Why J.C. Penney May Be a Better Turnaround Bet Than Sears

While J.C. Penney (NYSE: JCP  ) , Sears Holdings (NASDAQ: SHLD  ) , and Best Buy investors eagerly wait for elusive turnarounds, these beleaguered big-box retailers seem to be held together feebly by blue kinesiology tape. These three have witnessed more false dawns than Groundhog Day, and every time one of them turns a corner it quickly crashes into a wall.

That's why J.C. Penney investors were so excited when the company released its latest results, which revealed that chief executive Mike Ullman might finally be succeeding in turning his battleship around. Same-store sales improved 2% from the year-ago quarter, a 680 basis-point improvement. Its online division grew sales 26.3%. The company had free cash flow of $246 million and finished the year with more than $2 billion in available liquidity, which was something of a miracle considering that many sell-side analysts had expected J.C. Penney to go bankrupt during the year. Another bright spot in the company's earnings call was the 460 basis-point improvement in its gross margin, which rose from 23.8% to 28.4%.

Although the gross margin is still way below its historical average of around 38%, this is a sure sign that the company might be finally getting rid of its Ron Johnson-era merchandise. Heavy product markdowns on this merchandise led to J.C. Penney's low gross margins in the previous quarters. J.C. Penney's naysayers can squawk that 2012 was pretty awful so the year provided an easier benchmark for last year's metrics. The good news, however, was that J.C. Penney's absolute metrics such as free cash flow and liquidity were still quite impressive.

Meanwhile, ailing Sears continues to rely on its extensive real estate properties, some of which it intends to convert to data centers while it will sell the really prime ones. Sears reported that it lost $1.4 billion for the whole of fiscal 2014, with same-store sales plunging 7.8%. Ailing peer Best Buy at least turned a profit of $310 million in the fourth quarter of fiscal 2013, much better than the year-ago quarter's loss of $461 million.

J.C. Penney's strategy vs. Sears' turnaround strategy
J.C. Penney's turnaround strategy radically differs from that of Sears. Under former CEO Ron Johnson, J.C. Penney discarded its traditional retailing practice of marking up its products and then offering fat discounts and coupons on its merchandise, instead adopting an 'everyday low price' policy. Mr. Johnson reasoned that the company's heavy discounting policies not only cut into its pricing power, they also considerably diminished its gravitas in the eyes of its customers. He scrapped several brands that he considered rather drab and introduced newer ones such as the Martha Stewart and Joe Fresh lines.

However, J.C. Penney's customers were not happy and store traffic nosedived. By the end of 2012, sales had tanked 25%. The overambitious CEO tried feverishly to lure customers back but nothing seemed to work.

It was not until Myron Ullman returned to the helm that J.C. Penney stuttered back to life. He revealed sometime late last year that Penney was trimming or eliminating unprofitable brands such as JCP Menswear, Joe Fresh clothes, and several brands of Martha Stewart-designed furniture. Mr. Ullman also announced that the retailer planned to introduce new brands such as JCP Home, Cooks, and the Am Brielle lingerie line.

To get rid of the old merchandise, J.C. Penney has been offering heavy product markdowns and this has inevitably beaten down its gross margin. However, Mr. Ullman has revealed that the turnaround is almost complete, so investors can expect to see a natural upward progression of the gross margin. A quick caveat: although Penney's historical gross margin resides north of 37.5%, it is unlikely to zoom there quickly since the company plans to continue discounting its goods to keep its customers coming back.

J.C. Penney also plans to close 33 of its unprofitable stores. About 25% of these stores are concentrated in the Wisconsin area. However, it is unlikely that the company will close many other stores soon. This is due to the fact that anchor stores routinely sport long-term leases which are expensive to break. Penney might therefore prefer to continue to operate the unprofitable stores rather than break their leases and pay the price.

That is in and of itself a good thing, since the losses from these underperforming stores are already priced into J.C. Penney's shares. If J.C. Penney's turnaround continues moving along its current trajectory, then these unprofitable stores could potentially become goldmines for the company's shareholders.

Sears has a very different turnaround strategy from that of J.C. Penney. Its management and shareholders have continued to tout the unrealized value of its numerous real estate properties, many of which it intends to convert to data centers.

However, the real value of these properties continues to be a subject of debate, especially after the highly controversial Baker Street Report left Wall Street's opinions on the company divided right down the middle. 

Sears Holdings: Two views
The table below shows how Sears' assets are valued by two opposing firms, Baker Street and Credit Suisse; one has a bullish stance and the other is decidedly bearish.

 

Bull Case:

Bear Case:

Assets

Baker Street

Credit Suisse

Real Estate

$10.1 billion

$3.2 billion

Kenmore, Craftsman & Diehard

3.0

2.4

Home Services & Protection

2.4

1.0

Lands' End

1.6

1.4

Sears Online

1.5

0.3

Sears Canada

1.0

0.5

Sears Auto

0.7

0.5

Other

0.9

0.3

Value of Assets

21.2

9.7

Value per Share*

$169.0

$28.3

 

 

 

Research analyst Rich Kurtzbein, who follows data centers for 451 Research LLC, warns that the viability of converting Sears' shopping malls is questionable at best.

