There's just something magical about getting behind a great American turnaround story like J.C. Penney (NYSE:JCP). I guess we're a comeback nation of sorts. We almost lost The Revolutionary War like 37 times and then won in grand fashion, came back from the Great Depression and swept up the Dust Bowl to boot, rebuilt the WTC bigger and better than before, oh, and somehow un-mortgaged ourselves out of oblivion just a handful of years ago.
J.C. Penney is a natural turnaround story
And boy do we love our comeback movies. One of my all time favorites is The Natural with Robert Redford. You had a young, talented pitcher getting seduced by a gorgeous serial killer who doesn't quite finish the job, and then he fights back against all odds and a corrupt club owner to win it all.
Kind of reminds me a lot of how J.C. Penney got seduced by Ron "shiny Apple Store" Johnson, who didn't quite finish the job, and then fights back against a bunch of nay-saying shorts and buzz killers to reclaim its rightful place at the pinnacle of discount retail.
Granted, Johnson doesn't deserve all the blame as I discuss here; the starry-eyed JCP board had a lot to do with getting seduced by his siren song. What's more, a couple of his key strategies paradoxically set up JCP for its comeback.
JCP Stock Action
Anyway, enough with the syrupy nostalgia - let's get down to business. Actually, before we do, how is George Soros feeling right about now after dumping his JCP shares, huh!? Just had to get that off my chest.
JCP share action has been a thing of beauty over the last 8 or 9 trading sessions. Talk about the Little Engine That Could!
Citigroup's upgrade and $11 price target obviously didn't hurt, even though they cited some ongoing concerns.
#1 Key to Success - Higher Gross Margin
I won't wax poetic on this (well maybe a little) but it doesn't take a rocket scientist to figure out that a return to the private label brands will significantly increase margins. The majority of Johnson's hangover goods have been blown out, and the immensely popular and higher margin private label brands brought back, including St. John's Bay. It's so funny to hear the shorts bashing St. John's Bay and wondering who would buy it when the brand is more popular than Princess Dianna at her heyday.
In another story about the Citigroup upgrade, ValueWalk spells it out clear as day:
"Additionally, J.C. Penney Company … is returning to its historic mix of private labels (50% versus 30% under Johnson) whose margins can be as much as 500 bps higher than comparable national brands. At the same time, J.C. Penney has eliminated a number of private brands that were underperforming (JCP Men's, Stafford Prep, JOE by Joseph Abboud, William Rast, Joe Fresh Kids and JCP Everyday) and reduced a few others so that it can focus on the private brands that have proven to attract customers. Eliminating those brands forced J.C. Penney to take a one-off 190 bp gross margin hit (though it still improved 460 bps overall), but Chen expects to see strong margin improvement this year."
With 5% better gross margin on private labels, and a more favorable mix, JCP is well on its way to moving up from 28%+ margins reported in last earnings. Add back in the almost 2% gross margin hit from having to blow out the Johnson bargain bins, and JCP should be comfortably in the 33-34% range in the very near term. But wait, there's more - restoring the pre-Johnson pricing model and getting the higher-margin home goods in full swing will in my view get J.C. Penney up to 35-36% margins by Q3 without a hiccup.
#2 Key to Success - Sales Comps
Better margins usually lead to better comps, all other things staying equal or improving (such as the macro retailing environment). Speaking of the macro retailing environment - well whadayanknow - it's improving! On the other hand, while J.C. Penney's "easy" comps vs. last year will almost certainly help boost the stock, this won't be the benchmark for the company's improving financial situation.
The company MUST outperform these low expectations. This is where JCP's increased focus on Omnichannel retailing will really pay off, as I discuss in one of my previous articles on the topic. The return of legacy J.C. Penney customers - as well as those defecting from the likes of Target (NYSE:TGT) after their data breach - should also help boost sales above conservative guidance.
#3 Key to Success - Liquidity
This discussion is above my pay grade given the forensic accounting required, and the immense variability and potential for model error in the analyses. A bearish take is here and a contrarian response here. Needless to say, this is a critical success factor. For me, there should be no reason to doubt management's assertion that 2014 will end with at least $2B in liquidity. How the company gets there is another question entirely. A significant risk factor is the potential need for another dilutive event, and the rising stock price could increase the likelihood of this happening. Management steered well clear of specifics around how liquidity would be maintained or even improved during the most recent earnings conference call.
#4 Key to Success - Improving Image
In mid 2013, BrandIndex conducted a brand perception study that included J.C. Penney, which found that the retailer has significantly gained back lost brand perception following its "mea culpa" ads. What's interesting to note from the BrandIndex chart below is that J.C. Penney's perception scores were significantly above its competition before Johnson stepped on the scene. This just goes to show that the company has the potential to regain that advantage with the return of the business model that fueled those high scores to begin with.
An improving image and shiny new stores should combine to help sales further recover in short order. Can you say, "earnings surprise"?
I give the following 1-10 scores to J.C. Penney on the 4 success factors
- Potential to improve margin - 9
- Potential to improve sales - 8
- Potential to improve liquidity - 5
- Potential to improve image - 10
Problem is, these factors aren't all weighted equally, and they are interdependent. Liquidity definitely deserves higher weighting, so this will be heavily in focus in the coming quarters. The good news for JCP shareholders is that improving margins and better comps will be significant drivers for a higher stock price in the near and intermediate term, regardless of the liquidity risk that clouds J.C. Penney's long-term prospects.
This is my attempt at a "balanced" view. Truth be told, my gut tells me this company is on the verge of one of the greatest American comeback stories of all time.
Disclosure: I am long 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.
Additional disclosure: Please do your own due diligence before investing.