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There has been much talk about how much J.C. Penney (NYSE:JCP) might be worth if it can recapture its past business from 2010/2011 or even half of its lost business while simultaneously regaining its gross margin from 2010. This overlooks a couple of important points though.

  • The department store market has been declining by an average of 2% per year since 2000, including a similar pace of decline since 2010. If J.C. Penney recaptures half of its lost market share by 2015, it will reach $13.6 billion in revenues.
  • Gross margins for J.C. Penney and its competitors have come under serious pressure since 2010. Over that period, Macy's gross margin has declined by 0.59%, Kohl's (NYSE:KSS) has declined by 2.01% and Sears (NASDAQ:SHLD) Domestic by 2.33%. J.C. Penney's attempts to regain billions in lost sales will put these margins under increasing pressure, so if J.C. Penney can return its gross margin to within a couple percentage points of 2010, that would be a strong accomplishment.

The upside for J.C. Penney is therefore fairly limited even with a full recovery of lost market share and a strong recovery of gross margin. J.C. Penney's current market price already assumes an 87% recovery of lost market share, and anything less than that will cause J.C. Penney to be overvalued at its current price.

Fighting Over A Shrinking Pie

Department stores have been battling over a continuously shrinking pie for quite some time. Department store sales peaked at $232 billion in 2000, but have declined by 24.2% to $176 billion in the trailing 12 months ending October 2013. Since 2010, department store sales have declined by 5.3%. Since 2000, the only annual growth for department stores came in 2004, when they eked out a paltry 0.6% gain.

J.C. Penney had a 9.25% share of the department store market in 2011, but this has declined to 6.79% over the last 12 months.

2010

2011

2012

2013 TTM

J.C. Penney ($ Million)

$17,070

$17,114

$12,822

$11,961

Department Stores ($ Million)

$185,813

$185,089

$183,264

$176,278

J.C. Penney's Share

9.19%

9.25%

7.00%

6.79%

Note: J.C. Penney's sales for 2010 and 2011 have been adjusted to remove the impact of its catalog and outlet business that it no longer operates.

If department store sales continue to shrink by 2% per year, the department store market will decrease to $169 billion in 2015. If J.C. Penney maintains its current market share, it will have $11.475 billion in revenues. If it recovers 50% of its lost market share, revenues will be $13.554 billion. A 75% recovery would put J.C. Penney at $14.602 billion, while 100% recovery would put J.C. Penney at $15.633 billion.

2015 Sales

Current Share

50% Recovery

75% Recovery

100% Recovery

J.C. Penney ($ Million)

$11,475

$13,554

$14,602

$15,633

Department Stores ($ Million)

$169,000

$169,000

$169,000

$169,000

J.C. Penney's Share

6.79%

8.02%

8.64%

9.25%

Decreasing Gross Margins

Gross margins have also been under significant pressure over the last few years. Below is a table of gross margins for the last several years for J.C. Penney and its closest competitors. Since 2010, Macy's gross margin has declined by 0.59%, Kohl's has declined by 2.01% and Sears Domestic by 2.33%.

2010

2011

2012

2013

Macy's

40.71%

40.37%

40.27%

40.12%

Kohl's

38.23%

38.18%

36.26%

36.22%

Sears Domestic

28.57%

26.79%

27.98%

26.24%

J.C. Penney

39.19%

36.03%

31.31%

27.94%

A 1.19% decrease in gross margin from 2010 levels would bring J.C. Penney down to 38.00%, and that would represent a better than average showing amongst its peers. With the increased competition from J.C. Penney trying to regain up to $4 billion in sales, it is likely that margins for J.C. Penney and its competitors will decline even more. We are going to use 37.50% in our calculations.

SG&A Levels

We estimate J.C. Penney's current SG&A run rate at $4.15 billion per year ($1 billion per quarter in Q1 to Q3 and $1.15 billion in Q4). However, advertising spend is currently around $100 million below 2011 levels. It is very likely that J.C. Penney will need to increase advertising if it hopes to recover a significant portion of its lost business.