Sears, unlike J.C. Penney, does not seem to be very intent on turning around the flagging fortunes of its ailing retail stores. That's why its sales have continued to decline one quarter after the other.

Foolish takeaway
J.C. Penney is not the falling knife which it has been labeled by its detractors, it is rather a company that is serious on making a comeback. Meanwhile Sears is busy selling off its extensive real estate properties to fund its operations and keep investors happy while its retail fortunes continue on a tailspin. That strategy is comparable to burning your house furniture to keep warm; eventually you will be left with no furniture to burn. J.C. Penney is a better turnaround bet than Sears.

What does the Oracle of Omaha think?
Warren Buffett has made billions through his brilliantly simple investing philosophy and he wants you to be able to invest like him. According to Buffett "turnarounds seldom turn." Not because there's any lack of opportunity for the company, but rather the company lacks a competitive advantage to sustain long-term outperformance. Focusing on anything but that leaves you with only enough room for speculation. And we all know that's not how Buffett built his fortune. Tap into the best of Warren Buffett's wisdom in a new special report from The Motley Fool. Click here now for a free copy of this invaluable report.


Read/Post Comments (5) | Recommend This Article (7)

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  • Report this Comment On March 09, 2014, at 12:43 AM, Trayjay1 wrote:

    Nice article and I agree that JCP looks good for further improvement. I feel that you glossed over what I see as an exceptional opportunity in Sears. Below are some points that may encourage deeper evaluation. (I'm an individual investor with holdings in JCP, SHOS and SHLD).

    1) Eddie Lampert is migrating hard good sales (appliances, Craftsman, others) from SHLD to SHOS. Typically SHOS stores pop up around the locations where a major Sears store closes. Lampert owns over 50% of both, so he can treat them similar to a single entity and strategically migrate sales from SHLD to SHOS with no adverse financial impact. Looking at the combined sales of SHLD and SHOS indicates a relatively insignificant YOY change in total sales for this "ecosystem".

    SHOS has over 1100 stores now, and may grow to 3000 stores at full deployment. The company was profitable in it's 2nd year of operation, and is already the #5 appliance retailer in the USA.

    2) There is more to the activity around the commercial real estate (CRE). Some closed properties are re-leased as data centers, but others are leasing to the likes of Michael Kors and Whole Foods. Sears has a division called Seritage that handles disposition of the CRE freed up by store closings, Most of the quality properties are getting leased, not sold.

    Sears owns nearly all its property in class A malls - those operated by General Growth and Simon Properties.Some measures puts Sears footprint in these class A malls near 10% of the total footage. There is a shortage of property in these class A malls - expected to exist 5-10 years. GGP and SPG have expressed acceptance that Sears can lease these properties.

    SPG+GGP lease significant parts of the property under their malls and have combined market cap of ~$70B. SHLD owns nearly all their property in these malls, and with the $36B in sales and the CRE, has market cap of...$2B.

    Premature to conclude now, but one can imagine Seritage emerging as a major CRE REIT in a few years.

    3) SHLD has ~$3B in liquidity now, and will add $500M when Land's End spins off this year, so liquidity is a non-issue. In addition, the store closings decrease SGA expense, which creates leveraged improvement in EBIDTA. Leasing revenue will grow significantly via the efforts of Seritage.

    4) There's more - around the online/in-store evolution of Sear's other (non-hard good) sales and the auto centers. Both are significant in the forward strategy, but a story for another day.

    Lampert has been secretive in forming his strategy until now, and it's left investors confused and negative on the opportunity. This well may reverse -possibly this year, as the strategy become better known and (more importantly) the execution delivers results.

  • Report this Comment On March 09, 2014, at 5:38 PM, MSFInvestments wrote:

    Great points tray,

    Regarding the real estate, Bruce Berkowitz went to each property and did a valuation on them, he claims the stock is valued north if $150.00 in 2014. Baker Street also had a valuation done. Credit Suisse owns SHLD stock. Did they go to each property.

  • Report this Comment On March 09, 2014, at 8:39 PM, MSFInvestments wrote:

    Tray, the Call Options also expect a move in the stock this year.The Open Interest in the January 2015 $60 and $70 Calls are massive.

    www.seritage.com, KCD IP,llc., www.ubiquityce.com, www.metascale.com, Sears Reinsurance, are just a few of the holdings in the company.

    Sears Holdings is a holdings company.

    Lahiem

  • Report this Comment On March 10, 2014, at 3:34 PM, blogd2death wrote:

    Doesn't the math in your chart bother you?

    Fully dilluted SHLD shares are 109

    For 21.2bb to go to $169 implies debt is being taken out. However Baker Street is taking out $25 per share. The constantly bearish analyst at CSFB

    is taking out $60 per share to get to $28 value.

    Don't you wonder why one analyst is claiming $60 per share debt and another $25?

  • Report this Comment On March 10, 2014, at 7:29 PM, MSFInvestments wrote:

    The author forgot to mention Sears Reinsurance as well as other hidden value.

    SHOS will generate massive cash flow to SHC.

    Lahiem

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