out of the system. It strikes me that it would be reasonable to haircut JCP's inventory balance on its balance sheet by at least $1 per share if not $2 as a conservative approach.
  2. It struck me that because JCP has lost natural traffic flow over the past two years that it will have to discount/promote heavily to reacquire these customers. This will likely place additional pressure on the company's liquidity over the next 3-6 months. Realizing gross margins anywhere close to 40% strikes me as a pipe dream for the balance of 2013, especially if JCP has to incorporate any one-time inventory adjustments/impairments to true-up its books.
  3. Strategic inconsistency. Is it clear to JCP who its customer is? The current merchandise mix seems to scream "No" very loudly. The day I visited the store I saw some reasonable foot traffic in the kids' back-to-school area and the women's wear sections of the store. The rest of the store was like a vacant bowling alley. I asked the store clerk how business was doing. Her response was despondent. She even told me that her hours had recently been cut back due to slower business volumes. This from a 10-year employee.

To close, it is very tempting to take a flyer on JCP here. Ostensibly, the Book Value is only $12-$13 a share. On paper the company has 1,100 stores including over 400 that are owned, the Fixed cost structure of the business is definitely lower than it has been in a long time. The former CEO is back at the helm.

"If only we can get the sales up then the operating leverage will kick in and it will all be fine!"

Sounds simple. But likely easier said than done.

Investors who point to JCP's healthy inventory balance as support for the stock here at $13 or so need to question exactly how productive that inventory is likely to be.

Is it likely to be sold at full pop?

Is it likely to be sold at aggressive discounts?

Is it likely to be sold below cost?

What % is in need of impairment/liquidation?

A $200 - $400 million haircut to JCPs inventory value throws the rest of the balance sheet into stress. Coverage ratios for loans go out of whack, vendor willingness to extend future credit may tighten, the cost of money is likely to spike, etc.

JCP's "Nut" appears to be about $1 - $1.1 billion per quarter right now. Another quarter or two of weak operating results could leave you with year-end adjusted Book Value of $10 or less.

This begs the question:

At some point if JCP is to survive through 2014, perhaps another round of capital injection might be needed dilutive to existing shareholders?

Through my common sense lens it seems unlikely that the new CEO is going to be able to turn over the current inventory balance and cleanse it of the prior regime's merchandising mistakes without meaningful additional write-downs to the balance sheet.

Even then, I wonder who JCP is serving, when and where.

If you are looking to take a flyer on JCP stock.

Caveat Emptor.

Retail Balance sheets are only as good as the inventory on hand. Are the wares what people want at a price point that can deliver meaningful economic value to the company? Do the goods recruit customers?

If you are long JCP take a visit to your local store. Please share what you see.

I saw a place that neither appeals to fashionistas nor discount buyers. Tragically, the place looks stuck in the middle.

Is it a Value Trap?

My take - the odds of a turnaround look long.

Even if a turnaround is successful it seems unlikely that the company's restructuring expenses are in the rear view mirror. It would seem reasonable to forecast additional charges for:

  • fixtures
  • inventory on hand
  • customer re-acquisition
  • ongoing operating losses

Back of the envelope I have haircut JCP's Book Value to $10 to adjust for these dynamics.

Maybe at $13.50 JCP isn't so cheap after all?

Source: Dangers Lurking At J.C. Penney Make It A Value Trap