I continue to be amazed at how J.C. Penney (NYSE:JCP) the stock trades compared to JCP the business. Since the stock offering in the fall, the Company has stabilized and now grown comps in the face of severe industry headwinds, brought back private label and promotions which have improved margins, and guided to FCF neutral on the year. All of this in the face of a brutal retail environment. Bon-Ton Stores (NASDAQ:BONT) by contrast just reported another weak quarter though they did manage 35%+ gross margins which is where JCP is headed this year as well if not better. JCP debt has responded by rocketing to the highs while the stock is well off its lows, it continues to trade well below the $9.65 offer price and the intrinsic value.
Why the disconnect? I do believe that CEO, Mike Ullman, bears some of the blame. While I can not argue with his operational success if not genius in rapidly reversing the nosedive under Ron Johnson and credit the board for bringing him back in the face of withering criticism from Ackman, who resigned from the board and sold his stock over the issue of CEO control (among other things), I can fault Ullman's ability to manage the street and his stock price. From the ham-handed way the offering was handled to the two line holiday same store sales release that panicked investors that Christmas was a disaster when in reality it was on plan and one of the best showing of any department store chain. The 6-7% comp. in Q1 simply blew away expectations and left the bears scrambling for ways to knock the stock down. If Ullman is to be the permanent CEO, he must do more to manage investors and his stock price or he should go.
Here is where the story gets interesting. The bears have been mostly using static analysis to say J.C. Penney was going bankrupt. There last two quarters and FCF neutral guide for year end tell you that is just not going to happen. A new credit line with an extra $500mm also tells you that equity dilution is far less likely if not a zero possibility. For most of the time since I started posting on JCP after the offering, the bears have been saying that Chapter 11 or massive dilution was inevitable and that JCP was stuck at $12 billion in sales and low 30s gross margins, never mind that every comp does mid to high 30s and that sales were $17 billion before Ron Johnson came on board.
One thing to beware from the sell side and buy side commentators is a shift in story. The facts have clearly changed as even the most hardened bear will say that J.C. Penney is on the mend. The bear argument has now shifted to one of valuation which is a slippery slope since JCP is very cheap to its long-term earning power. Two of the biggest bears, Wells and Imperial are essentially using this argument to help the shorts and intercapital arbs cover in a bad macro tape at levels that are too cheap to be believed. For the last several quarters, Wells has been using JCP's good numbers and contorting the facts to say the Company is really still going bankrupt. Now that his theory has been blown out of the water (q4 and q1 results plus a 20 point drop in 5 year CDS to the mid teens from the mid 30s shows just how wrong Wells has been), the analyst has shifted to saying that the stock is overvalued. Valuation is more of an art and a science, but JCP appears to be on track to undo most of not all of the RJ damage. I am even running scenarios where the company actually gets to higher than $17 billion in sales, as it takes share from Sears (NASDAQ:SHLD), Kohl's (NYSE:KSS), Macy's (NYSE:M) and BONT.
What would a back to the future JCP look like? If JCP were to get back to $17 billion in sales and 39% margins which is where it was under Ullman before the RJ debacle (assuming no additional growth from the economy as they recapture share) and were able to keep SGA around $4 billion (it was bloated before that is one thing RJ got right and Ullman has continued), EBITDA goes to the $2.6 billion to $2.7 billion range by 2016. The Company pays off most if not all of its debt by then. A modest 6x multiple yields about $50 a share. If one looks at pretax free cash flow, the Company would generate about $7.35 a share, 10x that number is $75 for the stock. That is the money that the long-term bulls are playing for.
I think this can happen by 2016, which gives Ullman 3-4 years. If it takes longer so be it, but the point I would make is as long as we are fcf neutral we have unlimited time for this to play out. Also it is obvious that JCP is taking share from bont, m, kss, shld, etc. based on the recent reports. The assumptions would be:
Net Debt: 0
Multiple: 6x EV/EBITDA
With 400mm of cap-ex, should generate about 7.35 of FCF per share This is why stock was in 30s even before Ackman.
Bears will say that is impossible given where they are now, but bears have been calling for negative comps and near term bankruptcy and that looks silly now. These numbers are really just getting back to what JCP did under Ullman a few years ago with a lot of debt pay down and some SGA improvement and capital efficiency that they have already shown able to do. Who is really being more unrealistic? These numbers aren't even that exciting, what if JCP actually gets some of the sales productivity that Johnson and Ackman were dreaming of when they bought the stock in the 20s and 30s? Much higher numbers are possible.
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: Positions can and do change at any time without warning or notice.