There are few sectors I seek to avoid investing in more than retail. Fashion changes constantly and I believe the technological and sociological evolution to online purchasing will shake up the winners and losers in the industry to a degree far greater than what we have already witnessed. Therefore for me to be comfortable investing in J.C. Penney Co, Inc (JCP) I had to be confident that the margin of safety was large enough to whet my appetite. At $26.96 JCP has an enterprise value of $8.1 billion and a market cap of $5.9 billion. I believe that the stock serves basically as a call option on Bill Ackman and CEO Ron Johnson's plans to restructure the company, and the downside is protected to a degree by the real estate making it a compelling risk-reward opportunity. Short-term negative news headlines are to be expected and due to the high volatility in the name, I believe the best strategy is to sell put options in combination with buying the stock.
J.C. Penney's history is long and illustrious beginning in 1902 when James Cash Penney opened J.C. Penney's predecessor The Golden Rule Store. Like any retail operation that has experienced longevity the company has had many peaks and valleys, but few times have been as dismal as the present. As of year-end 2011 JCP has more than 1,100 stores, representing in excess of 111 million square feet of gross retail space, operating in every state except Hawaii. The company suffers from a bloated and inefficient cost structure, negative same-store sales growth, considerable operational risk, and a lowly macroeconomic backdrop. Despite these obstacles J.C. Penney is an exciting investment opportunity because the fat should be easy to remove, the real estate is arguably worth more than the current enterprise value, and new management has a solid plan to improve profitability.
JCP had $17.3 billion in sales in 2011 but those sales only generated net income of $389 million, reflecting a dismal profit margin of 2.19%. Renowned hedge fund investor Bill Ackman has produced a compelling investment thesis on the company, and while some of his projections seem a bit too optimistic in my opinion, the most obvious opportunity is in cutting costs. JCP's SG&A expenses as a percentage of revenue in 2010 (ex-D&A and rent) were 31% versus 21% for Kohl's (KSS). This bloated cost structure represents $1.8 billion of savings opportunities if the company can eliminate the gap. Management has already identified $900 MM/year in net savings by 2012, which is astounding in such a short time. Ackman points out that the $900 MM equates to 120% of 2011 EBIT, and this alone will have a considerable impact on boosting profit margins. $900 mm generates $2.50 of EPS and any upside from there should lead to considerable upside for the stock.
To accomplish the savings the company is reducing headcount and improving technology to reduce needed labor hours. Ackman's statistic on JCP's inefficiencies prior to new management are truly mind boggling, and I'd be shocked if management isn't able to cut that $1.8 billion gap considerably within the next 2-3 years. J.C. Penney was highly promotional and saw very little benefit despite spending nearly 50% and 20% more in advertising as a percentage of revenue than Macy's (M) and Kohl's respectively. New Chief Executive Ron Johnson's less promotional strategy should allow ample room for improvement on this front, and reducing the gap to competitors could result in several hundred million in additional savings. It wouldn't be heroic for J.C. Penney to achieve a 9%-10% operating margin when these savings initiatives are accomplished, which would produce about $1.5 billion in operating income on $17 billion in revenue.
The second aspect of J.C. Penney that gives me confidence in having an adequate margin of safety is that extensive real estate portfolio. The company owns 49% of its retail square footage and according to Ackman the balance is leased at an average cost of $4 per square foot. 80% of the real estate is "On-Mall" making it highly attractive for other growing retailers looking to expand. Ackman estimates the replacement cost for J.C. Penney's real estate to be $11 billion. As seen through some of Sears Holdings (SHLD) recent real estate transactions, and the market valuations of the likes of Simon Property Group (SPG), mall real estate is still highly prized even in this Amazon (AMZN) dominated retail world. JCP isn't as likely to liquidate as Sears is so I would give a significant haircut to Ackman's valuation due to this, but I could certainly see the company shutting down loss-leading stores to raise cash if the capital structure ends up needing further improvement. At worst the real estate significantly reduces the downside risk if Ron Johnson's plan doesn't meet expectations.
The third part of the investment thesis in JCP is the opportunity to improve sales. Ron Johnson's plan is to introduce new brands to reduce the commoditization of the product portfolio, and to emphasize everyday low costs as opposed to being the most promotional competitor in the industry. The company's plan is that 50% or more of the product will be new or revamped brands truly emphasizing the emergence of a new J.C. Penney. While Johnson's retail pedigree from Target (TGT) and Apple (AAPL) is extremely impressive I assign no margin of safety to improving sales projections, but if the company is able to revitalize similar to how Macy's was able to over the last several years, the stock could more than double from these levels. Unsurprisingly these initiatives got off to a slow start with same-store sales down a staggering 19%. I think the retail strategy is sound and the company should be able to achieve low single-digit revenue growth moving forward.
Upon Ron Johnson's hiring and the announcement of a new plan J.C. Penney's stock rallied into the mid 40s, benefiting from the Apple occult following of Johnson. Unfortunately the selling of men's underwear isn't the same as selling IPODs or IPADs so it is important not to get caught up in the hysteria. Similar to my approach used in the past investing in Sears Holdings, it is important to only buy at points of pessimism like there is currently in JCP. Selling put options captures the volatility present in the stock and enables an investor the ability to obtain an attractive profit, or end up owning the stock at an even cheaper level enhancing the margin of safety for long-term capital appreciation.
One strategy I'd suggest is to buy 1/3rd of your position at current prices, sell the January 13 $26 puts for $3.75, and leave another 1/3rd in dry powder to sell more puts or buy stock if the price drops further. By selling the puts you are creating a 'flip of the coin' type scenario where only two things can happen if you hold the options till expiration. If JCP closes above $26 is 233 days your return will be 17% on the maximum risk of the options or 26% annualized. If the stock closes below $26 you will in essence be acquiring the stock at a break-even price of $22.25. By purchasing the stock at today's prices you are ensuring yourself the opportunity to benefit if the restructuring goes ahead of schedule, or if overall sentiment improves as progress is made.