JC Penney: So Bad, It's Good (Again)

Summary:
Buy J.C. Penney (JCP) current price 6.75 with expected return of 110%-120% over 12 months. Target price of $14 for 12 months.

Main Points
• Easy comps and Improved Margins will lead to Positive Momentum
• Many Near Term Catalysts
• No Liquidity Issues/ Manageable Balance Sheet/ Asset Coverage
• Cost Management and Low CapEx

Business
J.C. Penney (JCP) operates about 1,100 department stores in 49 states and Puerto Rico selling apparel, footwear, home furnishings, accessories, fashion and fine jewelry, and beauty products. JCP saw its sales peak in 2006 at $19.9 billion and has dropped to around $12.1 billion for 2013, a 39% fall off. During that period the COGS and SG&A have dropped only 25.1% and 23.0%, respectively. Additionally, Capital Expenditures were $1.8 billion over the last 2 years. This led to a serious issue in both liquidity and the viability of the business. However, the old management team has returned and created a stable albeit mundane strategy.

This stability should lead to slow sales growth, normalized margins and a steady ship. Under this scenario, the stock should appreciate as all liquidity issues abate and cash flow and earning return.

Department Store Business is a Better Margin Business
Taking the rolling Gross Margin, Operating Margin and EBITDA Margin of competitors shows that most of the retailers have steady levels. From small revenue retailers like BonTon with $2.9 billion in sales to larger ones like Macy's with $28.1 billion in sales both have steady margins. This leads to the clear perception that the issues at JCP were self-inflicted. The industry trend remains solid.

To get an average margin level I took Macy's, Dillards, Kohls, Nordstrom, Bon-Ton, JCP, Target and Sears Holdings since 2009 and they averaged gross margin of 32.3%, operating margin of 5.4% and EBITDA margin of 8.8%. LTM, JCP is at 22.9%, (15.6%), (10.6%), respectively.

The cause of the drop was driving out their customers and stocking merchandise that did not resonate with the customer. Management has stated they are selling some product at a loss to clear inventory. Historically clearance is 15% of sales with 10% margins; currently it is 25-30% being sold at a loss. The management estimates that 200 bps of Gross Margin will return once the inventory is fully cleared; definitely by end of Q1 2014.

There were one off mistakes that they identified. For example, Ron Johnson wanted to move from sensor tags to RFID. They removed the tags but never added in the RFID technology which led to large scale theft. They also took returns for cash and were fooled by criminals into taking unsold merchandise as a return. This created a spoilage level that went from 0.20% to 1.20%. They see 100 bps of margin from re-instating the sensors.

They have seen private label items fall from 50% of sales to 35% of sales due to the Ron Johnson transition. They have focused on moving back to private label levels that will support a higher gross margin. (The jcpenney®, Fair and SquareTM, monet®, Liz Claiborne®, Okie Dokie®, Worthington®, a.n.a®, St. John's Bay®, The Original Arizona Jean Company®, Ambrielle®, Decree®, Linden Street™, Stafford®, J. Ferrar®, jcpenney Home Collection® and Studio by jcpenney Home Collection®). They see this as 300 bps of margin improvement.

JCP has taken $800 million in costs out of the business. They are also confident that they can better utilize the $1 billion in advertising spend or cut it. These adjustments should recreate almost 800 bps of margin according to the company.

Easy Comps to Beat
JCP has seen unprecedented same store sales drops as it tried to change its image. This has ended and they have bottomed on the sales losses. The website sales turned up and are tracking in high 20% growth. They cited that Ron Johnson led JCP had a website that didn't work and they fixed it. The website is 10% of sales and growing. More importantly, they see the website as a leading indicator of the physical store business.

It looks like December was a poor SSS comp based on the lack of details given in the press release. This has set the bar very low. Further, it seems management is intentionally tanking Q4 and Q1 to clear out inventory and should benefit coming into the 2H of 2014.

If this is accurate then JCP has a higher likelihood of recapturing the customer as they are price shoppers and will not be drawn away for the experience. Also, high probability that JCP shopper was already frequenting the Big Box and therefore only shifted purchases. A sign of the accuracy of the contention is that the St. Johns Bay label, which is owned by JCP, was shifted to TJX under Ron Johnson and has continued to sell through.

Near Term Catalysts
*JCP is currently searching for a new CEO. They should announce a new CEO during the next few months. This will allow for a "honeymoon" period which a new strategy can be formulated.
*JCP will probably announce some store closures which will lead to a cost reduction and some benefit to the stock.
*JCP has some non-core assets to sell; Tire & Battery business to Firestone and have been selling regional mall ownership.
*JCP will the end of sales losses and a move to slight growth. Driven by some simple changes into Q2 2014 (1) Return of commission selling in jewelry by February (i.e., Valentine's Day) with furniture and window coverings added by March, (2) Re-pricing effort under way with jewelry completed by February (return to High-Low = IMU benefit), (3) Assortment changes including improved St. John's Bay in-stocks w/ lower margin prior mgmt shop-in-shops reduced (i.e., Joe Fresh/Bodum), and (4) Return of Ambrielle by February - JCP's former private-label lingerie brand.

No Balance Sheet Issues
JCP refinanced its ABL facility, issued equity and pushed out maturities. They have no significant debt maturities until 2018. They have $1.2 billion in cash. They have spent $1.8 billion in CapEx over last two years reducing cash needs.

When JCP was most under duress the refinanced the ABL facility for $650 million with $400 million accordion feature. During this point GS valued their real estate at $4.1 billion based on a non-robust appraisal.
Valuation - 9 (10 best and 1 worst)

If JCP can stabilize sales and margins then they would have EBITDA margins around 9-10% on sales of $13-14 billion in 2015. At 7.5x EV/EBITDA JCP price should be $15-16.

Risks
1) Continued loss of revenue
2) Inability to find viable CEO/ management transition

Disclosure: The author, his family, and funds the author manages and/or is associated with may or may not have a position in any of the securities mentioned in this write-up. Any of the aforementioned may trade in and out and around any of the securities mentioned without notifying you. The analysis presented is the author's own and is believed to be accurate. Do your own diligence. This write-up constitutes analysis and/or market commentary and is not an investment recommendation and as such, should not be used in isolation to make an investment decision. The author undertakes no obligation to update this report based on any future events or information. Estimates are subject to numerous assumptions, risks and uncertainties which change over time