Having gained nearly 50% over the last six months, some argue that J.C. Penney (JCP) has meaningful downside from here. In my view, however, the company's new branding efforts (eg. slashing prices, more promotions, marketing changes) offer a significant catalyst to growth. Having provided marketing and investor relations services to retailers, I am optimistic that this effort will allow for greater-than-expected returns.
In this article, I will run you through my DCF analysis on J.C. Penney and then triangulate the results with an exit multiple calculation and a review of the fundamentals compared to Kohl's (KSS) and Macy's (M). I also recommend that investors consider backing smaller retailers like the Bon-Ton Stores (BONT) and Dixons Retail (OTC:DSITY), which will be prime beneficiaries of a recovery.
First, let's begin with an assumption about revenues. J.C. Penney ended FY2011 with $17.3B in revenue, which represented a 2.8% decline off of the preceding year. I conservatively model revenue growing 5% over the next years.
Moving onto the cost-side of the equation, there are several items to address: operating expenses, taxes, and capital expenditures. I model cost of goods eating 60% of revenue over the next few years compared to 31% for SG&A and 0% for R&D. These estimates are around historical 3-year average levels. Capex is estimated the same way, so I assume 3% of revenue over the next few years. Taxes are also estimated at 35%.
We then need to subtract out net increases in working capital: we model accounts receivable as 2% of revenue; inventories as 28% of COGS; prepaid expenses as 4% of SG&A; and accounts payable as 7% of OPEX.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 10.1% yields a fair value figure of $32.80. The WACC is derived from factoring in the unlevered beta of 1.19 and greater representation of equity in the capital structure. However, the 5% 6-year growth expectation is highly conservative.
All of this falls under the context of weak recent performance:
This morning we reported fourth quarter earnings in line with our expectations and our most recent guidance. On a gap basis, we posted a net loss of $87 million or $0.41 per share including previously announced restructuring and management transitions charges of $0.56 per share. As well as the financial impact of actions taken to execute the company's new pricing strategy which lowered our fourth quarter earnings by an additional $0.59 per share. While it was a challenging quarter from a sales and margin standpoint, the overarching theme in Q4 was the preparation and completion of the ground work necessary to begin the execution of our new transformational strategy which we launched on February 1st of 2012.
Now as we wrap up 2012, let me quickly walk you through our Q4 results. Comp store sales declined 1.8% in the fourth quarter compared to our guidance for the sales to be flat to down slightly.
From a multiples perspective, J.C. Penney is at a premium to peers. It trades at 12.7x forward earnings versus 9.4x for Kohl's and 10.6x for Macy's. Assuming a multiple of 14x and a conservative 2013 EPS of $2.98, the rough intrinsic value of J.C. Penney is $41.72.
Consensus estimates for Macy's EPS forecast that it will grow by 14.9% to $3.31 in 2013 and then by 13.6% and 19.1% in the following two years. Assuming a multiple of 14x and a conservative 2014 EPS of $3.68, the rough intrinsic value of the stock is $51.52, implying 29.9% upside. According to T1 Banker, analysts rate the stock around near a solid "buy".
As for Kohl's, sales momentum has been admittedly weak, but this has set the bar low from an expectations standpoint. I find that the retailer will nevertheless yield a double-digit return over the next three years. It is currently less preferred than Macy's, but more preferred than J.C. Penney.
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