Wall Street (and even, perhaps, some of Main Street) was wowed by the turnaround strategy outlined by new J.C. Penney (JCP) CEO Ron Johnson at the company's investor conference in New York last week. J.C. Penney stock gained about 20% in the last two days of the week. To briefly recap, on Wednesday, Johnson explained a strategy built around 1) a "fair and square" price policy (lower starting prices, no coupons, and only one promotion per month, instead of the 590 sales events last year), 2) a focus on popular exclusive and private brands, and 3) carving the stores up into 80-100 shops over the course of the next four years.
Then, on Thursday, COO Mike Kramer laid out an ambitious goal of meeting or exceeding last year's adjusted EPS of $2.16 (which would imply profit growth of at least 70-80% from this year's levels). He also informed investors that capital expenditures for the company's "transformation" would begin at $800 million for 2012, and would be paid for out of operating cash flow over the course of the four year plan. Most significantly, Kramer stated that he intends to cut $900 million in annual expenses over the next two years, in order to reduce expenses to a final target of 27% of sales [incidentally, that's roughly the level of Kohl's (KSS) expenses as a percentage of sales].
There's no doubt that J.C. Penney will take off if management can make good on its promises. If sales recovered to pre-recession levels around $20 billion, while operating margin widened to management's target of 13% (40% gross margin-27% OpEx), profit would widen to $7-$8 a share. However, a lot of management's plans, assumptions, etc. are being left unstated. From last week's announcements alone it is hard to judge how realistic the turnaround plan is.
Here are five critical questions that all investors (long, short, or still undecided) should want to ask Ron Johnson and his team:
1) How much merchandise did J.C. Penney sell at regular price last year? We know that 72% of sales last year was at 50% or greater discount to regular price. Obviously, very few people buy anything at full price at J.C. Penney today. But the important question is: how few? Is it 1% of sales? 2%? 5%? If even 5% of sales ($850 million) have come at regular price, then by lowering prices by 40-50%, the company is giving up $350-$400 million in pure profit. That would offset nearly half of the projected expense cuts. On the other hand, if 2% or less of sales came at or near full price, then this loss would be more manageable. Unfortunately, this data is not published anywhere, as far as I know.
2) What's Plan B? Ron Johnson knows a whole lot more about retail than I do. On the other hand, everyone is fallible. Typically, retailers that want to try out a new concept roll it out in a few stores for a year and then assess how it is affecting results. While there is a lot to like in Johnson's strategy, it's also possible that many current Penney's shoppers are so addicted to coupons and sales that they will take their business elsewhere [Kohl's, Macy's (M), Dillard's (DDS), etc.]. J.C. Penney is taking bold steps to reinvent itself, but I've seen very little discussion of the risk involved in the company's transformation. Suppose, for instance, that sales drop by 10% in Q1 of this year. Would management reassess the pricing strategy, consider closing stores, look for further cost cuts, try to accelerate the rollout of the new shops, etc.? With any change this big, there's serious potential for bumps, and investors should know how prepared management is to handle the unexpected.
3) What's the total cost of the transformation? While Mike Kramer said that the company would pay for the higher capital expenditures out of operating cash flow, it would be nice to know the total cost. J.C. Penney hasn't been very consistent about generating positive cash flow in recent years. So it would be helpful to know what management is assuming on the profit front over the next few years. It seems quite likely that future years will have higher CapEx, since the $800 million for 2012 only covers six months of rolling out the new shops. On this front, it's particularly unfortunate that management decided to stop issuing quarterly profit and sales guidance, and will also stop reporting monthly sales. If it takes longer than management expects to increase profitability, then the company could be forced to issue new debt or new stock. Neither should be particularly appealing to stockholders.
4) How much will building the new "shops" impact J.C. Penney stores? While the 80-100 shops being built in each location will not have "real" walls (the back of the display racks will form walls to separate each area), the construction process still seems like a potential nuisance. Is management confident that the renovation process won't make customers feel like they are walking around a mini-construction site? Since the transformation will be spread over nearly four years, it's very important to be certain that it won't hassle customers. Also, over the course of the transition, there's the risk of confusion as some of the merchandise remains on traditional racks while some is moved to the new brand-oriented shops.
5) How will you cut costs while maintaining/improving customer service? Many industry observers have compared Johnson's plan for more boutiques and his "town square" concept to his most famous creations: the Apple (AAPL) Store and its Genius Bars. The idea is that by delivering great customer service, J.C. Penney will not have to resort to heavy discounting to move merchandise. However, the company's cost-cutting plans involve $400 million in reduced spending for staff in the stores. It is true that the company will no longer need staff to change price tags and post sale signs (management also intends to cut some cashier positions). While the company can safely do away with these "back of the house" employees, they will probably need to spend that money on increasing staff on the selling floor to provide high-quality customer service. Bear in mind that the Apple Store has about 12 employees per 1000 sq. ft. of retail space; the same figure for J.C. Penney is 1 per 1000 sq. ft. Thus, it's not clear if staff costs will actually decrease in the long run.
Management may have good answers to all of these questions. But so far they have been fairly tight-lipped on the specifics. Investors should be very cautious regarding J.C. Penney stock until the answers become clearer.
Disclosure: I am short JCP.