J.C. Penney (JCP) 8/19/13 Close $13.22--Update 8/20/13
JCP reported an adjusted loss of $1.18 for FQ2, missed analyst estimate by 12 cents but exceeded the whisper number.
· The monthly comparables trends for online and apparels are encouraging, signaling that the reversion back to higher level of promotion is working
· JCP's back-to-school merchandises are resonating with customers and selling well
· JCP improved its liquidity profile and interest cost by entering into a $2.25 billion senior secured term loan facility
· JCP reaffirmed the level of inventory and capex requirement for the second half of the year, and they are roughly on targets
· Home continues to be a headwind and newly remodeled home sections fails to drive traffic
· With its new $2.25 billion term loan, JCP's debt loads are now higher its peer average
J.C. Penney is one of the largest retailers in America with 1,102 stores national wide. Its traditional targeted demographics are lower-end value focused customers. Its current woes began when Ron Johnson became its CEO on November 2011. Johnson hoped to translate his success with Apple's retail stores to JCP through rebranding and store remodeling, with the hopes of attracting more higher-end customers and reduce the amount of promotions. His strategy failed spectacularly because it alienated JCP's core base of value-conscious customers and failed to attract new demographics. Rather than his marketing strategy, he did not understand that his success at Apple was largely due to Apple's highly differentiated products; JCP retails largely undifferentiated products.
On April 2013, Ron Johnson was replaced by Mike Ullman who previously served as JCP's CEO from 2004 to 2011. Ullman's task is to stabilize the overall business and regain the lost wallet share of JCP's traditional customers. We do not believe JCP is fundamentally broken. In fact, JCP enjoys many competitive advantages such as cheap real estate, national scale, and brand legacy. At current valuation, JCP offers an attractive asymmetric risk/reward profile - its downside is anchored by the value of JCP's real estate assets and its upside can be unleashed if it eventually recovers to its historical average operating level.
· JCP's 5-year $1.75 billion senior secured loan gives JCP enough time to heal its self-inflicted wounds - JCP's cash balance was dangerously low prior to the loan infusion on April 2013. The loan served two purposes - one was to strengthen JCP's liquidity so that it would not violate any covenants on its other loans; another was to provide enough cash to complete JCP's remodeling and replenishing its inventories. With its store remodeling and inventory replenishment being close to completion, JCP's cash burn should substantially improve in the coming quarters.
· Ullman is making progress in his efforts to win back JCP's traditional customers - unlike Johnson, Ullman spent much his time listening to JCP's customers and its employees and tailoring his recovery strategy from their insights. Some of the examples include changing back from a one-level rewards approach to a tiered approach, bringing back private-label business such as St. John's Bay, Ambrielle and Intimate, and changing the inventory mix of its home section to be at lower prices.
· Reinstating dividend will bring back income oriented investors and result in multiple expansion - on May 2012, Ron Johnson discontinued the 20 cents quarterly dividend in order to fund his transformation plan, resulting in a large exodus of income oriented investors. During that quarter, JCP's stock price dropped from the mid 30s to low 20s. The current analyst expectation is that JCP will return to profitability within the next two years. Given its long dividend paying history, JCP is likely to reinstate dividend once it reaches sufficient profitability.
· Near-term liquidity - the $1.75 billion senior secured loan is critical to JCP's recovery plan. According to Barclays' calculation, the loan will increase JCP's cash balance from $821 mil to $2,123 mil. The maturities of JCP's debts are spaced out and they are in manageable sizes - the closest maturing debt is a $200 mil senior unsecured bond due in October 2015. JCP's store remodeling and inventory replenishment were main drivers of cash burn; they are largely completed and should cause the cash burn to come down in the next several quarters. If JCP can stabilize its sales within the next several quarters, JCP should have enough liquidity that it would not have to access the equity market.
· Damage to the brand - we do not know if Johnson's initiatives have incurred lasting damage to JCP's brand equity. After Ullman was reinstated as CEO in April, JCP had brought back its private brands. The fact that those brands are 50% or 60% back to the levels that JCP is expecting within a matter of months suggests that JCP is still resonating with its value-conscious customers if it has the right products at the right price points. In addition, Ron Johnson's one positive contribution to JCP is reducing its fixed cost by roughly $700 mil a year - JCP can absorb some damage to its brand due to its improved fixed cost operating leverage.
· The general economy - JCP's sole country exposure is to the U.S. As with any other U.S. centric retailers, JCP's fortune is closely tied to U.S. consumer spending. With a rebounding housing market, a relatively healthy stock market, and an improving labor market, JCP should benefit from the improving economy (less so than its higher-end competitors because housing market and stock market disproportionately benefit the wealthy).
Historically, JCP has between $2-3 in earnings power during stable economic conditions. Let's assume its improved fixed cost structure will roughly offset any damages to the brand equity. Assuming minimal growth prospects and using a conservative 10x multiple, JCP can potentially revert back to $20-30/share. If dividend is reinstated at 3% yield, it can add another $6-9 to the upside price target range.
JCP owns 49% of its real estates and has long-dated low-cost leases on the remaining real estates. According to Pershing Square Capital's analysis, the replacement value for those real estate assets can be as much as $11 billion. Even with a 30% haircut to the $11 billion estimate and adjusting for debts/pension obligations/expected losses, JCP's share is still worth a little over $12/share.
J.C. Penney first came to our attention when our Hidden Earnings quantitative strategy signaled the stock for inclusion. Hidden Earnings strategy looks for companies that historically have earned respectable returns on invested capitals but their current margins are below historical average. Under more normalized margin levels, these companies' earnings and, consequently, stock prices would have been substantially higher.
Income Growth Advisors offers a suite of quantitative strategies that seek to provide exceptional return profiles with less than market risk. We use empirically proven systematic investment strategies that take advantage various medium/long term market inefficiencies, and combine them with a rules based risk mitigation overlay. Examples of strategies include finding temporarily ignored companies with improving fundamentals, high quality companies that are selling at discounts to their intrinsic value, and inexpensive companies that are increasingly being recognized.
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