Immediately after J. C. Penney (NYSE:JCP) released its second quarter results I wrote an article in which I argue that J. C. Penney will either go bankrupt or substantially dilute shareholders in an attempt to stave off bankruptcy. I offer three reasons as to why this is the case:
- The company's financial position is deteriorating rapidly.
- Management has no vision of the company's future. It merely wants to recreate the past, and this is simply impossible.
- While conventional metrics suggest that the retail environment in the United States is not that bad, a quick glance under the hood reveals that the beneficiaries are high-end retailers and low-end discount retailers.
This is not the first bearish article I have written on the company, although it was the first one that I wrote where virtually every commentator agreed with me, and the one that disagreed with my suggestion to short J. C. Penney shares didn't argue against my fundamental case, but rather said that he wouldn't bet against George Soros, who is the company's largest shareholder.
As a contrarian I found this disconcerting. This feeling struck me again when on August 27th Bill Ackman announced that he would be unloading his stake at $12.70/share.
Is it possible that I am wrong? Is it time to become a contrarian and bet on J. C. Penney?
In my attempt to answer these questions I compiled a list of bullish arguments, and I find virtually no merit in them.
1: J. C. Penney Trades at a Low Price/Sales Ratio
On August 30th an article was published in which the author argues the following:
Delving into fundamentals, its price-to-sales ratio signals that J.C. Penney is severely undervalued in comparison to its competitors in the services industry. The company's price-to-sales ratio is a meek 0.23. Investors are valuing the price-to-sales ratio of Kohl's (NYSE:KSS) at 0.57 and Macy's (NYSE:M) at 0.60 higher than J.C. Penney.
The argument that a company is cheap because it trades at a low valuation relative to its sales is easily refuted: just imagine that company XYZ sells $100 bills for $1 each. Sure its sales would be high, but does anybody believe that this is a viable business to invest in? While J. C. Penney is not selling $100 bills for $1 each, there is no doubt that it has incredibly high costs. Furthermore, its costs are not coming down in line with its sales, which would give merit to the author's argument. While sales were down 11% in the second quarter, cost of revenue only fell by 7%, and SG&A only fell 4.5%.
2: J. C. Penney's Real Estate
A recent article published estimates that J. C. Penney's real estate is worth about $4.1 billion. The company borrowed $2.25 billion against the real estate, so were the company to simply sell all of its real estate and pay back these bondholders it would have $1.85 billion. This is less than the company's market capitalization of $2.75 billion, but one might argue that this is a floor.
This is overly simplistic (I should note that the author of the cited article does not make this argument). First, if J. C. Penney tried to sell over 1,000 stores at once this would severely depress their value. There are only a handful of competitors who themselves are not doing terribly well (other department stores are comfortably profitable, but they certainly aren't growing).
Second, the company's total debt--$5.8 billion total--exceeds the value of its real estate, and in order to pay these off the company would have to liquidate its second biggest asset--its inventory, which it currently values at $3.1 billion. Also the company cannot divest its real estate without first selling its inventory. Thus the "real estate" argument should be broadened to just a balance sheet argument: there is a floor in J. C. Penney shares because the stated value of its assets exceeds that of its liabilities by $2.3 billion.
So let us assume that a liquidation is announced, effective immediately.
We already saw that the value of the real estate has to be marked down, which decreases the company's shareholder equity. Also if the company were to liquidate its inventory in order to sell its real estate it would also have to discount this. A mere 10% discount on both real estate and inventory (and the inventory would almost certainly be discounted far more) would decrease this figure by $720 million to $1.58 billion. But if this quarter has been anything like the last one (and there is no indication otherwise), then the company conservatively lost $150 million, and so we are down to $1.43 billion, which means that the liquidation value of J. C. Penney is barely more than half the current share price. If the company took just 2 months to liquidate and we continue to use the $150 million/month loss rate, we are down to $1.13 billion, which means that the shares are just worth $5 each.
So there may be a floor, but it is a painful fall getting there.
3: The Company Has The Backing of Large Investors
This is the argument that I have been confronted with the most. There is no denying that there are investors who have far more money and experience than myself who are lending the company money or even buying equity. The latter means nothing fundamentally, although it does impact how the stock trades short term.
The fact that J. C. Penney has lenders needs to be addressed, because the company can survive so long as it has willing lenders. This argument is not unlike the previous one, because the loans being made to J. C. Penney are backed by the company's assets. Will the company have willing lenders if the loans are not collateralized? This has yet to be seen because so far the company has positive shareholder equity, and therefore it has had assets to offer as collateral. There is no reason to believe that the company will have willing lenders if it cannot offer anything as collateral.
4: J. C. Penney's Sales are Accelerating
Last quarter the company showed a decline in sales of 11% year over year vs. a decline of 16% year over year in the second quarter of 2012. While a double digit decline in sales is anything but positive, the rate of sales declines is slowing, and this implies acceleration. If this is extrapolated out far enough then it means that the company is anticipated to show sales growth.
The issue is that the company showed a 5% increase in sales growth (growth in this case being negative) year over year. Assuming that this rate remains constant we would need to extrapolate this out over two years before there was an increase in sales The company does not have that much time. Even assuming that the company's bloated estimate its asset values ($2.3 billion) is accurate, at the current rate at which the company is bleeding assets (about $1.5 billion annually and remember the bleed increases for over two years) it has significantly less time. My estimate above of $1.13 billion worth of assets gives the company just a few months. Unless the rate of acceleration increases dramatically, accelerating sales cannot be used as a bullish argument for J. C. Penney's shares.
5: J. C. Penney's Brand Recognition
While this fact certainly doesn't hurt the company, we can draw very little from this. General Motors arguably had more recognizable brands when it went bankrupt. Woolworths may have as well. The fact is that brand recognition does not translate into sales. However in the hands of the right management team J. C. Penney's brand could be a valuable asset.
Ultimately a brand is supposed to communicate a market function of a company. As I state in my previous article:
If we look at successful retail stories such as Wal-Mart, Costco, Dollar General, or Apple, there is a market niche that a large number of Americans can point out even if they don't shop at these establishments. It is no secret that Wal-Mart appeals to customers looking to buy virtually anything at a low price, or that Costco appeals to customers who want to buy every-day items such as toothpaste or cereal in bulk so that they can get a lower price.
J. C. Penney has utterly failed in this regard: if customers do not know why they should go to J. C. Penney, they simply will not.
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.