JCP: Johnson Premium Gone

So JCP tanked this week on bad earnings; it closed the week at $26.29/share.    I think this is an interesting situation but haven't done anything here yet, but things are getting interesting at this price.


The Situation
I assume most people in the market knows what's going on here.  Bill Ackman of Pershing Square along with Vornado Realty (REIT with real estate assets in NYC, Washington DC and others) bought a big stake in J.C. Penney to turn things around.  Last year they hired Ron Johnson, the guy behind the hugely successful Apple stores and was a factor in the success of Target.

They did a big presentation early this year laying out their plan to turn JCP around.  I posted some comments on that here:

Part 1
Part 2


The Johnson Premium
So the point now is that the stock price decline has pretty much taken out the Johnson premium and then some.  When he came on board, the stock price popped.

The announcement of his hiring came on June 14, 2011.  The stock closed on the day before that at $30.11/share.  After the announcement, the stock price closed at $35.37/share.

On January 25, 2012, JCP held a big meeting to present their new plan.   I think Ackman called this the most important day in retailing or some such.  The stock price on January 25, 2012 closed at $34.28/share and on January 26 it closed at $40.72/share  (This was actually the second day of the investor presentation when they announced the financial details).

So you can say that the JCP stock price of $30-35 is really the pre-plan-announcement JCP price.  $30 is the pre-Johnson-hire price. 

The JCP stock price is now trading BELOW the price on the day before it was announced that Johnson was hired and below the pre-presentation price.  In other words, the Johnson premium, or the Johnson plan premium is now more than gone; it's a Johnson discount.


JCP Floor Price
The above can be sort of a floor price (well, not a real floor as obviously Johnson can make things worse, the economy can get worse, the decline at JCP may continue etc...) on JCP stock, especially when looking at JCP as an event trade; will Johnson succeed or not?   "Yes" would take the stock up, and "no" would leave it stuck where it was before he came on board.

Another way to look at it is to assume, in the case of failure, that JCP will just muddle along as it has in the past five years.

The adjusted EPS (exclude charges and pension expenses) over the past five years were:

               JCP adjusted                  Operating
               EPS                                margin
2007       $4.63                              9.0%
2008       $2.17                              5.4%
2009       $1.86                              5.5%
2010       $2.24                              6.1%
2011       $0.94                              3.1%

average:  $2.37                              5.8%

So if JCP just muddles along as it has in the past five years, it may earn $2.37/share and on that, JCP stock is trading at 11.0x p/e.  All you need for this stock to be at 11x earnings is for JCP to do sort of what is was doing in the past five years.

OK, so sales have been declining so this five year average may be no good.  So let's assume that cost cutting and other things will keep operating margins around where it has been in the past five years; that's 5.8%. 

2011 sales were $17.3 billion (I know it dropped a lot this past quarter, but let's assume that is due to many big changes, inventory adjustments and other things going on now so may be temporary).  Assuming no growth in sales and a 5.8% margin, that's $1 billion in operating income.  Take out $227 million in net interest expense (2011 amount) for $773 million in pretax income and $464 million in net income.  With 218 million shares outstanding, that comes to $2.13/share.

So if sales can be maintained at the 2011 level and they can earn a 5.8% operating margin, that's $2.13/share in EPS and on that, the stock trading at 12.3x.  So that's not bad at all.  All they need to do is maintain sales and get a 5.8% margin.  Anything on top of that is a bonus.

Put a 10x multiple on the five year average EPS of $2.37 gives us a floor price of $23.70/share and a 10x multiple on the $2.13/share EPS derived above gives us $21.30/share. 

So let's say the Johnson non-success, fail price is around $21.00-24.00/share.  At $26/share, we are not very far from it.

Of course, I understand that a real failure may lead to further sales declines and actual losses.  So this isn't really a floor, floor.  It's just a reference point.

Upside
So anyway, Ackman said that JCP could earn $6.00/share in EPS by 2015.  At 10-15x p/e, that could lead to a stock price of $60 - 90/share. 

