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JC Penney: High Risk, High Reward

|Includes: J.C. Penney Company Inc. (JCP)

I'd like to quickly share my thoughts and opinions on JC Penney (NYSE:JCP). I originally had high hopes for the company after Ron Johnson's departure; now, my perception of where the stock is headed towards in the future is rather ambiguous. I don't like to blindly follow the market consensus, but after doing some due diligence, the market valuation reflects the truth. I've concluded that JCP is a high risk, high reward investment. The likely outcome is skewed more towards the risk side of the spectrum.

What I though months ago

My original idea was that JCP was a good asset play. I thought the PP&E figure on their balance sheet was dramatically understated because of accounting rules. As a result, the company's property value alone could equal its entire enterprise. My logic went as follow: 1) JCP has been in business since 1920, 2) the company owns half of its retail locations 3) so if the company has consistently purchased property since 1920, regardless of location and other factors, the figure for PP&E on the company's balance sheet will understate its current market value, given the nominal rise in property value over the last century and the GAAP accounting rule stating assets may be marked down, but not up. As it turns out, an appraiser valued JCP's property at a discount to the company's PP&E figure, I believe around $3.3bn, about equal to the company's market cap. However, due to its debt burden, JCP's enterprise value is unattractive. It gets uglier when you tack on negative EBITDA and therefore, negative free cash flow. If the company cannot generate positive EBITDA, how can it continue to support the expenditures necessary to maintaining its $3.3bn worth of real estate? Through debt, which the company is already overburdened with, or equity offerings, which would lead to dilution, or spinoff of its real estate and debt into a REIT, which could create an investment opportunity afterwards.

Will the turnaround be successful?

The two x-factors vital for a successful turnaround are 1) excellent management, and 2) existing competitive advantages that previous management improperly utilized. Unfortunately for JCP and its shareholders, the company has little or none of either. First, JCP's current CEO, Mike Ullman, was the CEO responsible for initially making JCP a turnaround company back in 2011. Second, JCP sells near commodity products in a very competitive retail environment. To turn itself around, JCP needs to recapture its core customer base of middle-class Americans, which does not occur overnight and requires extensive marketing, efforts the company can barely finance. JCP's leverage might destroy the company before it can complete a successful turnaround.

Conclusion

Of course the current market valuation is indicative of what I described. If JCP can somehow turn itself around by reporting positive comps, EBITDA, and yoy revenue improvements to begin with (margins, ROIC, FCF improvements, deleveraging, and recapturing lost market share can wait), then JCP's stock price appreciation will award new shareholders wildly. However, improvements are extremely difficult at the moment given the adverse tailwinds affecting the entire retail industry and the company's own problems.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.