Is Ron Johnson's J.C. Penney A Buy?

| About: J.C. Penney (JCP)
This article is now exclusive for PRO subscribers.

By Brian Tracz

J.C. Penney Company, Inc. (NYSE:JCP) has been something of an enigma as of late. It has been increasingly unpopular in the blogosphere over the past month, even though its shares have emerged over 25 percent from their July bottom. On the company's conference call, CEO Ron Johnson coaxed the market into docking off 5.9 percent from the 12 percent dip shares took on August 10, the day J.C. Penney reported a $147 million second quarter loss. The company is turning from a sale-a-week department store to a boutique-filled "mall in a mall" - a veritable "tur-ducken" in the retail world.

After combing over the data, I have tried to crystallize a few bullish observations about JC Penney. There are also quite a few wishes of mine about the oft-maligned retailer. Of interest as well are the couple of insider purchases from directors in the past month (you can view these here).

Ron Johnson's "vision" is for a leaner cost structure. There is no need to romanticize executive vision. Bill Ackman's first quarter letter to investors details J.C. Penney as a company that, in the past few years, has seen decreasing sales volume on ever-decreasing profit margins. Under Ron Johnson's vision, new brands and vendors will be willing to sell their merchandise at J.C. Penney stores. Johnson's vision is, in final estimation, to lower the cost structure and to expand margins. Note that the narrow gross margin of 33.2 percent for the second quarter, below the analyst estimates of 37 percent, was due to merchandise liquidation and deep discounting. Management wanted to clear room for the new fleet of vendors and apparel, so this margin contraction does not reflect the new sales approach.

As Johnson notes in his second quarter conference call, the one boutique concept that has already landed at stores - the Levi's bar - has already shown promise. The Levi's sales trend at these Levi's bars was 25 percent better than at stores without the bars. Additionally, J.C. Penney collected $5 more per pair of jeans than they did last year, again owing to the new concept. There are 94 store concepts that management intends to roll out, so if one, two, or even ten don't pan out, they will still have an arsenal of others. That ought to assuage former CEO Allen Questrom's anxiety that this set of changes is too much at once, or that the company should have single test stores. The reality is that they will have experimental stores - 94 of them! What's more, the company will have $1 billion in cash on the balance sheet come the end of the year, so this vision-execution will not be cut short.

Ron Johnson is inviting a new customer. And, of course, he is implicitly "challenging" (read: frustrating) the old class of coupon-cutting hobbyists and deal-seeking moderate shoppers. In the words of Liz Dunn, senior analyst at Macquarie, since the "moderate department store space was dying a slow death," management is partially "firing its customer base." The store is adopting some strategies already implemented by Nordstrom, Inc. (NYSE:JWN), most notably the boutique model. Additionally, like Nordstrom, Johnson intends to place small cafes and eateries where cash wraps used to be stationed (the company is going paperless over the next year). All of that said, the hope is that a new customer will begin to wander into J.C. Penney.

Management is reconsidering its promotional strategy. The new strategy gets rid of the arbitrary promotion (which Johnson recognized as such) of having "month long values." Instead, "everyday pricing" simply means that the price of J.C. Penney's goods will not change unless those goods fall into clearance. That's simple enough and has worked at Wal-Mart Stores, Inc. (NYSE:WMT) and off-price retailers like Ross Stores, Inc. (NASDAQ:ROST). Management pulled its television spots, catalog, and inserts to institute an ongoing "marketing blackout" to insure that it could properly "educate" its customers for once and for all.

Some comparisons with Gap and J. Crew. Take a look at the websites of The Gap Inc. (NYSE:GPS) and J. Crew (taken private in 2010). There are important comparisons and contrasts with these two companies and J.C. Penney. First, both The Gap and J. Crew have two general sales categories: regular priced and sale/clearance. As Ron Johnson noted on the second quarter earnings conference call, J.C. Penney adopted this same strategy on August 1. The other tendency from The Gap is, within this two-tiered sale structure, to issue general coupons that count for an overall, non-specific discount. J.C. Penney used to do this (I remember it fondly), but no longer does so. At least not yet.

This is something that I wish would return and that will return, but in due time. Johnson's vision of "everyday pricing," in which the price of goods does not change unless they fall into clearance, is perfectly coherent within The Gap's model of issuing non-specific, store-wide coupons. You give the hobbyist/deal-hunter a motivation for coming to the store or shopping online, while everyday shoppers will have the impression that the merchandise is of higher quality, more attractively arranged, and clearly priced.

Johnson realized he is selling merchandise, not a lifestyle. Put differently, he realized that he is working for a chronically distressed J.C. Penney, not for a booming Apple Inc. (NASDAQ:AAPL). Say what you will about the colors and social statements that J.C. Penney was displaying in its "lifestyle" ads - they lacked attention to brands and to increasing store traffic.

That said, Johnson's ambition is an inoculation for the chronic lack thereof over the past 20 years. Look at sales per square foot at J.C. Penney. As Johnson took the helm in November 2011, the company maintained sales $130 per square foot. Compare that to Urban Outfitters, Inc. (NASDAQ:URBN) at $532 and J. Crew at $593 (data from That's what management sees: a company that owns about 50 percent of its stores but that had no idea, up to now, about how to make them revenue generators.

So we think that Johnson needs a chance - longer than 9 months - in order to turn around this decent brand. After all, it's only with that outlook that a decent brand could be transformed into a great brand, a brand that Ackman thinks might be worth upwards of $77.

Disclosure: I am long AAPL, JCP.

Business relationship disclosure: This article is written by Insider Monkey's writer, Brian Tracz, and edited by Meena Krishnamsetty. They don't have any business relationships with any of the companies mentioned in this article and they didn't receive compensation (other than from Insider Monkey and Seeking Alpha) to write this article. Brian has long positions in JCP and AAPL. Meena has a long position in AAPL.