I haven't seen the actual presentation that Ackman made at the recent conference, but some reports have said that Ackman said JCP could be worth from $191 to $315/share.  JCP has sales per square foot of $132, but if they can get that up to $250/sf, JCP would be worth $191/share and it could be worth $315/share if sales got up to $350/sf.

That really sounds like a stretch.  Sephora boutiques inside of JCP stores have sales per square foot of $600, but I imagine that's quite a bit different than your typical department store space (apparel etc...).

It seems they believe that the store-within-a-store concept is going to really bump up those sales per square foot figures and drive traffic (Martha Stewart etc...).

Ackman apparently stressed that the key here (as if people didn't get it) is that it's is substantially cheaper for brands to have a store inside of JCP than in a separate space in a mall.

Anyway, those are Ackman's upside values.

To use more conservative figures, let's assume that JCP can keep sales flat with 2011 and then achieve 8% and 10% operating margins.

This is what they can earn with these operating margins (assuming 218 million shares outstanding, $227 million net interest expense and 40% tax rate):

                                    EPS                  Stock price range at 10-15x p/e
8% margin                  $3.18                $31.80 - 47.70
10% margin                $4.14                $41.40 - 62.20

(actually, with both Macy's and Kohl's trading at 10x or so p/e, there may be no reason to look at 15x valuations here, unless the JCP turnaround really starts to work)

Conclusion
At the very least, JCP stock has come down to the Johnson hire pre-announcement price so any premium attributed to the Apple magic is competely gone at this point.  The above shows that JCP is priced reasonably even if nothing exciting happens going forward.  If they just muddle along, the stock is priced within reason (or slightly on the high side).

However, if this turnaround starts to work, there can be substantial upside. 

Of course plenty can go wrong with this too.  But I don't think this is another Sears; JCP is now being run by a bunch of retailers, not finance people.

I think it's wrong to evaluate Johnson when he is just starting out.  He is trying to make a lot of changes at once so it's understandable that things are going to be tough until they get on track.  You don't sign a star to play for your team and then evaluate his performance after one or two games!

Let's see how this unfolds.

I do not own JCP at this point, but may in the future.  This may be one of those things you can play as a binary bet via longer term options; you bet that Johnson will succeed and don't worry about what happens in the short term.

The risk/reward ratio now with JCP at $26 is attractive also as a simple long as the upside can be $34/share (10x $6.00 eps in 2015) and downside of $2-4/share (you can plug in your own figures to get upside/downside ratios).

America's Favorite Store?! (Part 2)

So I listened to the second day presentation.  This was more of an investor day with financial details.  Much of the presentation was done by Michael Kramer, the COO of JCP.  He too comes from Apple retail where he was CFO of the retail business, he became CFO of Abercrombie and Fitch and then later CEO of Kellwood, a supplier to department stores.  So Kramer has a lot of retail experience.  This is good.

Like yesterday, Kramer started off talking about how department stores have dropped the ball and how that doesn't make any sense.

He offered the advantages that department stores have compared to specialty stores.  Below is a table that shows the advantages in two of the major expenses of  a store.  Department stores spend a lot more on marketing, and have rent expense that is way lower than specialty stores.

How can this be?  How can department stores lose so much market share with such advantages?  Over the years, see how department stores have lost share:

Johnson showed this chart yesterday, but a little more detail shows that of the 69% that is not department store sales, 37% of the total is actually specialty stores (the rest are discount retailers etc...).

So what happened?  Johnson yesterday spoke of the deterioration of the 6 P's.  Kramer says that department stores have basically lost sight of their customers.

As an example, he spoke of his experience as a supplier to department stores.  One unnamed department store had unproductive brands sitting on their shelves and Kramer asked for that space for his better products.  The department store said no.  Why?  Because those unproductive products made as much money as the other products due to vendor kickbacks.

