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I've been asked to attempt a bullish argument for J.C. Penney (NYSE:JCP) and will construct an estimate of J.C. Penney's value if things go well for them in terms of recapturing lapsed customers, restoring gross margin and maintaining/trimming SG&A expense. I am doing this from the perspective of a bull who is quite optimistic about J.C. Penney yet still grounded in reality.

As a bear, I believe that J.C. Penney will not achieve the estimates that I am mentioning in this article and will fall well below its targeted minimum liquidity level in 2014. Each quarter that goes by without meaningful growth substantially diminishes the probability of J.C. Penney regaining lost customers. Nonetheless, I am attempting to estimate J.C. Penney's value in a bullish scenario that is based on research on what is actually possible (in a non-miracle situation).

What Percentage of Lapsed Customers Can J.C. Penney Get Back?

One part of the bull argument is that J.C. Penney can regain a portion of its lapsed customers. The problem I have had with this argument is that many numbers are thrown around without any research into what percentage of lapsed customers might be lost forever to new shopping habits.

After searching around, I found an academic study that indicated that "the probability of a customer being active in the future is reduced by half for every additional year that a customer is inactive". Simplified, if a customer has left J.C. Penney for a year there is a 50% chance of regaining them. If a customer has left J.C. Penney for two years, there is a 25% chance of regaining them, and so on. There is probably some minimum level that this bottoms out at, but that is mostly irrelevant for our purposes here.

Most of J.C. Penney's lost business occurred in 2012, and the average duration that those customers have been gone is currently around 1.5 years. I'll assume that J.C. Penney makes excellent progress recapturing those lost customers over 2014, so that it recaptures those lost customers after an average of 2 years away.

Therefore, we'd estimate that J.C. Penney can realistically get up to 25% of its lapsed customers back.

What Revenue Does This Translate Into?

J.C. Penney is currently doing approximately $11.8 billion revenue per year with its current store base (and adjusting for announced closings). The comparable number from before Ron Johnson is approximately $17.1 billion (2010 numbers were higher than this due to the catalog business and more stores). Hence J.C. Penney lost $5.3 billion in sales.

Recapturing 25% of this would add $1.325 billion back to $11.8 billion, bringing the total to $13.125 billion. If we add 2.75% growth (midpoint of Macy's 2014 expectations) on top of getting back the lapsed customers, this gets us to $13.86 billion in revenue in two years.

What About Gross Margin?

J.C. Penney's gross margin was at 39.2% in 2010. Since 2010, its competitors have suffered gross margin erosion. Since 2010, Macy's gross margin has declined by 0.59%, Kohl's has declined by 2.01% and Sears Domestic by 2.33%. If we assume that J.C. Penney's gross margin potential has held up very well, we could use 38.5% as the gross margin number.

What About SG&A?

J.C. Penney's current SG&A run rate is around $4.15 billion (just over $1 billion per quarter in Q1 to Q3 and around $1.1 billion to $1.15 billion in Q4). This represents a reduction from the trailing year total of approximately $4.3 billion. J.C. Penney's store closings will save another $65 million. That brings us to $4.085 billion.

In an attempt to win back lost customers quickly and achieve positive growth independent of the regained customers, it is likely that advertising will increase at least slightly. For reference, advertising was $1.172 billion in 2010 and now appears to be in the $900 million to $950 million range.

If advertising is increased by $100 million and other SG&A (corporate office, etc.) is reduced by $135 million, that brings SG&A to $4.05 billion. Ron Johnson already implemented many corporate office layoffs and other cuts to SG&A, so I don't think there is too much left to squeeze, especially if J.C. Penney is aiming for growth. Further SG&A cuts may be possible if J.C. Penney is attempting to remain an $11 billion to $12 billion revenue company.

Valuing J.C. Penney

Putting all those factors together would give an EBITDA of $1.286 billion. At an EV/EBITDA multiple of 6.0x, that would make J.C. Penney worth an $7.716 billion in net debt plus market capitalization.

Revenue ($ Million)

$13,860

Gross Margin (%)

38.5%

Gross Margin ($ Million)

$5,336

SG&A ($ Million)

$4,050

EBITDA ($ Million)

$1,286

Net debt would be approximately $3.8 billion (assumes an average inventory level of around $3.1 billion), so J.C. Penney's market capitalization would be $3.916 billion or $12.86 per share.

Conclusion

If I were very bullish on J.C. Penney and believed that it could make immediate and substantial progress in terms of regaining lost customers, restoring gross margins fully and slashing SG&A some more, then I would estimate J.C. Penney's value to be around $12.86 per share in a couple years.

This is dependent on J.C. Penney making substantial progress in terms of regaining lost customers starting in Q1 2014. If J.C. Penney can achieve over $2.8 billion in revenue in Q1 2014 with 33+% gross margin, that is an indication that it is making the necessary progress to reach my bullish value forecast.

If J.C. Penney does $2.6 to $2.65 billion in revenue in Q1 2014, then it has wasted another quarter in terms of regaining lost customers. At that point, the potential recapture of lapsed customers falls to 21% from 25%, and it also has negative effects on the net debt calculations (due to slower growth). That would reduce my estimate of top end value at the end of 2015 to around $10.80 per share if substantial customer recapture started in Q2 2014. Another quarter of flat/minimal growth after that would reduce my bullish end of 2015 value estimate to around $9.00 per share.

Another key risk to this value estimate is gross margin. If gross margin ends up at my standard model percentage of 37.5% [based on a gross margin decline closer to Kohl's (NYSE:KSS) than Macy's (NYSE:M)], then even with a substantial recovery of customers starting in Q1, the end of 2015 value estimate falls to around $9.50. With 37.5% gross margin and a substantial recovery of customers that doesn't start until Q2, the end of 2015 value estimate becomes $7.50.

Disclosure: I am short JCP. 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.

Source: J.C. Penney: Attempting A Reasonable Bullish Argument