Plucking Penney From the Scrap Heap

Last year at this time, if anyone was discussing J.C. Penney at all, it was generally to disparage the company as its operations turned negative and its stock headed south. Arne Alsin saw something else: a company with new management that had turned around several hounds and made some much-needed changes. So far, Alsin has been dead on.

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By Bill Mann (TMF Otter)
August 27, 2001

My "You've got to be kidding me" call of the year has to go to Arne Alsin, head of Alsin Capital Management and contributor to Last December, when J.C. Penney (NYSE: JCP) was trading at $10 and change he called it a top turnaround candidate for 2001.

The company now sits at $25.

Everyone gets a flash in the pan once in a while, right? Heck, tech stocks used to go up 150% in a day, and now that they're down Alsin is just benefiting from an investor flight to safety. Well, maybe, but who was calling J.C. Penney a "safe stock" in 2000? Many four-letter words were being used to describe Penney's stock, but "safe" was not one of them.

Alsin did some great fundamental research, and he deserves to be praised for it. Last year, Penney's business looked like it was collapsing -- just one more big retailer that had simply failed to change with the times. Its brothers in arms, Kmart (NYSE: KM) and Sears (NYSE: S), were right there with it.

Follow the CEO
But Alsin did something very smart: He followed the CEO. In this case, Penney's incoming CEO, Allen Questrom, had already performed CPR on retailers Federated Department Stores (NYSE: FD) and Barneys, which is a private company. Alsin bet that Questrom had not lost his touch, and that Penney was a vessel with potential for recovery. (Our recent special feature on "How to Evaluate Management" has more on this topic.)

The most important issues Alsin picked up on were the company's profit margins and same-store sales growth, both of which were miserable through the late 1990s, even in comparison to the company's peer group, among whom 5% net margins are essentially unheard of. But Penney's was running at a slight net operating deficit. The question then became: What underlying strength could the enterprising investor have perceived?

Penney's new management was rapidly delivering its balance sheet. Where long-term debt was $6.5 billion in October 1999, it was down to $5.4 billion by the same time in 2001. The money saved on interest payments alone in 2000 came out to $145 million. This debt retirement caused a drop in capital-to-debt ratios in the year, but would also pay excellent dividends in the form of avoided cost of capital.

The other promising trend in Penney's financials was a dramatic lowering in both receivables (money owed by customers) and inventories. Some receivable reduction came due to Penney's exit from its credit card operations, but another factor also began to pay off: Merchandising decisions were, for the first time, being made centrally as opposed to by individual stores. This allowed the company to take advantage of its size in regard to its purchases, and should help Penney become more responsive to ever-changing styles. Using its former method, Penney was getting murdered by fashion risk.

These days investors seem to be taking another look at J.C. Penney -- as well as Sears and Kmart -- as each continues trying to re-establish themselves in the low- to middle-ground of retailers. Each has a long way to go. I received an email the other day titled "Note from Australia: Sears sucks."

But Alsin had the right idea last year: Look at companies everyone else hates -- or, even better, ignores -- and see if any of them have signs of hidden value or potential. It's not an easy way to invest, but it can pay off nicely when you do your homework.

Bill Mann's favorite Steve Forbes quote is "Rage Against the Machine is here!" At time of publishing, Bill owned none of the companies mentioned in this article. The Motley Fool is investors writing for investors.

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