Kramer said this is one of the problems that department stores have.  They think financially that the unselling product is OK to have in the stores as they get paid back by the vendor.  But what happens to the customer?  If you have stuff they don't want on the shelf and you are OK with that because someone else is paying you, that's not a good long term strategy.  Eventually, the customer will stop coming.  (They did say that JCP does not have this problem).

As Johnson said yesterday, Kramer said they will simplify pricing and stop confusing customers.

How will all this 'change' be paid for?  They already talked about how they can redirect all that money they spent doing the 590 promotions that nobody responded to to better, more effective and less frequent promotions.  The press reported that $80 million will be spent on promotions but failed to mention that this is cost that is coming out of the 590 promotions they did before, so I don't think there is a net increase in spending there.

Costs
Kramer pointed out that corporate overhead at JCP is a bit higher than Kohl's (KSS), a competitor, and they feel they can bring JCP's cost down to KSS's level.

By bringing SGA level down to KSS's would be worth $1 billion in savings.  That's pretty big for a company with $18 billion in sales (that would lift operating margins by more than 5%).

They can't do this overnight, so they will cut costs over time towards 2015.

Where will the savings come from?  They have identified areas of savings in the following areas:

(I know I am getting a little trigger happy with the Windows 7 "Snip" function.  I have to admit, it's pretty convenient!).

They can also save labor costs by increasing labor productivity.  The amount of labor hours to operate a store at JCP is much higher than at KSS, and they think they can get it down to KSS's level.   If they do, that can amount to a lot of costs saved:

Advertising cost is also a bit higher than the competition and they think they can get that down too. They believe that events, brand/store announcements and things like that will offer a lot of free publicity over the next few years as they develop their stores.

Also, corporate headquarters is inefficient with too many layers of management that they plan to cut down:

Span of control is basically how many people directly report per manager.  Increasing this, (or cutting layers) can save $90 million.

Another example of cost saving Kramer mentioned was the number of cashier stations in the store.  There are currently a lot of them where they are not utilized at all except during peak times (he said they are "rarely used") and yet the stations are still staffed even during off peak hours.  By shutting these stations, they can save $100 million.

So with these and other initiatives, they expect $900 million in savings over the next two years.   They plan on getting SGA down to less than 30% of sales by 2013.  They will spend $800 million in capex in 2012 for the transformation which includes the development of the first 10 shops in their stores, investments in store infrastructure, IT and inventory for changes in the store (movable walls etc...).

How Do They Lift Sales?

Shops in the stores and partnerships with brands should increase traffic and help sales.  When Sephora was put into JCP stores, it lifted sales +2% in the rest of the store. 

Some argue that Johnson was able to create the great Apple store because Apple had great products, but the fact is that throughout the existence of Apple stores, they were never the cheapest seller.  Customers were always able to buy the very same Apple products for less at Best Buy or on Amazon.  And yet the Apple stores have done so well.  The Apple stores also never got preferential treatment despite begging by Johnson. 

By December 2015, they will have 100 shops in their stores and the transformation will be complete.  At this point they expect:

• 40%+ gross margins
• 27% SGA to sales
• 13% contribution margin (operating margin)

Also, there is potential for more JCP stores.  The number of stores in the top 50 MSA's (market service area) are as follows:

             JCP            398

             Macy's       517

             Kohl's        722

This implies that there is potential for 300 more stores.

JCP believes that with better, simpler pricing, partnerships with key brands and instore shops and their Market Square concept will drive traffic and help boost sales.

Investor Updates

JCP going forward will only provide annual guidance, and sales will be announced only quarterly instead of monthly.

EPS guidance for 2012 is for $2.16 (before pension expense).  They expect to meet or exceed their 2011 EPS.

There was a question from an analyst with respect to some suppliers/vendors saying that orders from JCP are down 10-15% for the spring season.  The question was whether JCP is expecting sales to be down.  Johnson said that this is not the case; that their inventory turns are a bit lower than the competition and they are just managing their inventories down a little bit to get the turnover up to more competitive levels.

