I Not Only Covered My J.C. Penney Short, I Bought The Stock

About: J.C. Penney Company Inc. (JCP)
by: Scott Fearon

After its former CEO almost ruined the company, J.C. Penney's new management team has smartly reversed course.

The company is still losing money, but with growing margins and sizable PP&E, it could easily outpace bearish expectations.

The negative Wall Street consensus on J.C. Penney could actually be the best news of all for investors.

I spend a lot of time bashing J.C. Penney (NYSE:JCP) and its ex-CEO Ron Johnson in my upcoming book Dead Companies Walking--and for good reason. During his brief tenure, Johnson committed two of the six deadly business sins I describe in the book that often bring about corporate failure. First, he alienated Penney's core customers (deadly sin #3) by attempting to remake its stores into places he and his rich friends would like to shop. Second, he remained physically and emotionally removed from the company's operations (deadly sin #6) by refusing to relocate to its Plano, Texas headquarters and electing to fly thousands of miles to work by corporate jet instead.

Both of these decisions proved, predictably, disastrous. By now the story is well-known. Sales plummeted by 25 percent and the company lost roughly $1.5 billion in 2012, Johnson's first and only full year as CEO. As its business imploded, I took a short position in JCP. I fully expected J.C. Penney to join the list of over 200 companies I have shorted on their way to bankruptcy. But, to my surprise, JCP wound up on a different list: shorts that I have covered and eventually bought. I devote a whole chapter in my book to these corporate Lazaruses. If I could, I would add J.C. Penney to that section now. After a large equity offering last year, I do not believe it will go bankrupt. On the contrary, I think the retailer's stock has a good chance of climbing back at least halfway towards the Johnson-era high of $40.

First, the bad news. J.C. Penney is still losing money. Consensus earnings-per-share are losses of almost $3/share this year and $2 next. This isn't surprising. Johnson turned the company into the business equivalent of a tire fire and it's going to take a while to put it out. But now that the new-old management team helmed by former CEO Myron Ullman has reversed Johnson's worst maneuvers (like getting rid of coupons and making it virtually impossible for customers to pay cash), comps have turned positive, gross margins are improving and sales trends are heading north. Penney has $4.7 billion in debt and $2.8 billion in equity market capitalization, vs. earnings before interest, taxes and amortization of $200M this year and $500M next. But as sales continue to improve, operating profits could surprise, and EBITDA could exceed estimates. Two factors could make this happen:

First, as others have noted, J.C. Penney is boosting margins by reemphasizing in-store brands like St. John's Bay, rebuilding its once thriving online business (another area torched by Johnson), and regaining market share in the "big and tall" category. As I write about in the book, one of Johnson's worst blunders was turning away from big and tall apparel. With an obesity epidemic raging, American consumers are definitely not getting slimmer, and if there is any (ahem) growth opportunity out there for retailers like J.C. Penney to take advantage of, it's in the big and tall space. But, instead, Johnson and his team stocked higher-end brands. These items not only underperformed sales-wise, they earned much lower margins than in-store brands. Since the company reversed strategy, its gross margins have improved. They were 36 percent in the second quarter of this year, up from 33 percent in 1Q, and the company believes those numbers could return to all time highs of 40 percent.

The second factor in J.C. Penney's recovery has been less publicized: the company has lots of assets, some of which are being monetized. Property, plant and equipment is a healthy $5 billion. More than 400 of its 1060 stores are company owned; the rest are leased, many at below-market rates. Most promisingly, Penney owns a large amount of land surrounding its impressive corporate campus in Plano, and it's turning a lot of that real estate into revenues. Remember the big news a few months ago of Toyota moving from Southern California to Texas? Guess who sold the land for the carmaker's massive new North American headquarters. J.C. Penney. Federal Express is also buying a large plot of J.C. Penney-owned real estate for a new facility.

But the best news of all for JCP might seem at first blush like the worst: most of the 18 Wall Street analysts that cover the company rate the stock either neutral or sell, a far cry from the almost unanimous buy recommendations soon after Mr. Johnson became CEO in 2011. This kind of Wall Street groupthink can often signal the best opportunities. It certainly did on the short side after Johnson's initiatives started turning sour, and I think the same applies today on the long side. It means the markets haven't caught up to the company's improving fortunes. While I prefer to invest in smaller companies with lower revenues and far less Wall Street coverage, this turnaround could easily catch analysts and investors by surprise. If comps and margins continue to grow, the Street will eventually take notice. That's when the stock's gradual recovery could accelerate into a serious rally.

Disclosure: The author is long JCP. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.