Seeking Alpha
Long/short equity, special situations, growth at reasonable price, deep value
Profile| Send Message|
( followers)  

My review of the J.C. Penney (NYSE:JCP) situation over the past year has led to an understanding of why the operations faltered this past quarter and what led to it. I know how to fix the situation over the short-term as well, and in a way that allows the company to proceed with its long-term strategy. I provide some advice to the JCP team herein. With regard to investors, based on my analysis of the company's current position and direction, and taking valuation and yesterday's share price discounting into account, I would still sell JCP today unless the company immediately acts in the manner I describe at the conclusion of this report.

In my view, J.C. Penney hit the panic button after its relatively poor holiday shopping season last year, with Wal-Mart (NYSE:WMT), Amazon.com (NASDAQ:AMZN) and other discounters and online retailers stealing share. As I see it, J.C. Penney then overreacted to its showing, which fit its troubled span through the financial crisis and recession. The company then initiated a complete overhaul of its operating strategy in response, which was probably too much change too fast for the established and profitable business. Based on the company's deep misstep in its fiscal first quarter and the shares' 20% demise the day after, I would say the management team failed to adequately vet the potential repercussions of its actions. Though, I see the execution of the strategy as the main issue at fault this quarter. What's playing out now in my opinion is an ugly scenario the company did not expect. I tend to avoid shares of companies in such flux, whose management teams seem to be caught off guard by it all.

JCP admirably held to its laurels with regard to its opening time around Thanksgiving, while Wal-Mart had many stores open right through the holiday. Target (NYSE:TGT) attracted a ton of bad publicity because of one of its employee's protests against his Thanksgiving eve call to serve. JCP ducked bad publicity by opening around its usual time and keeping to the long-standing tradition of remaining closed through the holiday. Still, Wal-Mart collected cash and holiday shopping share through it all, along with the online retailers like Amazon and eBay (NASDAQ:EBAY), which have no issue with staying open 24/7.

It's what JCP did next that I believe destroyed significant economic value (based on EPS result) and market value (based on share price dive) this week. In my view, the company overreacted to a poor showing. However, change is always needed in our dynamic world, especially considering how rapidly our lives are changing these days. Certainly, value can be added through change done smartly, and J.C. Penney hadn't been excelling before its change. Look at Tractor Supply (NASDAQ:TSCO) for a good example of positive change. In this case, I think JCP's implementation was too dramatic and its change too abrupt for its customers, who had been conditioned to deal with the company in a certain way through many years of relationship building.

When you have an established brand, you do better to test a new strategy in limited and isolated markets before extending it across your entire channel. This is how we avoid mistakes like the one committed by JCP this past quarter. In its presentation, interestingly titled "In Praise of Fresh Air," Ron Johnson, the company's new CEO, "re-imagined" J.C. Penney as America's favorite store. The management team took a fresh perspective of how J.C. Penney did business and basically overhauled it. The problem is that many of JCP's customers were conditioned to buy on impulse and when goods are on sale, like much of the retail world beyond the discount stores.

"Fair and Square" pricing was the keystone of JCP's new strategy, a simplification of the way it did business. The company had been employing multiple marketing strategies and various special offerings to reach its customers regularly, and its customers were adept at buying based on what sale was effective on a particular day. This happens to be what U.S. shoppers respond best to today, and they seem to me to be more than willing to change their plans around a good deal. But JCP wanted to present a new perspective, one that I think is a cross between Macy's and Target's respective strategies. Everyday low pricing would be the new draw, plus a jazzy new layout to show their wears. JCP would treat customers the way its managers would like to be treated, fairly.

J.C. Penney still employed sales promotions, but it simplified how it did. A three-tiered plan was employed, with everyday low pricing complemented by month long deals on timely items and twice a month special sales to move inventory. It was all fine in theory, but it really was too much change in contrast to its brand image, which clearly was well-embedded in the minds of its customers. Perhaps JCP should have launched a new concept, if not trying out the idea in a small and specific test market to see where it might be tweaked and polished.

