Update: J.C. Penney - Substantial Upside With Solid Margin Of Safety

| About: J.C. Penney (JCP)
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Several months ago we profiled J.C. Penney Co. Inc (NYSE:JCP) after the stock had gone out of favor on Wall Street due to short-term execution issues. I'm not going to rehash the investment thesis as it hasn't changed up to this point. Since that time pressure has become even greater as marketing missteps have confused the customer base, while legacy inventory issues have become even more pronounced with the rapid decline in traffic and sales. While some of these problems were undeniably self-inflicted, it is important to understand that CEO Ron Johnson's plan has always been longer term in nature. His plan involves incorporating a number of fresh brands into the stores to become more relevant with consumers and to aggressively cut the fat out of a bloated organization, to optimize the cost structure of the business. These actions in addition to the real estate, which could potentially be worth more than the current enterprise value, make J.C. Penney an attractive turnaround investment opportunity.

Prior to Ron Johnson JCP ran 590 unique promotions and the average item had 20-30 different prices during the year. Customers had grown accustomed to using coupons and visiting the store when specific items were on sale. Johnson's original plan for JCP was to have three types of prices to simplify the process and reduce the expenses and brand deterioration that these sales had brought about. The key to the new pricing plan was having everyday low prices to ensure the company drives traffic and turns over the inventory. Then selectively the company planned to have month-long sales on various products and clearance sales. Unfortunately for the company, the plan wasn't communicated with frequent JCP customers as much as with investors; the lack of the attractive "sales" that customers had gotten used to caused them to stay away. Management has now made things even more straightforward by focusing only on everyday low prices and then having clearance sales when inventory bulks up. This is a key decision that makes much more sense in the intensely competitive retail industry, where online stores battle physical stores, and prices are often the key determinant of who wins.

Secondly management has admitted that it made the mistake of attempting to reshape the way people think about J.C. Penney before the actual changes to the business have taken place. Without the new store formats and the introduction of the exciting brands, existing J.C. Penney customers were left confused to what the new vision of this 110-year old operation is now. To address these problems in the short term, Ron Johnson decided to drastically reduce the company's advertising efforts to avoid doing more damage until a better path emerged. J.C. Penney is also refining its marketing to more print related materials that emphasize products and pricing, so that customers understand the key issues that determine their shopping as opposed to having to understand a new lifestyle image of JCP, before the stores are actually ready to fully exhibit the changes.

In the 2nd quarter J.C. Penney reported an adjusted net loss of $81MM or $0.37 per share, excluding a wide variety of charges involved in the reshaping of the company. On a GAAP basis, JCP lost $147MM or $0.67 per share in the quarter. Same-store sales for the 2nd quarter were down a staggering 21.7% and total sales decreased 22.6%, including the effects of JCP's exit from its outlet business. Once again the company took an inventory write down, which negatively impacted gross margins. Much of the sales decline is attributed to the marketing mishaps and the subsequent "blackout" while adjusting to making the message more transparent to core JCP customers, particularly during this transitional phase.

Much of our investment thesis is based on the company's ability to reduce costs without reducing the company's opportunity for creating future growth. In the 2nd quarter the company successfully decreased SG&A expenses by $193MM compared with last year's 2nd quarter. Management is confident that savings will continue to accelerate and exceed an annual run rate of approximately $900 million at the end of 2012. Considering that operating income in 2011 was $832MM, these expense initiatives position the company for far greater profitability in the future. Obviously this is contingent upon the company reinvigorating sales growth in 2013, once more of the stores are retrofitted with the store-in-store model, which is currently being laid out. While the dramatic sales declines are pressuring the turnaround plan, J.C. Penney still expects to finish the fiscal year with in excess of $1 billion of cash on the balance sheet after spending $800MM in capital expenditures to fund the transformation. This is vital as the company's balance sheet and cash flow optimization will buy it the time to fully implement Johnson's 4-year plan.

J.C. Penney's plan of having up to 100 shops inside of one J.C. Penney gives me the confidence that growth will indeed commence next year. The stores within the store look fantastic and the new brands that Johnson has put in will resonate with the younger, higher-spending demographics. J.C. Penney is offering things like free haircuts for kids, and light food and beverages within the store to increase traffic and the time customers spend perusing for merchandise. Retail is experiencing so much change and while the turnaround has been a bit more volatile than initially planned for, it would be erroneous to assume that J.C. Penney could have done nothing and stayed relevant in these changing market dynamics. This new format allows JCP to optimize its vast real estate portfolio to offer some of the most attractive brands, and to adjust the SKUs when needed. Individual brands and stores give customers many more reasons to visit JCP, as opposed to the traditional mall experience where the customer wanders throughout a giant area looking for items that appeal to him or her. Being a 30-year old male that spends a lot on clothes on a regular basis, I tend to go directly to the individual sections that appeal to me, and I don't even look around the rest of the store because I don't enjoy that type of shopping experience. While I don't believe that just because I feel that way others will feel the same, I can tell you that I'd be willing to shop at JCP if it carries the types of brands that I buy, particularly if I know that I can rely on it to be the low-cost provider of that brand.

While buying the stock certainly makes sense for the patient investor, we have been creating a much safer way to generate above-average returns by utilizing options. Currently one can sell the January 2014 $15 puts for $2.42. This means that if the stock is trading above $15 in 522 days for every option sold the investor would make $242, or 19.2% on the maximum risk of $1,258. On an annualized basis the returns would be 13.42%, which is obviously exceptional considering the current interest rate environment. Even in the unlikely case that Ron Johnson's plan completely fails, the company could sell off the real estate, including below-market longer-term leases, to generate cash and boost the stock. JCP only makes sense for long-term investors who understand a 4-year plan means 4 years as opposed to making quick judgments based on one or two bad quarters. With that said one doesn't need to reinvent the wheel as selling the put options gives the investor a less stressful, and more simple way of generating above-average returns in a difficult environment.

Disclosure: I am long JCP.