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Summary

  • J.C. Penney appears cheap historically, if you look at a stock chart. That does not account for added shares or added debt.
  • J.C. Penney's current stock price is equivalent to when it traded in the $20s before.
  • Department store valuations have generally only increased in the last three years for companies that have strengthened financially.
  • Using J.C. Penney's 2011 EV/EBITDA multiple means that it will need to grow at 5%+ for four to five years and attain 38% gross margin to justify a $9 price.

One thing that has puzzled me during the debate about J.C. Penney (NYSE:JCP) is the assertion that J.C. Penney is currently undervalued or cheap. I'm willing to entertain the idea that various factors, such as high short interest, positive sentiment about a recovering business (however modest the recovery), momentum, chart patterns or other similar factors indicate that J.C. Penney might go higher. However, I have yet to see a good argument that J.C. Penney is undervalued based on financial metrics using the outlook for the next few years. The arguments that J.C. Penney is undervalued have so far either neglected to include debt in calculations, or assume that since J.C. Penney is expected to go from $11.9 billion in sales in 2013 to $12.4 billion in 2014, getting to $15 billion should be a piece of cake.

To get to the point where J.C. Penney is fundamentally undervalued either requires one to scrap J.C. Penney's guidance and use growth rates that are much higher, or project J.C. Penney's guidance out another four years at the same rate, assuming it can keep growing at that rate, and then talk about a potential valuation for 2018 or 2019. Before the guidance, there was at least the hope that J.C. Penney could do $14 billion-plus in 2014, and one could do some valuation calculations that justified a higher share price based on 2014/2015 numbers with that rapid turnaround.

Anchoring Bias

So why do some people think that J.C. Penney's shares are currently cheap? I think the answer has to do with anchoring to historical stock price. J.C. Penney traded at around $37 before Ron Johnson in April 2011, and at $16 this past April, so $9 seems quite cheap in comparison. What that glance at a stock chart doesn't take into account, though, is the extra shares and extra debt that have been added since then.

Recreating The Financial Position From Last Year

I'm going to take a look at what J.C. Penney's current share price (using $9) would be equivalent to if it had the same debt and shares outstanding as one year ago. To do this, J.C. Penney is going to issue shares at $9 per share and then do a reverse split.

After the Q4 FY2013 report, J.C. Penney had 304.7 million shares outstanding and net debt of $4.086 billion. This compares to 219.8 million shares outstanding and net debt of $2.052 billion after the Q4 FY2012 report.

April 2013

April 2014

Shares Outstanding (Million)

219.8

304.7

Total Net Debt ($ Million)

$2,052

$4,086

The first step to equalizing the two situations is issuing 226 million shares at $9 per share. This brings current net debt down to the same $2.052 billion, and leaves J.C. Penney with 530.7 million shares.

April 2013

April 2014

Share Price ($)

$16.00

$9.00

Shares Outstanding (Million)

219.8

530.7

Total Net Debt ($ Million)

$2,052

$2,052

The second step is to do a reverse split of 2.41 shares to 1 share. This reduces the current share count to 219.8 million, and also increases the price from $9.00 to $21.73.

April 2013

April 2014

Share Price ($)

$16.00

$21.73

Shares Outstanding (Million)

219.8

219.8

Total Net Debt ($ Million)

$2,052

$2,052

Therefore, J.C. Penney's stock is actually trading at a 36% premium to its price in April 2013 once you adjust for share count and net debt, not the 44% discount that would be suggested by a price of $9 versus $16. I don't think anywhere as many people would be claiming that J.C. Penney is undervalued or cheap if the current stock price was $21.73, even if Enterprise Value was exactly the same with $2 billion in net debt and 220 million shares outstanding.

J.C. Penney has apparently halted its sales decline now, compared to the free fall it was in at the beginning of last year. However, the midpoint of 2014 guidance still calls for revenues that are around $600 million less than 2012, and still approximately $480 million less than J.C. Penney's targeted sales level for 2013. J.C. Penney's internal 2013 plan called for $12.872 million in revenues and an operating loss of $106 million.

This is important, since internal sales targets for J.C. Penney in 2013 were about 4% higher at the beginning of FY2013 than current guidance for FY2014, yet the stock is trading at a significant premium now, once debt and share count are equalized. Internal targets do usually involve some stretch, but it seems reasonable to say that internal expectations for 2013 were likely fairly similar to (and probably better than) current guidance for 2014.

Recreating The Financial Position From Three Years Ago

I am going to do the same exercise versus April 2011, before Ron Johnson become CEO. After the Q4 FY2013 report, J.C. Penney had 304.7 million shares outstanding and net debt of $4.086 billion. This compares to 229.9 million shares outstanding and net debt of $477 million after the Q4 FY2010 report, which is the last full year under Ullman.

