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Tuesday, May 18, 1999

An Investment Opinion
by Warren Gump

Will J.C. Penney Moves Make Dollars?

J.C. Penney (NYSE: JCP), the mid-scale department store and drugstore operator, announced this morning that it was going to implement a couple of initiatives in an attempt to enhance shareholder value. First, the company plans to sell off a 20% interest in its Eckerd drugstore unit via a tracking stock IPO sometime in Q4 1999. The remaining 80% of Eckerd's tracking stock is expected to be spun off to shareholders in a tax-free transaction sometime in the year 2000. In addition, J.C. Penney plans to sell off its credit card receivables and outsource its credit card operations to a third party. Investors seemed to think the news was better than a dose of Prozac, running the stock up $4 7/16 (or 9.7%) to $50 1/8.

The logic behind the Eckerd spinoff is quite simple. The stock market values department stores and drug stores very differently. This valuation discrepancy results primarily from department stores being a fairly mature business that is highly dependent on economic cycles, whereas drugstores are considered to be a recession-resistant growth industry (thanks to aging baby boomers). Looking perfunctorily at the average Price/Earnings (P/E) ratio for the four largest drugstores and major department stores on Bloomberg, drugstores are trading at 28x current year earnings expectations, while department stores are trading at 19x estimates. If J.C. Penney were able to maintain its own multiple and attract a closer-to-market multiple on its Eckerd earnings, value would obviously be created.

Another important factor to the tracking stock is the consolidation of the drugstore industry. Over the past few years, drugstores have been gobbling each other up. Many of these transactions have involved the acquiring company paying the acquired in stock. The higher your earnings multiple, the fewer number of shares you will need to issue in such acquisitions. With a competitor like CVS Corp. (NYSE: CVS) having a multiple of 31x estimates for 1999, J.C. Penney is at a distinct disadvantage as an acquirer if it uses a stock trading at 17x current year estimates (today's multiple). If the company could use an Eckerd tracking stock trading at, say, 25x-30x estimates, the playing field would be closer to being level.

As to sale of credit card receivables and the outsourcing of credit card functions, J.C. Penney is raising cash and trying to improve its product offerings. At the time a sale is expected to be completed (sometime during Q4), the company should have about $4 billion in receivables. The proceeds will be used to reduce J.C. Penney's debt outstanding, reducing leverage on the balance sheet. In addition, ongoing working capital needs will be reduced since receivables won't need to be funded. The cost of these moves, which is not insubstantial, will be the loss of profitability associated with the credit card business. From a product standpoint, a third-party manager should be able to provide more comprehensive and customized offerings since they will likely have a much more sophisticated technological infrastructure.

Beyond these strategic initiatives, J.C. Penney also announced earnings for its first quarter. While earnings per share (EPS) of $0.60 (excluding a one-time gain of $0.01) were well ahead of the $0.53 estimate, they were still below the $0.64 earned last year. Total revenue increased 7.3% to $7.5 billion, while net income fell 4% to $167 million.

Sales at the department and catalog stores were basically flat overall, but comparable department store sales declined 0.5%. Even worse, margins were hampered as the company tried to clear out merchandise that wasn't selling well. Operating profits for the division fell 29% to $167 million from $234 million.

J.C. Penney department stores have been suffering as consumers go elsewhere for their clothes. Consumers have generally been favoring specialty stores over department stores of late. In particular, competition from quickly expanding concepts like Old Navy and Kohl's (NYSE: KSS) have hurt Penney's. To combat this threat, J.C. Penney management is trying to emphasize its proprietary brands like Stafford, Hunt Club, and St. John's Bay by setting up "specialty shops" within the department stores. J.C. Penney Chairman James Oesterreicher reportedly said that sales for these brands increased 10%-16% in April.

An important thing to remember when investing in J.C. Penney is that the department stores and catalog operation account for a majority of profitability at the company. Despite a 26% fall in operating profit for the division last year, department stores and catalog still accounted for two-thirds of J.C. Penney's overall operating profit. This business is key to the company's overall health. While results later this year will likely show an improvement when compared to last year's disastrously weak numbers, expectations for this year are still below the levels achieved two years ago. Penney's will have to make some drastic changes to achieve positive long-term growth in this business.

Eckerd's results were much stronger than J.C. Penney's department store business. Overall revenue grew 19% and comparable store sales increased 12.3%. This increase was driven by a 17.7% increase in same-store pharmacy sales and a 4.5% improvement of "front-end," or nonprescription, merchandise. Although sales were increasing nicely, operating profit only increased 8.4% to $129 million as margins were squeezed by an increasing percentage of lower-margin managed care pharmaceutical sales.

To put those results in perspective, CVS reported an 18% increase in revenue and a 23% increase in operating profit in its first quarter. Walgreen (NYSE: WAG), generally considered the preeminent retail drug chain, saw a 15% increase in sales and 17% jump in operating profit in its most recent quarter. Given the nature of Eckerd's business, it will obviously be accorded a higher earnings multiple than J.C. Penney's namesake stores. For it to achieve a comparable multiple to its peers, though, it will need to achieve reasonably comparable results. Right now, that doesn't appear to be happening.

Today's announcement of J.C. Penney's strategic initiatives indicate that management is trying to address the problems plaguing the company. From an investment standpoint, however, potential investors need to ask how confident they are that these changes will ultimately revive performance in company stores. While Eckerd's results simply need some spiffing up, the department stores -- the major contributor to earnings -- need a full makeover. If you believe management will turn around operations, the stock could be appealing right now. If you aren't sure how the ship will be turned around, holding off for clearer signs of rejuvenation may be more prudent.

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