JCP does not expect sales to slump during the transition, nor do they expect the new pricing scheme to reduce sales.

I noticed that the press were writing things like "every day low price" or that JCP will deeply discount to get sales up, but that's not really the case.  As you can see from the slide in the JCP presentation yesterday, they expect to sell things at the same price they have been selling it at; just not with sales and promotions so much.  The impact on revenues should be zero (all else equal).

(for reference, the sales-to-inventory ratio at KSS was 5.6x compared to 4.8x at JCP on a last four quarters average basis).

Back of the Napkin

So those are my notes from the presentation.  I just jotted down what interested me, so it's by no means a summary of the whole presentation.  Anyone interested should listen to the presentation.  It is very interesting and there is something to learn from a well-prepared presentation. 

So what does this all mean to the investor?  What we know is that they want to get to a 13% operating margin by 2015 by maintaining gross margins above 40% and getting SGA down to 27%.  If we assume sales to be flat (just to be conservative), what kind of EPS are we looking at?

Let's assume:

• debt remains unchanged so interest expense remains the same at around $231 million/year
• total shares outstanding is 213 million, which is the average shares outstanding for the quarter ended October 29, 2011  (since the transformation is planned to be completely self-funded, this is not unreasonable)
• Sales of $17.8 billion, which is the sales for the most recent full year
• 40% tax rate (which is a little higher than the 37-39% range it's been recently)

So, with sales of $17.8 billion and a 13% operating margin, that's operating income of $2.3 billion, less $231 million in interest expense is $2.1 billion pretax income, and with a 40% tax rate that's a net income of $1.26 billion.  With 213 million shares outstanding, that's an EPS of $5.92/share.

At the current $41.00 or so per share, JCP is trading at 6.9x what JCP could earn in 2015.  If JCP succeeds in this transformation, then a p/e ratio of 15x is not at all unreasonable, as even mediocre retailers have traded at that multiple in normal times.

So that would put the possible value of JCP in 2015 at $89.00/share.  From the current $41/share, that's more than a double and over the four years through the end of 2015, that's an annualized return of 21%/year.  Not bad at all.  You can see why Ackman might be excited.

If they really do well, then maybe they get a 20x multiple.   That would take the stock price to $120/share by the end of 2015.   But for JCP to get a 20x multiple, they would really have to do well.

Retailers tend to be cheap now, so even if we assume that JCP will only get a 10x multiple on their $5.92/share EPS in 2015, that's still close to a 10%/year return through 2015.

The great thing about this analysis is that it assumes zero sales growth when in fact, if the transformation is successful, it is more likely that sales will grow over time.

Here are the trailing and forward p/e ratios of some similar retailers now (pulled from Yahoo Finance):

                          trailing                

                          12-month             Forward

Macy's               12.4x                   10.5x

Saks                   24.0x                   19.4x

Kohl's                10.9x                     9.4x

Nordstrom         15.7x                   13.6x

Dillard's               6.1x                    9.5x

I think Saks p/e ratio is high due to their depressed earnings so it may not be an indication.  Morningstar's industry average p/e ratio, however, is around 15x.

Sanity Check

Of course, the other big question is whether JCP can actually achieve a 13% operating margin by 2015.  Retail is a very competitive business.  What does a 13% operating margin look like versus the competition?

I just grabbed some operating margin figures from Morningstar and created the below table so we can see how the 13% operating margin compares to other department stores and over time.  Is it doable?

I don't see anyone achieving 13% operating margins in the department store sector even in the good times of 2006-2007.  Peak margins even at Kohl's seem to be around 11.7%.  So JCP is aiming for something even better than what Kohl's did during the best of times.  But then even Macy's achieved a 10.8% margin in 2006, so maybe it is doable.

Conclusion
The 13% margin does look aggressive given the table above, but these guys are really overhauling JCP in a major way so it may happen.  If it does, there seems to be plenty of upside in the stock price, even after the close to 20% rally on the presentation.

