J.C. Penney Fundamentally Broken, Peers To Outperform

Jul.12.12 | About: J.C. Penney (JCP)

Over the last twelve months or so, JCPenney (JCP) has seemingly done everything within its power to re-excite the market about how powerful its brand once was and still can be. They brought on retail visionary Ron Johnson as CEO from Apple (AAPL), mixed up its corporate logo and design, sold off its catalogue business, introduced an "Every Day" pricing model, and scaled back its workforce, among other efforts. The problem is that the strategy has failed to work, and it has come off as desperate.

JCPenney's recent efforts have come off as desperate, because it's the fundamentals that are broken and not the "cosmetic" features. Shareholders don't find a brighter colored logo or a different store layout as meaningful drivers of value creation in and of themselves. They care about whether the firm's same stores are outperforming peers' and to what extent this will continue into the future. Yes, retail is largely a function of marketing, but value can be more directly driven from expansion. Expansion is a risky strategy to execute when current demand is tepid; however, Say's law argues that supply creates its own demand. As it stands, JCPenney physically lacks the earnings power to be worth north of $4.4B.

JCPenney currently has 1,102 department stores in 49 states and Puerto Rico. The firm generated $17.3B in revenue last year - a figure that has actually shrunk over the last four years. Net income trends have been even worse with a loss of $152M in 2012 versus a profit of $378M in the preceding year. Wal-Mart (WMT) currently has profit margins of 3.5% versus 6.2% for Kohl's (KSS) and 4.8% for Macy's (M), 4.8%. JCPenney isn't quite as much of a discount retailer as Wal-Mart and targets a slightly lower-income market than Kohl's does, so we will assume it should have normalized profit margins of 5%.

Retailers trade around an average PE multiple of 11.5x. This means that JCPenney will have to generate only $7.6B worth of revenue at normalize margin levels to merit is current valuation. It currently pays $5 per square foot in rent for every $132 generated in sales. As can bee seen below, there is plenty of room for JCPenney to improve by this metric.

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The average JCPenney store is around 100K square feet, which means it just needs slightly less than $70 per square at a 5% profit margin to justify the current valuation. Net income was $389M in 2011 and $572M in 2012, which would have warranted either the current valuation or a $6.6B valuation at a 11.5x multiple. The problem thus is about growing that stream of revenue and spreading out fixed costs. By saturating more of the market, JCPenney will physically attract back customers. As it stands, however, JCPenney is fundamentally broken absent a commitment to growth.

In the meanwhile, I advise retail investors to back Kohl's and Wal-Mart. Kohl's is more of a peer to JCPenney in the unpredictable clothing and specialty market while Wal-Mart is more broadly diversified in the sector. I thus recommend Wal-Mart as a way to hedge against an uncertain economy, especially since the firm has a proven business model (with revenue greater than many large economies) and especially because it has a low beta of 0.8. More specifically, Wal-Mart is a stable growth stock that is roughly as expensive as the S&P 500 with a PE multiple of 15.5.

Analysts expect Wal-Mart to grow EPS by 8.7% over the next five years (roughly 500 bps less than what it yielded over the past five), which means 2016 EPS of around $6.86. At a 14x multiple, Wal-Mart's future stock value is $96.04. A 8% discount rate yields a price target of $65.36 - roughly in-line with consensus and ~10% below consensus. This does not make Wal-Mart a value play, but it is structurally safe from a double dip.

By contrast, Kohl's has more of a discount to intrinsic value. It trades at only a respective 11x and 9.2x past and forward earnings; but, more meaningful, its PEG ratio is well below 1 at 0.75, which indicates future growth has not been fully factored into the current stock price. Analysts expect the company to grow 14.6% annually over the next 5 years, which means 2016 EPS of around $7.82. At a multiple of 12x, the company's future stock value is $93.84. At a 10% discount rate, I give the company a price target of $58.27, which is at roughly a 25% premium to the current stock price.

In short, while JCPenney may never get to the sheer scale it needs to create value, Wal-Mart and Kohl's remain attractive investments. Wal-Mart will hedge against uncertainty as Kohl's closes its discount gap.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.