Bill Ackman's Presentation On J.C. Penney: A Lottery Ticket Without The Risk

| About: J.C. Penney (JCP)

J.C. Penney's (NYSE:JCP) stock has roared ahead nearly 5% since Bill Ackman's presentation on J.C. Penney on May 16 at the Ira Sohn Conference!

We all know it's a joke to look at a two week time period like that. It's just as much of a joke to base your fundamental analysis on the results of one quarter. That's the crazy thing, though. Most investors don't look at the fundamentals, don't read the filings, and don't look at such things as Ackman's presentations. Most "investors" simply reacted primarily because of two reasons: They saw that J.C. Penney cut its dividend and they saw a few retail consultants and analysts tell the world that there's no way this turnaround can work-- no matter that those analysts are always the ones who like to see their name in the paper and face on CNBC, and often formulate their opinions accordingly.

If you take away nothing else from this article, take away this: the purpose of financial news is not to help you become a better investor. The purpose is to drive ratings. CNBC does not get ratings by having guests say, "je ne sais pas." If you disagree with me, stop reading, go straight to the comments and leave a note about J.C. Penney's chart or about how this isn't Apple (NASDAQ:AAPL), or about how you went into one of the stores once and were treated badly. Even better, how about saying that you'd never buy this stock because the company hired Ellen as a spokesman. I've seen all sorts of comments like that about J.C. Penney. Sorry, they're ridiculous.

If you're not quite so flippant, and would like to look deeper, look at Ackman's presentation. Here are a few highlights.

J.C. Penney has been chronically mismanagement since at least 1983. That was when it shifted to an apparel-focused department store. The infrastructure was not overhauled and eventually overwhelmed the store. There were too many layers, too many software programs, and too much waste.

Competitors have been winning, but J.C. Penney has advantages it can utilize. The company owns much of its real estate and has affordable leases for the rest. It has huge scale, attracts national brands, and has the capacity to spend a lot of money on advertising.

The new management team is properly incentivized. New CEO Ron Johnson has personally invested $50 million on warrants with a strike price of $29.92, a time period of 7.5 years, without the ability to hedge or sell for six years. Johnson brought over other team members who gave up great jobs to work with Johnson.

Prices were too high and the reliance on discounting turned away good brands. The change in the pricing strategy is what caused the Q1 miss, but it was necessary to do now in order to attract great brands, many of which are already signed up and will be rolled out late summer and early fall. Old customers may be confused now, but when they start seeing great, new brands at affordable and fair prices, they'll come back. I don't buy the shtick about customers only wanting to buy if they feel like they're getting over on the store. This may be true for some, but you can't rely on those for your customer base. That's what J.C. Penney had been doing and it wasn't working.

The first shops have already been announced, and they are impressive. J.C. Penney would not have gotten many of these brands with its old pricing strategy.

There was and is much to cut on the cost side. Consider this: Ackman points out that 20% of the company's internet bandwidth was taken up by Netflix during working hours. Plus, the average employee clicked on YouTube 1,000 times per month. That means there is fat to cut, and the new management is cutting it while motivating those who want to stay.

Other expenses can also be right-sized. J.C. Penney will cut $500 million of unproductive inventory in 2012. Truck deliveries will be drastically reduced. Capex will be spent with ROIC in mind, not simply on square footage like before.

Comparison to The Gap (NYSE:GPS). Ackman compares J.C. Penney now to the beginning of Mickey Drexler's tenure at The Gap. Its stock price went up 60 times during his tenure, after a rough first year. Yes, 60 times.

The dividend cut caused forced selling by dividend-focused mutual funds. This has helped to temporarily depress the stock price.

Ackman thinks J.C. Penney stock could trade between $77 and $125 in 2014. He refers to J.C. Penney's sales per square foot in 2007, which he believes is a base case. That, combined with the cuts in expenses, would cause EPS of $6 in 2015. His upside case is an EPS of $9.25 in 2015. He feels downside is protected because of the leases and real estate controlled by the company, and the fact that the $900 million of cuts in expenses translates into about $2.50 in EPS alone.

The lottery ticket might be the store in a store concept. If J.C. Penney can generate sales approaching specialty stores, its sales per square foot would triple. Consider that it generates $132 sales per square foot now, but Sephora, the existing store within a store, generates more than $600 per square foot. If it gets up to $350 per square foot, the stock would trade at more than $300 per share.

Those last numbers may sound a bit crazy-- and maybe they are-- but they show the lottery ticket potential. There are no lottery ticket downside odds though. If Johnson is an utter failure, they still cut the fat, make at least $3 per share and trade in the mid-$30s. I think the odds of that happening are much worse than the odds it will pull down $6 per share by 2015.

Now is the time to be patient and let management do their job.

Disclosure: I am long JCP.