I don't own any JCP at the moment; these things are very hard to evaluate.  Who knows if they will succeed or not?

But it seems like they do have an active shareholder that has a strong interest in seeing JCP succeed (including Vornado's Roth who would love to see JCP do well as it would enhance the value of Vornado's Manhattan Mall).  It seems like they do have a solid, experienced retail team that is energetic and motivated to succeed.

An interesting point is that since this makeover doesn't include anything drastic on the balance sheet, like huge debt increase or massive financial engineering, like repurchasing shares (or leveraged recap) at the expense of capex and store maintenance, there might be little risk involved.

If the makeover fails, what happens?  JCP goes back to being what it was; a mediocre department store?  This may not be such a disaster on the downside.

JCP stock has traded in the range of $20-40 post crisis (excluding the 2009 panic low) before Johnson came on board.  So let's say that if this doesn't work out, JCP goes back to $30/share.

That's a 25% drop; not a complete disaster.  And on the upside, you have a potential double or more.  So that's $11 downside risk ($41 down to $30) and $48/share upside potential ($41 up to $89/share); not at all a bad risk/return profile if you think there is at least a 50/50 chance of the makeover succeeding (in fact, it can be interesting even if there is a less than 50/50 chance of a successful makeover).

Not bad at all.

As usual, this is not a stock recommendation.  I don't have any more insight than anyone else on whether this 'transformation' will succeed or not, which will be the primary driver of the stock price going forward.  I may buy and sell this stock in the future according to how things develop.  

America's Favorite Store?! (Part 1)

  (JCP's new logo)

Ron Johnson joined JC Penny (JCP) as CEO back in June 2011 from Apple with great fanfare.  He is the guru that was behind the amazing Apple stores.  Ron Johnson was brought in after Bill Ackman (of Pershing Square Capital) and Steven Roth (or Vornado Realty Trust) took a large stake in late 2010 and got elected to the board of JCP. 

Of course, JCP doesn't have the products that Apple does, so it's hard for me to imagine what Ron Johnson can do to transform this place.   What's he gonna do?  Install a glass staircase so people line up outside to buy...  jeans?

But you have to take a look when good investors like Ackman and Roth get involved with something.  Of course, most of the time you will take a good, hard look and still have no idea how this will work out.   Initially, I think the view was that Ackman and Roth were interested in JCP's real estate, but Ackman insists that is not the case at this point.  Roth is a retail guy (Vornado Realty), but he does have an interest in seeing JCP succeed as it is an anchor tenant in Vornado's mall in NYC (Manhattan Mall).  A revival in JCP would be very good for that mall.

One thing right off the bat we can say is that this is not Sears all over again.  The Sears trade was a great one initially (K-Mart bought out of bankruptcy on the cheap etc...), but didn't go too well after Lampert, a hedge fund operator and not a retail guy tried to run the place.

With JCP, Ackman and Roth are not at all involved with the retail operations.  They were involved with selecting and getting a good retail CEO.

Some may argue that an Apple guy can't run a department store, but Johnson started his career in retail (Target) so that's a good thing.

Over the past two days, Johnson unveiled their new strategy to transform JCP and turn it into a "America's Favorite Store".  

I listened to the presentation online and thought it was interesting, even though I have no idea how much impact it will have on sales.  The stock price didn't react at all on the first day, but popped +19% today on the financial presentation.  I haven't heard that yet so I'll make another post after I listen to that.  Obviously, there were things there that got the market excited.

Anyway, Johnson started out by analogizing his moving to JCP with his quitting Target to go to Apple back in 2000.  People around him were surprised, wondering why he would want to leave such a hot retailer like Target to go to a non-entity like Apple.  He points out that his move to Apple was not a bad decision. 

He says he sees the same thing now that he saw back then with Apple.  And when he told Steve Jobs that he is going to leave Apple to go to JCP, Jobs was surprised and didn't understand why he would leave such a hot company to move to a mediocre retailer.

