J. C. Penney: How Pennies Make Dollars

Feb. 6.14 | About: J.C. Penney (JCP)

Current sentiment surrounding J. C. Penney (NYSE:JCP) and its prospects of a turnaround is cautious at best. Threats of insolvency, gross margin pressure and a slow sales recovery have dragged the stock to 30-year lows. Over the ensuing months, these concerns should subside as the market opens its eyes to an actual turnaround, resulting in a significant rally of its shares.

Company Overview 2012

Ron Johnson was appointed CEO to lead J. C. Penney out of a period of complacency. In doing so, he attempted to fundamentally disrupt the retail paradigm by overhauling pricing and reinventing the in-store experience. Arguing that J.C. Penney's brand image had been tarnished from years of discounts and "cheap" product, Johnson introduced a "fair and square" pricing strategy that attempted to maintain the product's integrity by pricing it at a "fair value." This value, under the previous discount strategy, reflected the merchandises selling price net of markdowns. Additionally, coupons, presented in 40% of all transactions in 2011, were eliminated, and promotions were cut from 592 to 12 per year.

Within the first three months of Johnson's tenure, same store sales and gross margins fell 18.9% and 2.85%, respectively, as the new pricing strategy failed to resonate with the value hungry J. C. Penney consumer. As a result, the buyer migrated to other discount retailers who offered 50% off $50, rather than J.C. Penney's $25 fair value, as the former yielded $25 in savings.

Not every move he made was bad. Johnson materially improved the look and feel of all 1100 stores and further developed "shops," an exclusive 300- 2,500 square foot section of the J. C. Penney store delegated to select brands. This delegation of space promoted autonomy over the merchandising presentation, aligning the "shop's" image with that of the brand. Over the course of three years, Johnson planned to introduce 100 "shops" that were connected by a 15-foot wide aisle called "the street" and organized around a central attraction known as the "the square."

To regain the company's image, 505 home department stores were renovated from the ground up, adding new brands such as Martha Stewart, Terrance Conran, and Johnathan Adler. Originally viewed as a sales catalyst, the launch of the home department proved otherwise, as designer merchandise was priced above the consumer's price point. The discontinuation of key private label brands, viewed as "cheap," made way for higher end products, such as Joe Fresh, which sold well in specific categories, but overall demand fell. Dissatisfied consumers demanded the reinstatement of these key private labels.

Johnson's pricing mistakes outweighed the positive impact of his in-store merchandising improvements resulting in a revenue decline of 24.8% (~$4.3B) from 2012 to 2013 and his termination as CEO. Myron Ullman, the previous CEO, returned to stabilize the business and regain lost customers; he immediately reinstated private labels and promotional pricing.

Key Investment Points

Johnson's vision for "shops" and merchandise presentation will be the foundation for J. C. Penney's forward success, and the beginning of a paradigm shift in department store retailing. The aesthetic presentation of "shops" enhances the visibility and value of merchandise previously hidden by racks of clutter. This increases the number of items a consumer views per visit and in turn the probability of conversion (percentage of consumers that enter a store and make a purchase).

The data behind "shops" supports this assertion. In Q2-12, while sales decreased ~23% YOY, Levi's "shops" increased their average selling price by $5 and their respective sales by 25%. An additional 33% sales increase was realized in the eight shops rolled out in Q3-12; however, considerable advertising revenue was spent promoting these brands, so this number likely needs discounting. A separate figure reported by Reuters and the Dallas News, had "shops" outperforming the remainder of the store by 20%. This trend will continue as current management builds on Johnson's framework.

On the Q3-13 earnings call, Ullman stated, "given the proven success of Sephora and the encouraging performance by our Levi, Izod, Liz Clairborne, Arizona and jcp shops, attractions are going to remain a strategic emphasis. We aren't going to set a specific number of shops. We will test and build out the ones that customers clearly want." The expansion of shops, combined with the reinstatement of promotional pricing and reemergence of key private labels should materially increase conversion rates. This leaves J. C. Penney competitively positioned as industry foot traffic continues to decline.