The second part of JCP's plan would make it more like Macy's ([M) in another way, bringing in a new brand shop layout instead of the traditional department store layout. The company highlighted the initiative, which is seemingly based on a walk through Macy's flagship Manhattan store. I must confess that the layout only confuses me when I visit the Macy's over by Herald Square, but it also keeps me wandering sort of lost through the store as I come across new and interesting items that I normally would find all in one place elsewhere - like say perhaps T.J. Maxx, owned by TJX Companies (TJX]. TJX blew out its numbers this past week by the way, probably because its old tag line, "Get the Maxx for the Minimum" is something I still get, and so do others.

Along with all the changes, J.C. Penney has redesigned its logo and its signage to reflect a new modern and very American image. The company re-hired its old employee, Ellen DeGeneres, this time to appear in advertising announcing and promoting the new pitch. It's a memorable ad campaign, I must say, and was clear enough to me that J.C. Penney was up to something different and big.

As part of its layout transformation over the next few years, the company also plans to add a "Town Square," where it will offer services and basically become a mall within itself, it would seem. You know, it was not this aspect of the effort that hurt the company this past quarter, because foot traffic and revenues fell. That means it was the draw of discount offerings that were missing from the hearts of the store's legacy customers. Thus, so were they missing from J.C. Penney stores.

Revenue dropped 20% in the quarter ended April, partly on JCP's closing of its outlet business, but also due to lighter foot traffic. It seems obvious now that the some 600 sales promotions the company previously promoted per year, many through mailing and email, drew customers from distance. Without that pull now, those same shoppers are more likely visiting the stores of competitors that might be closer situated or which broadcast sales. The failure is best seen in the 18.9% quarterly same-store sales decline, which must have broken the hearts of long time shareholders. The company posted an adjusted net loss of $0.25 per share before markdowns and charges, versus a profit of $0.28 in the year ago period. The company missed by far the consensus EPS estimate for a loss of $0.10. That's even worse news when considering the fact that 90 days ago, that estimate stood at $0.25.

Despite the 20% discount to the stock price and my expectation that the management team will tweak things to restore profitability eventually, I would not buy into JCP today. I hope the iconic American brand is rejuvenated and restored, and the company's stores become the favorite destination of American shoppers like the team hopes. However, I'm not willing to bear the burden until that prospective day comes, and I'm not happy with management's too courageous plan which I think was implemented too abruptly.

More write-downs are expected over the next few quarters at minimum, and so the company revoked its GAAP earnings guidance of $1.59 for the year. It also discontinued its $0.20 per share quarterly dividend, as it invests in its restructuring. With its earnings outlook clouded, though JCP still sees $2.16 for FY 2013 when excluding non-cash pension expense and restructuring charges, it's hard to peg a valuation on the stock. Meanwhile, JCP's revenue attrition is a deterrent. The consensus of analysts' views sits at $1.53 for FY 13 (Jan.), but that should come down now. It seems to me the company will have trouble earning the $2.16 it expects to make, given the circumstances. However, applying a price multiple to that figure gives a P/E-ish multiple of 12.4X or so. The problem is that the market is using the relative comparable EPS estimate, and even if we assume the $1.53 estimate could hold, JCP would have a hopeful P/E of 17.5. Macy's P/E against its consensus EPS estimate for FY 13 (Jan.) is 11 today. JCP is valued too high for a company in such flux, and I'm not buying into the 18% long-term growth rate listed at Yahoo Finance.

On top of everything, shareholder pressure will now mount on the company's management team, and for good reason. CEO Johnson came highly touted from Apple (NASDAQ:AAPL) and Target before that, but seems overmatched so far at JCP. I'm sure the incentive is as intense as ever now for the JCP team to turn this around, but unless a good bit of the old promotional efforts are restored immediately and eased out over time (that's advice for JCP), I can see more of the same trouble in the coming quarters for JCP. Therefore, I would sell JCP shares today. By the way, I'm available for consulting services for businesses of all sorts, including J.C. Penney.

Source: Sell J.C. Penney: Too Much Change Too Soon