JCPenney: Why Ackman Isn’t a Fool

by Will Ashworth | November 16, 2012 6:15 am

Warren Buffett’s 2004 letter to shareholders discussed the idea of market timing, referring to the mistake investors make buying and selling equities at the end of bull and bear runs.

He went on to say, “And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.”

I don’t think the head of Berkshire Hathaway (NYSE:BRK.A[1], BRK.B[2]) had JCPenney (NYSE:JCP[3]) in mind when he made that statement, but nonetheless, the fear factor for the department store’s stock has hit a fevered pitch in recent days.

Others ARE Fearful

JCP just announced an adjusted $203 million net loss on revenues of $2.92 billion, which was far less than forecast. InvestorPlace editor Jeff Reeves called for CEO Ron Johnson’s firing this week[4] and outlined many reasons why this turnaround has run aground.

It’s hard to argue against the general consensus when the numbers are so painfully awful. Since JCPenney announced Johnson’s hiring, its stock is off 40%, and its core customer appears missing in action. Its stock closed trading Nov. 14 at $16.89 — 8 cents off a 52-week low.

Investors have every right to be fearful.

And that’s what makes Bill Ackman’s support of JCPenney and Ron Johnson so compelling. Ackman’s contrarian play will either make him a lot of money, or be one of the few mistakes in a very  successful career.

Although I’ve never been a fan of his activist brand of investing, his recent appearance[5] on CNBC’s Squawk Box should at least make you think twice before writing off JCPenney. Although Andrew Ross Sorkin did his best spoiled child imitation in the interview, Ackman’s main argument was simple and to the point:

JCPenney’s stores-within-a-store revitalization is working.

The Turnaround

JCPenney is transforming 64 million of its 111 million square feet during the next three years. In the third quarter, 7.2 million square feet was converted into 10 separate shops, including Sephora, Mango, Levi’s, Liz Claiborne and others. Those generated $269 per square foot in sales, compared to $134/sq.ft. for the rest of the store.

JCP plans to add 30 more shops to each location in each of the next three years, bringing the number of stores-within-a-store to 100 by the end of 2015.

While it currently has no plans to convert the 400 stores within smaller communities — preferring to focus on its 700 locations in major metropolitan markets — it’s possible those could see a makeover in 2016 or beyond. It’s also possible that some of them could be sold, but that’s an argument for another day. Right now, I simply want to point out the long-term financial implications of JCPenney’s transformation.

The Math

Let’s assume Ron Johnson is able to finish JCPenney’s three-year project. At the end of 2015, revenues would be $23.5 billion — that’s based on $269/sq.ft. for 64 million square feet of the “new” JCPenney, and $135/sq.ft. for the remaining 47 million of “old” JCPenney locations.

However, analysts’ projections for lower 2012 revenues suggest the revenues for “old” JCP locations will deteriorate as old customers are replaced by newer, higher-spending ones. So, perhaps a more realistic estimate for 2015 would be $269/sq.ft. for “new” JCP locations and $100/sq.ft. for “old” ones, for revenues of $21.9 billion.

I’m not some pollyanna here. Analysts expect an adjusted loss of 66 cents per share in 2012, which is considerably worse than the 26-cent estimated gain before it released earnings Nov. 9 … and given the downward spiral JCP is on right now, I wouldn’t be surprised if it were worse than that.

Still, with plans to invest $850 million in capital expenditures in 2012 and more than a billion dollars annually over the next three years, here’s what I expect to see at the end of 2015:

2015 2012
Revenues $21.9 billion $13.6 billion
Gross Profit $8 billion $4.9 billion
Operating Profit* $2 billion -$500 million
Net Income* $1.08 billion -$471 million
Earnings Per Share* $4.11 -$2.15
Net Interest Expense $340 million $225 million
Long-Term Debt $4.5 billion $2.9 billion
* Not adjusted for special items

Bottom Line

Whenever I’m at a loss for words, I seem to always fall back on a quote from Wall Street. In this instance, I look to Lou Mannheim for inspiration:

“Stick to the fundamentals. That’s how IBM and Hilton were built. Good things, sometimes, take time.”

I don’t mean to make light of this situation, but only time and execution is going to solve JCPenney’s problems. Fifth & Pacific (NYSE:FNP[6]) has given CEO Bill McComb six years to turn around its business, and it wasn’t in nearly as difficult a position as Johnson finds himself. You can call for his firing all you want, but you’re just making it that much harder on his replacement. (And frankly, who would want the job?)

Deutsche Bank (NYSE:DB[7]) analyst Charles Grom feels JCPenney’s business is not getting better, and 2013 could spell the beginning of the end for the department store. While I understand his rationale, I find it hard to believe that in a worst-case scenario it couldn’t find additional capital to keep it afloat to the end of 2015.

JCPenney is an afterthought for many Americans, and no amount of promotional offers and pricing will change that fact. To become relevant, the stores-within-a-store format is the best way out of the hole it’s in.

Bill Ackman has put his money where his mouth is, and I think he’s going to have the last laugh when it comes to JCPenney.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

  1. BRK.A:
  2. BRK.B:
  3. JCP:
  4. called for CEO Ron Johnson’s firing this week:
  5. recent appearance:
  6. FNP:
  7. DB:

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