Can J.C. Penney and Its Shareholders Be Saved?

Can J.C. Penney (NYSE: JCP  ) be turned around? Doubts have been growing thanks to the company's litany of problems. A failed store revamp, increased management turmoil, and a surprise stock offering all hint at a continued decline. The retailer wasn't always the struggling business we see today, of course. There is some historical evidence that shows that the company can earn a decent profit. Here's a take on what a successful Penney turnaround might look like and what it could mean for shareholders.

Penney's past: The good and bad
An indication of what a renewed Penney could accomplish can be found in the firm's past performance. Penney's current business is clearly in a sorry state. Last year's result is ample proof. Net sales fell over 24% in 2012, compared to the prior year. The drop was due to a massive customer exodus when the company tried to enter the up-market specialty store space. Comparable-store sales, an important indicator of a retailer's health, dropped over 25%. Profitability also plummeted. Penney's gross margins as a percentage of sales fell to a dismal 31.3%, compared to 36% in 2011. The company posted a stunning cash earnings loss of around $643 million, compared to profits of $411 million a year earlier.
 
J.C. Penney wasn't always in such a dire way, however. It has delivered respectable results in the past, even in tough economic times. In 2009, the company reported comparable-store sales decreasing over 6% as mall traffic dropped due to weak overall consumer spending. Despite this, the company held its own profitability wise. Gross margins increased to 39.4% of sales, thanks largely to good inventory control and limited clearance selling. These steps helped Penney post fairly good cash earnings of around $716 million, or about 4.07% of total sales. 

Penney's peers
While the retailer's capability for generating profits in harrowing conditions shows what might be accomplished, peer comparisons may also uncover the most that can be expected from a Penney's rebound.

Macy's  (NYSE: M  ) , a well respected competitor and one of the nation's premier retailers, reported that its sales for fiscal 2012, including an extra selling week, were up 4.9% year over year. On a comparable store basis, sales were up 3.7%. The company's gains can be attributed to a successful merchandise and marketing strategy, including specifically targeted goods and discounts for different customer categories and locations. Gross margins came in at a strong 40.3% of sales, equal to the prior year. Cash earnings were $1.91 billion or 6.89% of sales, up nicely from 2011's earnings of $1.76 billion or 6.65% of sales.

Kohl's (NYSE: KSS  ) , a value-oriented department store, also competes for the J.C. Penney customer. Its 2012 results were solid but subdued. Total net sales for 2012 were $19.3 billion, a 2.5% increase over 2011, but comparable-store sales were basically flat. The company's 2012 gross margins fell to 36.3% of sales, resulting from a drop in selling prices that was needed to drive customer traffic during the holiday season. Higher apparel costs also hurt profits. Cash earnings were reported at $1.39 billion, or around 7.20% of sales, versus 8.12% of sales in 2011.

A summary of past and peer results
A review of the company's past performance and its peers' comparative results can provide a guide for a reasonable J.C. Penney turnaround. While it's doubtful that Penney will be able to match Macy's or Kohl's performance anytime soon, it could come near its own past results.

Summary of Retail Performance
 

  JCP 2012

 JCP 2009  Macy's 2012  Kohl's 2012
Revenue      $13.0 B      $17.6 B         $27.7 B        $19.3 B
Gross margin         31.3%        39.4%            40.3%           36.3%
Cash earnings  -$643 mm   $716 mm         $1.91 B        $1.39 B
Earnings margin                nil        4.07%            6.89%           7.20%

Source: SEC 10-K filings.

What could a turnaround look like?
Based on the historical figures, a successful Penney turnaround might look something like this:

              JCP Goal
Revenue                $15.2 B
Gross margin                  35%
Cash earnings             $456 mm
Earnings margin                   3.00%

If the company can meet this objective, what would it mean for the stock price? Using a cash earnings times capitalization multiplier valuation method, Penney's fair business value would calculate to around $10 to $11 a share. This is assuming the $456 million in cash earnings warrants a 7x multiple, which is a little less than the unassuming 8x multiple that Macy's and Kohl's are currently trading at.

How likely is a rebound?
J.C. Penney might have a decent chance of meeting this turnaround target. The company's recent equity offering probably provides enough liquidity for the company to get into 2015 before it runs into potential cash difficulties. Given that, its estimate of around $2.15 billion in liquidity at the end of this fiscal year (including the roughly $850 million provided from the recent stock sale) can likely be met or topped.

Though the company may have the time to rebound, it still faces some daunting obstacles. The most obvious is faulty execution. Being in such a weakened financial state, J.C. Penney has little wiggle room. One mistake in implementing the rejuvenation could sink the company.

A less recognized, and possibly more lethal, risk is a general economic downturn. In my experience with retail failures such as Ames Department Stores in 1990 and 2001, Caldor's Stores in 1995, and Kmart in 2001, it is often an unexpected economic decline that tips a damaged retailer into bankruptcy. While struggling businesses can usually be kept afloat during good times, reduced consumer spending and a tightening credit environment brought on by a faltering economy will often force strained retailers out of business.

Bottom line
J.C. Penney has shown in the past that it can earn a profit. It now has a chance to do it again, though it is a perilous endeavor. Poor implementation or an unexpected business downturn could force the company into insolvency. If investors choose to participate in this renewal, they may want to make sure they are going to be well compensated for betting on a successful Penney turnaround.

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  • Report this Comment On October 07, 2013, at 3:59 PM, a1sauce wrote:

    Even if JCP managers a turn-around with large debt and enthusiastic creditors, naive shareholders and trusting suppliers, it will be just another large "me too" chain-store in a crowded field dedicated to selling mid-price goods to a rapidly shrinking middle class. But JCP has proven to be too asset-based and inefficient in today's market. Sometimes, its important to allow assets and people to be recyled from being tied-up in failing businesses so that more efficient businesses can progress. I say, the earlier the better, not only for JCP but its investors, creditors, employees, suppliers and customers. The first shoe has fallen, now for the second.....

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