by Lawrence Meyers | May 23, 2012 9:14 am
Much has been made of J.C. Penney’s (NYSE:JCP) terrible quarterly report, yet few seem to give any credit to the fact that this is a heck of a turnaround that is being engineered. Remember, this is a $17 billion sales juggernaut with 1,100 stores.
Let’s take a hard look at exactly why Bill Ackman, whose hedge fund owns some 26% of Penney and brought in new CEO Ron Johnson from Apple (NASDAQ:AAPL), thinks it remains a great opportunity.
Penney sells a lot of clothing, yet it wasn’t always that way. It was more of a multi-product retailer forced into focusing on clothing by Wal-Mart (NYSE:WMT), and its infrastructure couldn’t handle that product focus. Other core problems popped up, including an ill-advised purchase of Eckerd drug stores. The company has, simply put, been mismanaged for a very long time, sells a commodity product with no price integrity, has a tired brand and became complacent. Sales are too low and costs are too high. The good news is that it owns half of its real estate, has brand legacy and does dominate several small-town markets.
Ackman brought in Johnson not just to tinker with a few things, but to completely remake the entire company. They discovered Penney was relying too much on promotions, and its discount distribution was too narrow — 75% of revenue came in a 20% price band. So, high-quality brands didn’t want to get involved; they didn’t want to see their product discounted.
The new model is to provide a single everyday price, with one month-long season promotion each month, and offer clearance sales on Fridays (payday). This strengthens J.C. Penney’s brand equity and frees the company to focus on product — not promotional — cadence. JCP has totally redesigned the tired Penney look with a more contemporary feel, and has begun a store-within-a-store concept for several major brands. Higher-quality brands will no longer see Penney as this tired old discounter, but as a flashy new store.
Ackman makes it clear that the massive sales declines in Q1 are because Penney first had to address brand, price, promotion and design before it could bring in all the new products. As 2012 continues, 10 of these new internal brand-name stores will appear, with 100 done by 2015. In the meantime, the customer will have time to become familiar with the new concept.
On the cost side, Penney is attacking the inefficient cost structure, aiming to bring SG&A expense down from 31% of revenue to 21%, as competitor Kohl’s (NYSE:KSS) enjoys. The company expects to cut $900 million from its cost structure. That’s gigantic, some 120% of 2011 EBIT.
If you remember, Gap Inc. (NYSE:GPS) also was a turnaround play at one point, and its first year was challenging. Johnson has been the CEO for all of three-and-a-half months. This is a long-term project. Of course, when Penney cut its dividend, the stock got a double whammy in losing all the income investors.
Ackman thinks Penney could be making 6 bucks a share in 2015 from $1.41 this year. That’s quite a leap. But even at 25% annualized growth, that would bring earnings to $3.50 per share. A 25x multiple would give it an $87 share price, or 250% returns from here.
So either you bank on Ackman’s case and Johnson’s execution, or you don’t. That’s what it comes down to. Certainly their track record is excellent, and their vision is clear. Can they execute? At $26 per share, it might be worth taking a gamble on.
You also could hedge your bets by selling some in-the-money naked LEAPs, collect a premium to wait it out, and see what happens.
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc., which brokers secure high-yield investments to the general public and private equity. You can read his stock market commentary at SeekingAlpha.com. He also has written two books and blogs about public policy, journalistic integrity, popular culture and world affairs.
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