The construction of 505 department stores and 7000 shops had a onetime material adverse impact on sales, and its completion provides a catalyst for growth in 2014. 8.6% of J. C. Penney's total square footage was idle from the commencement of construction on February 1st, 2012 to the home launch in June of 2013 (Average 19k sq. ft. *505 stores/111.6M sq.ft.). Combined with 2012's "shop" construction, Q2 and Q3-12 saw periods of 15% idle floor space (7.2M sq ft. + 19k sq. ft. *505 stores/111.6M sq.ft). This trend continued into Q4-12 and Q1-13, as 9.86% floor space was at times idle (11m sq.ft/111.6M sq. ft.). No definitive numbers were given for the 3-4 shop constructions throughout 2013, but the significant idle floor space is likely comparable to Q1-13.

At the end of Q2-13, management realized non-renovated home stores outperformed those that were renovated. The failure resulted from poor spacing allocation, the organization of goods by brand rather than by category, and higher end merchandise not resonating with the consumer. However, online home sales for the quarter were strong, implying in-store structural issues was the culprit for weak sales. This resulted in major repurposing of home department merchandise throughout the back half of 2013.

Over 95% of 2012 and 2013 was adversely affected by either construction or the repurposing of merchandise. This reduced sales from unutilized floor space and the areas around it, as construction impaired the in-shopping experience. Based on management's guidance, minimal construction will take place in 2014 and a significant amount of the home department organizational limitations will be mitigated by March 2014. This will materially improve sales and sales per square foot as previously idle floor space now generates revenue. Additionally, sales of renovated home departments should significantly improve from Q2-Q4, 2014 due to the mitigation of structural limitations.

The magnitude of margin destruction from current inventory overhang is significantly less than the realized destruction under Johnson; resulting in a net margin improvement. Based on management's comments, there will be no substantial discontinuation of brands, mitigating concerns of forced-selling margin deterioration that negatively impacted Q412&13's gross margins by 925 basis points. The current threat of inventory overhang is the home department, specifically furniture. 150 stores have high levels of furniture inventory, and an additional 150 stores have low/moderate levels. While this will adversely affect gross margins, its magnitude relative to overhang under Johnson will result in a net positive effect.

The return to promotional pricing will protect gross margins from inventory overhang while driving sales. On the Q3-13 conference call, Ullman signified that margins obtained after promotional markdowns will not be remarkably different from 2011 (high 30s) due to sufficient markup levels. Understanding that previous historical margins were attained when greater than 72% of revenue was marked down by 50% or more, should mitigate concerns of substantial markdowns adversely affecting margins. Further, it should be viewed as a catalyst to move through the current inventory overhang; as the 2012 sales data clearly shows, the J. C. Penney consumer has a significantly higher probability of buying a marked down product. Additionally, the promotional "value" effect will materially drive sales as it is combined with new merchandising presentation, the return of key private label brands, and the repurposing of home.

Forward outlook

Tuesday's 2% SSS gain, while not great, was an improvement YOY. Had J. C. Penney not lost its momentum from various winter storms shutting down parts of the country, this number could very well have been 5-7%. Unfortunately, that is not how events transpired, and the small SSS gain sparked large revenue reductions for fiscal 2014 and beyond, thus downgrades, from multiple analysts.

However, this holiday season should by no means be an indication of future sales. If anything, lost sales from December and January may be realized in the subsequent quarters. Therefore, given normalized selling conditions, there should be nothing holding J. C. Penney back from comping positive 5-10% throughout fiscal 2014. The foundation for these gains is in place and the implementation of a full time CEO can only help.

Earnings on February 26th will give some insight on where margins currently stand. With expectations at such low levels, any positive margin data or positive outlook should result in a significant relief rally. Based on the aforementioned points, this is quite possible.

At ~$5.50, the market believes J. C. Penney will not be here in a few years. I am here to take the other side, as this iconic American name has significant untapped value and is not on its final breath just quite yet.

Disclosure: I am long JCP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.