Ackman: If He Can Defend J.C. Penney, He Can Defend Anything

| About: J.C. Penney (JCP)
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J.C. Penney's predicament reminds me of another large retailer that never quite turned around-Sears (NASDAQ:SHLD). Warren Buffett described the situation well during a meeting at the University of Kansas in 2005.

Q: What is your opinion of the prospects for the Kmart/Sears merger? How will Eddie Lampert do at bringing Kmart and Sears together?

Nobody knows. Eddie is a very smart guy but putting Kmart and Sears together is a tough hand. Turning around a retailer that has been slipping for a long time would be very difficult. Can you think of an example of a retailer that was successfully turned around? Broadcasting is easy; retailing is the other extreme. If you had a network television station 50 years ago, you didn't really have to invent or be a good salesman. The network paid you; car dealers paid you, and you made money.

But in retail you have to be smarter than Wal-Mart. Every day retailers are constantly thinking about ways to get ahead of what they were doing the previous day.

Retailing is like shooting at a moving target. In the past, people didn't like to go excessive distances from the street cars to buy things. People would flock to those retailers that were near by. In 1996 we bought the Hochschild Kohn department store in Baltimore. We learned quickly that it wasn't going to be a winner, long-term, in a very short period of time. We had an antiquated distribution system. We did everything else right. We put in escalators. We gave people more credit. We had a great guy running it, and we still couldn't win. So we sold it around 1970. That store isn't there anymore. It isn't good enough that there were smart people running it.

It will be interesting to see how Kmart and Sears play out. They already have a lot of real estate, and have let go of a bunch of Sears' management (500 people). They've captured some savings already.

We would rather look for easier things to do. The Buffett grocery stores started in Omaha in 1869 and lasted for 100 years. There were two competitors. In 1950, one competitor went out of business. In 1960 the other closed. We had the whole town to ourselves and still didn't make any money.

How many retailers have really sunk, and then come back? Not many. I can't think of any. Don't bet against the best. Costco is working on a 10-11% gross margin that is better than the Wal-Mart's and Sams'. In comparison, department stores have 35% gross margins. It's tough to compete against the best deal for customers. Department stores will keep their old customers that have a habit of shopping there, but they won't pick up new ones. Wal-Mart is also a tough competitor because others can't compete at their margins. It's very efficient.

If Eddie sees it as impossible, he won't watch it evaporate. Maybe he can combine certain things and increase efficiencies, but he won't be able to compete against Costco's margins.

Sears' stock is down 40% from the time of this speech and sales have been declining for several years in a row. Sears doesn't have a moat. Buffett was exactly right.

The interesting thing is that Bill Ackman once invested in SHLD. Then he changed his mind, ostensibly when he realized that Eddie Lampert didn't have a long-term plan for the business to improve. Now Ackman has made a big investment in another struggling retailer because he has a plan. That plan is essentially to sublease JCP stores to various great brands-to create stores within a store. He went on CNBC to defend the strategy.

Ackman's pitch is that the market is misunderstanding JCP because numbers look terrible on a consolidated basis. Sales are declining more than 20% vs. the same period a year ago. What the market should be paying attention to instead is the new JCP, which Ackman describes as a small startup within the old J.C. Penney. The new JCP concept has high margins than the rest of J C Penney, but occupies less than 10% of the store space. The contribution of this isn't noticeable now because old J C Penney is dragging the whole organization down. But as the new JCP concept rolls out and accounts for a greater proportion of sales, we will see numbers improve in the aggregate.

I haven't tried to corroborate Ackman's claim that the new JCP is high margin. I'd give him the benefit of the doubt though. He seems like an honest person. And if the new JCP really is a good business, buying the stock here would make a lot of sense.

What's strange to me is that JCP is allowed to sublease its stores. Why would Simon or GGP allow that? If JCP gives brands a good enough deal, it is logical that these brands would set up shop inside JCP stores instead of occupying the typical full-size in-mall stores. That would decrease the occupancy rate for Simon and GGP. Strange.

I'll find this out later. But for now I'm comfortable making JCP a 2% long.