Tuesday, March 26, 2013
JC Penney - Maximum Pessimism?
If you go to Yahoo Finance and search for headlines of J.C. Penney (JCP), chances are you will not see many positive headlines. In fact, you probably don't even need to go to Yahoo Finance — the popular media and Wall Street analysts have been nothing but negative about the outlook for J.C. Penney. Below are a few quotes:
"An analyst at BMO Capital Markets downgraded JCP from marketperform to underperform, and said at this rate the company may go bankrupt next year. The company's stock is now at less than 40% of its 52-week high, which was a year ago tomorrow."
"J.C. Penney has been a train wreck whose comeback always seems just around the next earnings corner, but investors are beginning to doubt that CEO Ron Johnson can weave the same magic that he did at Apple." — CNBC
"J.C. Penney is doing everything short of walking into your living room and executing short trades for you. They're screaming from rooftops in their last annual filing that things aren't going as planned. The stock chart looks like a slalom route for the '98 Nagano men's Olympic downhill team." — Motley Fool
"The company is stuck on a mezozoic era branding problem, and has failed to make massive, paradigm shifting changes to their business. They are not focusing enough on online sales and younger generations, all the while seriously burning through cash." — Seeking Alpha
Further evidences of pessimism include a 42% short interest in J.C. Penney's stock and only one "buy" rating from analysts covering J.C. Penney. So the pessimism is obvious, but the question is, does this represent "rational herding" (i.e. JCP is a value trap) or does this represent a buying-at-maximum-pessimism opportunity? There are a few apparent and seemingly compelling arguments for being bearish on JCP:
1. The turnaround has not been working. Sales are down 25% year over year and 31% for the most recent quarter. The loss is even more horrendous and profit margin is deteriorating.
2. J.C. Penny has been losing old customers and not been able to attract enough new customers. The pricing strategy in 2012 isolated itself from its loyal old customers and they may never come back.
3. A major insider (Varnado) has lost faith in J.C. Penney by dumping 40% of its shares.
4. J.C. Penney will be burning cash at an accelerated rate and may not exist in a few years.
5. Sales will most likely continue to go down unless Johnson is fired.
6. The Martha Stewart Store may not work out.
7. The shops are not enough to save J.C. Penney.
8. J.C. Penney's new executives are not even living in Texas. They are not involved enough in the day-to-day operation.
I think these are all valid points, but I do have a few questions to the investors who share the above bearish view:
1. Are the bad news reflected in JC Penney's stock price?
2. Does the other side of the trade-namely the buyers of JC Penneys' stock, know about those negative views?
3. Are you subject to the availability bias, the confirmation bias, the endowment bias and the social proof bias?
4. Have you done a thorough research (not just visiting stores) and come up with risk/reward analysis?
5. Did Ron Johnson and the Penney Board ever say the turnaround will be done in 2013 and did he mention that sales and profits will be down for a while?
If you read "Celebration of Fools" by Bill Hare, you will find out that the problem with J.C. Penney did not start with Ron Johnson. Early problems with J.C. Penney emerged at the late years when Bill Howell was still Penney's CEO. Bill Howell was not known for any particular stellar accomplishment, unlike the previous Penney's CEOs. He was charismatic politically with an executive image. He always chose his publicized appearance with great care, favoring prestige events like serving on a While House Blue ribbon panel. He started paying a lot of attention to Wall Street and under his reign, J.C. Penny became overly bureaucratic. Jim Osterreicher, the CEO after Bill Howell, was unable to make important decisions until last minutes and not communicating what he wanted exactly. Osterreicher also made bad acquisitions such as Eckerd. Neither Allen Questrom nor Mike Ullman made things better for J.C. Penney. Mike Ullman initiated massive off-mall stores investments which proved to be unsuccessful.
Continued struggle since the 1990s made it clear that J.C. Penney needed a change, to quote Mil Batten, J.C. Penney's legendary CEO, "Change, of course, is the only constant, the future never assured. So to not plan for change and not invest in the future would be crazy, no matter what Wall Street says." This is why I believe Bill Ackman brought in Ron Johnson. J.C. Penney needed a change, and not a small one.
The changes Johnson made have been discouraging so far, to say the best. However, there is some hope. First, Johnson made a few big mistakes, but he had realized that he screwed up and he had taken steps to correct those mistakes. Admitting mistakes and learning from them is not the easiest thing in the world. Second, J.C. Penney only installed a very small portion of shops so far. The result of Joe Fresh and the like is still to be seen, but it is hard to imagine those shops will do worse than their current lineups. Third, one reason sales and margins were down dramatically last year is that Johnson's team got rid of a lot of old obsolete inventories. Inventories went down by $600 million during 2012 and most likely the majority of them were sold below cost. This is unlikely to happen in 2013. Therefore, I expect at least better margins for 2013.
One of my favorite and most respected writers and investors on GuruFocus, The Science of Hitting, has done a masterful job of analyzing J.C. Penney from a consumer's perspective. His article is a good read (at least for the sake of disconfirming evidence) for JCP bears.
As far as valuation is concerned, I calculated for the liquidation value and came up with a range of $13 to $16, assuming a 33% discount on inventory at lower cost or market as shown on the balance sheet, and if you mark up 40% of J.C. Penney's property value by 50% (Penney owns a little more than 40% of the approximately 1,100 stores). There are other assumptions regarding other assets such as deferred taxes assets but they are not material. I think Whitney Tilson and Bill Ackman have also calculated the down side risk for J.C. Penney as well. The point is, at less than $15 per share, the market has pretty much priced in the worst for J.C. Penney, and it looks that at this point the risk/reward ratio favors the long side of the stock. Of course I could be very wrong about JC Penney but if that's the case, I will be grateful for the learning oppportunity.
I also want to share with you the stories of a few most recent notorious value traps:
Current Price as of 3/26/2013: 3.30
Current Price as of 3/26/2013:23.64
Current Price as of 3/26/2013:14.46
Current Price as of 3/26/2013:27.60
Current Price as of 3/26/2013: 3.36
Let me end with one of my favorite quotes:
"The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell." — Sir John Templeton
With that, I welcome any criticism and further discussion.
Disclosure: Long JCP and long JCP Call Options