If J.C. Penney manages to recover lost sales, it will also incur additional staffing expenses to handle the increased volume of transactions and shopper traffic. We are estimating this expense at $300 million for a full recovery, which would put J.C. Penney's SG&A at $4.55 billion under that scenario. This still reflects a major savings from the $5.1 billion in SG&A that J.C. Penney had in 2011 as well as improved efficiencies (approximately 14% decrease in non-advertising SG&A vs. a 9% decline in sales compared to 2011).

2015 Sales

Current Share

50% Recovery

75% Recovery

100% Recovery

J.C. Penney ($ Million)

$11,475

$13,554

$14,602

$15,633

SG&A ($ Million)

$4,150

$4,400

$4,475

$4,550

SG&A (%)

36.17%

32.46%

30.65%

29.11%

J.C. Penney's Valuation In A Recovery

We have taken the information from above and are going to look at J.C. Penney's value under several scenarios. Interest expense is assumed to be $400 million per year, and capital expenditures are expected to increase back up to $400 million in 2015 (still lower than historical levels). Net debt is estimated at $4.2 billion under all scenarios for simplicity. This probably is an optimistic estimate as net debt is already slightly above that level, J.C. Penney is still burning cash, and even under a full 100% recovery scenario, J.C. Penney is generating only $512 million in positive cash flow per year.

Using an EV/EBITDA multiplier of 6.0x, J.C. Penney's value per share is negligible with its current market share and with a 50% recapture of its lost market share. In reality it will probably still trade at several dollars per share as long as cash burn isn't too excessive.

With a 75% recovery, its value per share is $5.93 and with a 100% recovery, its value per share is $12.06. J.C. Penney's current share price implies an 87% recovery of lost market share.

FY 2015

Current Share

50% Recovery

75% Recovery

100% Recovery

J.C. Penney ($ Million)

$11,475

$13,554

$14,602

$15,633

Gross Margin @ 37.50%

$4,303

$5,083

$5,476

$5,862

SG&A ($ Million)

$4,150

$4,400

$4,475

$4,550

EBITDA ($ Million)

$153

$683

$1,001

$1,312

Interest Expense ($ Million)

$400

$400

$400

$400

Capital Expenditures ($ Million)

$400

$400

$400

$400

Estimated Cash Flow ($ Million)

-$647

-$117

$201

$512

EV/EBITDA @6x ($ Million)

$918

$4,098

$6,006

$7,872

Less Net Debt ($ Million)

$4,200

$4,200

$4,200

$4,200

Market Capitalization ($ Million)

N/A

N/A

$1,806

$3,672

Price/Share @ 304.6 Million Shares

N/A

N/A

$5.93

$12.06

Conclusion

Due to the shrinking size of the department store market, J.C. Penney's market share from 2010 and 2011 translates into $15.6 billion in revenues for 2015. There has also been significant margin pressure among department store peers, which will intensify as J.C. Penney attempts to claw back billions in lost sales. As a result, 37.5% gross margin would look pretty good for J.C. Penney and would signify above average performance relative to its peers compared to 2010.

Even if J.C. Penney fully recovers its lost market share from 2011, its shares will be worth approximately $12 per share and it would still face significant challenges in a market that is shrinking by 2% per year with declining gross margin as well. This upside scenario is significantly less rosy than bull expectations.

The current share price of J.C. Penney assumes that J.C. Penney will recover 87% of its lost market share by 2015. A 75% recovery would make its shares worth around $6. If J.C. Penney recaptures 50% of its lost market share, then it will still be burning cash in 2015 and probably is worth only a few dollars per share (an EV/EBITDA multiple of 6.0x would say that J.C. Penney has minimal value). We remain bearish on J.C. Penney because we believe that J.C. Penney will recapture less than 75% of its lost market share by 2015.

Source: J.C. Penney: Worth $6 If It Recaptures 75% Of Lost Market Share