This Is What Bill Ackman Sees When He Looks at JCP

At a current share price of $17.29 per share JC Penney (“JCP” or “the Company”) is trading near ten-year lows and the market seems to be heavily discounting any possibility of a successful retail turnaround. Below is a short discussion of the events of Q2 and Q3 and their impact on the outlook for the turnaround plan and the resulting intrinsic valuation.

Turnaround Strategy
CEO since November 2011, Ron Johnson has brought a strategy of repositioning the Company away from deep discounting and coupons to offer everyday low prices. Recognizing that the Sephora store-within-a-store concept was generating $600/SF, roughly four times the store average, Johnson planned to expand the concept to 100 “shops” within every JCP location. By giving brands their own mini-shops and eliminating deep discounting JCP would once again attract premier brands.

Johnson’s plan also involved dramatic cost-cutting throughout the organization. The Company expected to realize $900mm in annual savings by laying off employees at the home office ($200mm), reducing store labor hours through process changes ($400mm) and decreasing advertising spend as the company becomes less promotional ($300mm). Johnson also believed that $500mm in unproductive inventory could be eliminated, lowering the Company’s working capital requirements.

Catalysts Update
1. Same Store Sale Turnaround: Management plans to improve SSS through the introduction of everyday low prices, communication of changes to customers, and a move the store-within-a-store concept. SSS numbers have been declining dramatically, but the success of the new JCP provides an optimistic outlook.

2. Cost Reductions: In the short time that Johnson has been with the Company, they have already identified and begun to execute on $650MM of the cost reduction opportunity. Management recently reaffirmed the $900MM cost-reduction goal by year-end.

3. Management Team: JCP senior executives are seasoned retail veterans who have built best-in-class companies. The strategic, technological, and operational changes taking place at JCP are extremely challenging. A portion of the long JCP equity thesis is that management is focused and capable in executing their plan. The exit of Francis, the poor promotion of new pricing and the early strategic changes point to a management team that has stumbled thus far.
Remaining question: has JCP management fundamentally misunderstood their customer?

4. Executive Compensation: CEO Johnson purchased $50MM in warrants upon arriving, ensuring that his incentives are aligned with shareholder returns. These warrants have a strike price of $29 and cannot be hedged or sold for 6 years. Johnson’s personal financial success remains intricately tied to the success of JCP.

5. Stronger Brands: JCP is strengthening their brand portfolio by adding companies such as DC Shoe Co., Martha Stewart Living, and MNG by Mango to existing brands like Nike, Sephora, and Liz Claiborne. New shops to be added in 2013 include prime brands such as Dockers, Haggar, and Disney.

 
Valuation
JCP owns the majority of their real estate, a huge asset that could be sold off if the company ever neared bankruptcy. Taking the assumption that the properties owned by JCP are worth their book value ($5.4Bn) and netting out debt yields an equity value of $15.75 per share. Owned real estate provides strong downside protection.

The upside case remains fairly unchanged from the June report. If the turnaround is successful and management is able to drive traffic, the sky is essentially the limit for JCP. Dialing back the weightings slightly from the June report the base case was deemed to have 50% likelihood while the upside and stress cases were equally likely at 25%. The resulting valuation is $24.2 per share, $7.0 above the current price for an equity upside of ~41%.

Recommendation
JCP is currently trading near ten-year lows and the market is heavily discounting the Company’s probability of success. Market sentiment and short interest in JCP remains very negative, causing dramatic volatility in the share price.

While 2012 has been a year of disappointment, there is still very much reason for optimism in the case of the JCP turnaround. While SSS and SSF have declined more dramatically than anticipated, management has succeeded on the cost cutting front and the new JCP, while still very small, has exceeded management’s projections. However, the base case (showing a moderate turnaround) indicates that JCP should be worth at least $25/share and the upside case (turnaround success on all fronts) indicates a valuation of almost $45/share. For the value investor who believes in this management team and is willing to ride out the volatility an investment in JCP is still very attractive.