Wal-Mart Should Pick Off J.C. Penney

| About: J.C. Penney (JCP)
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By Richard Saintvilus

It's hard to quantify how unimpressive, if not pathetic J.C. Penney's (NYSE:JCP) current situation has become. While the company still has a historical brand, J.C. Penny will also go down in history as a company that seems to always have an answer for "how much worse can things get." While the Street has written this company off for dead, Wal-Mart (NYSE:WMT) should step in and scoop up the good that remains in J.C. Penney.

It wasn't going to be Rome, but it was set up to fail

J.C. Penney's problems (among others) have been its lack of leverage. What do you go into J.C. Penney to buy that you possibly would not find at 10 other stores on your way there? Plus the company lacks identity. Complicating matters is that even at its current locations, which have been predominantly in shopping malls, J.C. Penney still had to compete with better loved rivals.

Ron Johnson thought he had the answers to these challenges. For that matter, so did J.C. Penney's board. And given that Johnson had a winning pedigree, which included the successful launches of Apple's (NASDAQ:AAPL) retails stores and before that, serving as an executive at Target (NYSE:TGT), investors wanted Rome built in a day.

Johnson tried unsuccessfully to change the mentality of the J.C. Penney shopper. J.C. Penney had a strong focus on promotions, to which shoppers had become accustomed. In fact, 40% of J.C. Penney's transactions for 2011 were sales-related. While Johnson may have realized this and figured he could increase profitability by reducing promotions, he also underestimated the cost burden of that process. Plus, customers were not going to be pleased.

For J.C. Penney, what resulted was a disaster to the extent of a 20% revenue decline and a 19% drop in same-store-sales, or comps, in his first full-quarter at the helm. Clearly, these shoppers were protesting these changes by not coming to the stores altogether. Making matters worse, management then felt it was then a good idea to institute higher markdowns in an effort to clear inventory.

This is despite an initial three point drop in gross margin, which reversed the profit that J.C. Penney had earned the year before into a loss. Again, all of this occurred as soon as Johnson was installed as CEO - J.C. Penney really had no chance. Losing more shoppers sent J.C. Penney into a further decline, which created more distance between better operated rivals like Macy's (NYSE:M) and Kohl's (NYSE:KSS).

Why Wal-Mart should step in

Customers know they can walk into a Wal-Mart store and get the best possible low prices every day. To some extent, that's what makes Target so popular, even though customers have shown they are willing to pay more at Target since it often carries designer brands that Wal-Mart may not have. Target is often considered "more upscale." It makes sense, then, for Wal-Mart to go after J.C. Penney. Why not?

Customers are proving that there's a market for what Target has created. With J.C. Penney, Wal-Mart would immediately remove Target's "upscale advantage," especially since J.C. Penney has deals with Martha Stewart. Meanwhile, this is the sort of identity that J.C. Penney has failed to create. Granted, the company has been fighting Macy's for the rights to Martha Stewart.

However, if Wal-Mart enters the mix, given its wide domestic and international reach, this is not a deal Martha Stewart can afford to pass up if she cares about furthering her brand. For Wal-Mart, aside from luring in the upscale shopper, Wal-Mart would begin to change its image. The company would be able to succeed where J.C. Penney had failed.

Here's making sense

While it's true that Wal-Mart performed pretty well in the most recent quarter, the company only posted 4% year-over-year revenue growth, which arrived below consensus estimates. Earnings were better than expected, but was boosted by a favorable tax rate of $1.67. Given the soft macro environment, these results were good. But not as good as the potential traffic J.C. Penney can bring in, which would result in lower traffic for rival Target.

As of this writing, J.C. Penney's stock is up 4% to $14.65, which just pushed its market cap to $3.14 billion. This deal would only cost Wal-Mart $18 per share, or a premium of 22%. This premium factors in J.C. Penney's current cash at $930 million and $3 billion debt. At the most, it would cost Wal-Mart $4 billion to close the deal. Given that Wal-Mart has $8 billion in cash and $25 billion in operating cash flow, this is a deal that Wal-Mart can close today, which would immediately make Target "just another store." How much is that worth?

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. SaintsSense is a team of financial writers. This article was written by Richard Saintvilus, founder of SaintsSense. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.