Here are some tables from the presentation:

He says that when he quit Target to go to Apple, Apple had 3% market share and was losing money.  Apple now has 30% market share. 

Interestingly, JCP now has 3% market share and is actually making money.   He says that with a 3% market share, if you gain one point of market share, that's a 33% increase in sales and that's tremendous opportunity.

Johnson believes that department stores have made mistakes and that it doesn't have to be this way, and that department stores can do well if they improve their business.

Here is an example of what JCP has done wrong over the years.  He first mentioned the P's of retailing:

• Product
• Place
• Presentation
• Price
• Promotion
• Personality

It is said that if you can get one or two of these really down, you can do really well in retailing.

Anyway, first, he talked about how department stores were in the old days.  Way back when they dominated, department stores always promoted their own brand.  They didn't promote products; they promoted the stores;  Santa Claus for Christmas etc...

But what has happened with JCP is that they have really discounted their brand by their poor pricing strategy.

Here is an interesting chart Johnson put up to demonstrate this.   Between 2002 and 2011, JCP's retail prices have risen 43% while the cost of their products remained the same.

It looks like this should lead to higher margins and profits, but what actually happened?  Due to all the promotions, sales, specials and discounts, these prices were never realized.  Below is an interesting chart that shows that the real sales price for JCP products (I think he said this includes all items in JCP stores) have not changed at all over those years:

So raising prices only served to increase the "discount" rate that the products were sold for.  Johnson believes that this dilutes, or discounts the value of the JCP brand, the store.

Above is a chart that shows the average discount of items sold in JCP stores.  And below is a chart that shows the distribution of sales according to discount rates:

This shows that nothing is ever sold at the marked price,  and an astounding 72% of items are sold at a discount of more than 50%.   I guess that does look bad, as it looks like the store is going out of business if things are so marked down all the time.  At best, it makes the store look really bad in inventory management, having to mark prices down to clear inventory (this is not a discounter or off-price retailer like TJX/Marshall's).

So Johnson's new pricing strategy is to stop with the frequent sales and promotions and simplify the pricing strategy to three types below:

Johnson also presented his concept for JCP in the future.  One of them was to create more floor space by getting rid of the old fixtures; those old racks that have been used to hang clothes for decades.  He wants to use movable wall units to create wall space where images can be displayed with products hanging next to them; this will create more floor space instead of having the floor cluttered with racks like in old department stores.

Also a major new idea (for JCP, at least) is to break up the store into little stores.  JCP has had great success with Sephora stores;  Sephora stores inside of JCP stores have sales per square foot of $600 versus $200/square foot for the rest of JCP.

The idea is to create, eventually (by 2015) 100 stores within JCP stores.  They will start with brands they own that are popular, like Liz Claireborne, Izod and others. 

I didn't think that was a particularly new concept, but I suppose it's new for JCP.  (Higher end department stores have had stores-within-a-store for a long time, I think)

JCP will also have Martha Stewart stores inside of them, and Johnson announced that Ellen Degeneres will be a spokesperson (or whatever you call it) for JCP, being featured in TV commercials, and stores being promoted on her show. 

The other new concept was to move jewelry and watches out of the center of the store, which has been the standard forever.  They will move jewelry somewhere else and replace it with a Town Square.  He didn't give much information about what the Town Square will be, but the hint was that at Apple stores, a good half of the floor space is devoted to services and activities other than selling products.  What can this be in a department store?   Someone to patch torn jeans?  Repair shoes?  Probably not, lol...   Maybe some virtual/technological fashion advisor?  Play area for kids?  Who knows.

Anyway, I'm not a retail guy so I have no idea what all of this means so I will just have to watch as the story unfolds.

I have to say that this stuff does actually make me want to go to JCP, even though I hate shopping, just to see how it goes.

I will listen to the replay of today's investor day presentation later and will post my comments about that tommorow.