April 2011

April 2014

Shares Outstanding (Million)

229.9

304.7

Total Net Debt ($ Million)

$477

$4,086

The first step to equalizing the two situations is issuing 401 million shares at $9 per share. This brings current net debt down to the same $477 million, and leaves J.C. Penney with 705.7 million shares.

April 2011

April 2014

Share Price ($)

$37.00

$9.00

Shares Outstanding (Million)

229.9

705.7

Total Net Debt ($ Million)

$477

$477

The second step is to do a reverse split of 3.07 shares to 1 share. This reduces the current share count to 219.8 million, and also increases the price from $9.00 to $27.63.

April 2011

April 2014

Share Price ($)

$37.00

$27.63

Shares Outstanding (Million)

229.9

229.9

Total Net Debt ($ Million)

$477

$477

Therefore, J.C. Penney is actually trading at a 25% discount to its price in April 2011, once you adjust for share count and net debt, not the 76% discount that would be suggested by a price of $9 versus $37. Meanwhile, 2014 guidance is for sales that are down 30% versus 2010, and approximately 32% less than its guidance for 2011 at the time. Profitability is also significantly different, with 2011 guidance calling for $2.00 to $2.10 per share in earnings, versus analyst estimates ranging from a loss of $1.79 to $3.73 in 2014 and ranging from a profit of $0.05 to a loss of $2.59 for 2015.

Department Store Valuations Versus Three Years Ago

One argument that has been brought up is that department store valuations have improved in the last three years. That varies on a case-by-case basis, though. Nordstrom (NYSE:JWN) and Kohl's (NYSE:KSS) have the same EV/EBITDA ratios now as three years ago, while Macy's (NYSE:M) and Dillard's (NYSE:DDS) have improved.

EV/EBITDA (Trailing Year)

April 2011

April 2014

Nordstrom

7.8

7.8

Macy's

5.3

7.0

Kohl's

6.1

6.1

Dillard's

5.0

5.7

J.C. Penney

5.6

NA

The S&P credit rating seems to correlate well to both EV/EBITDA multiples and change in those multiples over the last three years, as investors are generally willing to pay a premium for a financially stable company. Nordstrom has the highest EV/EBITDA multiples, and also has the best credit rating. Macy's has demonstrated a strong improving trend, with its credit rating upgraded three notches in the last three years and its EV/EBITDA multiple also taking a big jump. Kohl's has stayed stable in both credit rating and EV/EBITDA multiple, while Dillard's has been upgraded two notches and had its EV/EBITDA multiple increase as well.

S&P Credit Rating

April 2011

April 2014

Nordstrom

A-

A-

Macy's

BB+

BBB+

Kohl's

BBB+

BBB+

Dillard's

BB-

BB+

J.C. Penney

BBB-

CCC+

J.C. Penney, on the other hand, has been severely downgraded over the last few years. Even if it does start generating substantial EBITDA, it will still be in a significantly worse financial state than three years ago. Therefore, a 5.6x EV/EBITDA multiple is likely very generous, and there are good reasons to think that it should command less than the 5.0x EV/EBITDA multiple that Dillard's had when it had a credit rating of BB-.

J.C. Penney's Valuation

Based on a 5.6x EV/EBITDA multiple, J.C. Penney needs to generate $1.218 billion in EBITDA to justify a $9 share price. Based on a 5.0x EV/EBITDA multiple, J.C. Penney needs to generate $1.364 billion in EBITDA to justify a $9 share price.

Target EBITDA ($ Million)

5.6x EV/EBITDA

$1,218

5.0x EV/EBITDA

$1,364

When will J.C. Penney achieve those targets? If J.C. Penney can grow by mid-single digits indefinitely (+5%) and achieve 38% gross margin, then J.C. Penney will be able to reach $1.25 billion in EBITDA in 2017 and $1.48 billion EBITDA in 2018. Therefore, the $9 share price represents a good target based on valuation for April 2018 or April 2019, if J.C. Penney can maintain its 2014 guidance growth rate over a four- to five-year period.

Conclusion

J.C. Penney's shares seem cheap if you look at a stock chart and see the decline over the last few years. However, if you account for the added debt and added shares, J.C. Penney doesn't seem as cheap. It is trading at a significant premium to its price last year, despite an outlook that is similar. It is only trading at a 25% discount to 2011 prices, despite sales that have fallen by 30% and profitability that is not even remotely comparable.

The valuation of department stores has not changed over the last three years either. Department stores that have strengthened financially command higher multiples. Department stores that have remained the same financially command the same multiples as before. J.C. Penney's financial position, on the other hand, has weakened considerably over the last three years.

J.C. Penney will need to grow at 5%+ for four to five years and achieve 38% gross margin to justify a $9 share price in 2018 or 2019. Valuation is not an argument that can be made in favor of J.C. Penney.

Source: J.C. Penney: The Illusion Of Cheapness