Not often do inflection points come along for turnaround stories, let alone two in the same day. However, two news items hit the tape yesterday that I think represent a fundamental change in how investors should look at two legendary retailers.
What It Means for J.C. Penney
Positive November sales data, coupled with CEO Mike Ullman's purchase of 112,000 shares bodes well for J.C. Penney going forward. While the company admittedly relied heavily on discounting and door buster specials, 10.1% same-store sales growth signals that the company has recaptured some of its lost customer base.
After CEO Ron Johnson's tenure, J.C. Penney has brought back its core products that appeal to its core customer. As fashionable as some of Johnson's products were, J.C. Penney customers (apparently) didn't care for newer fashion or styles. Rather, the customers want frequent discounting and a product mix more comparable to Kohl's (KSS) than Nordstrom (JWN).
However, sales are only half of the equation, the other part being margins. Because J.C. Penney's sales and promotional strategy so closely resembles what Ullman did during his first tenure atop J.C. Penney, I think it's safe to say gross margins will return to at least the mid-30% range. With this sort of drastic improvement from the firm's mid-to-low 20% range, I believe operating cash flow will recover tremendously. More importantly, if sales continue to recover, J.C. Penney will not have a problem finding new financing going forward. The "liquidity event" that I've seen some bears call for will be proven foolish.
As for the share price, after the massive equity raise, I think shares are worth about
What It Means for Sears
Eddie Lampert has had turnaround plan for Sears for nearly a decade now. Unfortunately for Sears' shareholders, the plan hasn't translated into increased same-store sales or improved profitability. There are several reasons why the plan has failed, including Sears' massive underinvestment in its own stores, competition in the appliance space from the likes of Best Buy and Home Depot, and the negative corporate culture that Lampert has developed.
However, at the end of the day, shareholders could find some peace in the sense that the company's largest shareholder was "in it for the long-term." I don't necessarily believe the long-term has come, but rather Lampert's hedge fund partners are likely frustrated that they would have been better off in an index fund over the past five years.
I completely understand the real estate investment case for Sears, and actually, I think positive momentum for J.C. Penney's business is actually positive for Sears' real estate value. If J.C. Penney was on the path to bankruptcy, then there would be considerably more big box and mall-based real estate poised to hit the commercial real estate market, potentially depressing real estate prices. For the time being, that possibility seems to be off the table.
Additionally, J.C. Penney's recovery may accelerate Sears' demise, forcing Sears and Lampert to monetize real estate and brand assets sooner rather than later.
Yet, further redemptions from Lampert's hedge fund partners could put significant downward pressure on the stock. Lampert has opted to honor redemptions in Sears' stock rather than cash in the past, and I suspect those receiving Sears stock in a redemption will want to sell it immediately, creating more downward pressure on the share price.
Sears' operating business is in a long-term decline, and a housing recovery, long heralded as a savior for Sears, was not even able to turn same-store sales positive.
What's the Trade?
In my view, long J.C. Penney is a fundamentally attractive idea that looks even stronger from a valuation standpoint. Consider the magnitude of a 10% same-store sales growth rate for J.C. Penney in the fourth quarter. If the company achieves such a robust rate, it will add over $1 billion in incremental sales and close to $300 million in gross profit. Assuming a similar cost structure, J.C. Penney could swing to a profit in the fourth quarter.
In fact, I think the firm can earn at least $1 per share next year. Assuming a market multiple of around 14, and I think shares could touch $14 in the next 12-18 months. That could prove to be conservative given the tremendous momentum in the name. Still, 40% upside would be fantastic.
As for Sears, a valuation becomes very murky thanks to the real estate portion of the business. Seeking Alpha contributor Todd Sullivan does a fantastic job addressing this issue. The potential real estate value coupled with the nightmare of actually shorting Sears (a company with two major shareholders hoarding the majority of a float) are reason enough to stay away on the short side.
Perhaps the best way to bet on Sears' fundamental decline is, oddly, by going long J.C. Penney. You receive the benefit of Sears losing market share without the risk of asset monetization.
Sears as a retailer is dead, but the best way to play it might just be with another retailer that seems to have passed its darkest days.