Exclusive update by Jeremy Bowman
Well, we knew it was coming; we just didn't know when.
Ron Johnson finally got the boot at J.C. Penney after one of the more terrific implosions in the history of retail. Rumor has it his next step will be to reformulate the Coca-Cola recipe or go in search of the Northwest Passage. I'm kidding, of course, but it's hard to exaggerate the disaster that was Johnson's tenure.
Let's take a look back at some of the numbers from Penney's fiscal 2012:
- Full-year loss of $985 million or $4.49 a share, down from a loss of $152 million or $0.70 a share the year before. Adjusted full-year loss of $766 million or $3.49 a share down from a profit of $207 million or $0.94 a share.
- Total sales down 24.8%. Same-store sales down 25.2%. Internet sales down 33%. Each quarter's results were worse than the one before it.
- Gross margin down from 36% in 2011 to 31.3% in 2012.
- Share price down 68% from a peak of $43.13 on Feb. 9, 2012, to $13.93 on April 9, 2013, when Johnson's departure was announced.
- Net tangible assets down 21% to $3.17 billion, now essentially equal to J.C. Penney's market cap.
Johnson's fatal error seemed to be misreading Penney's customer base. Unlike Apple, his former employer, Penney isn't selling any kind of innovative technology or chic product, nor was it selling to a young, tech-savvy crowd willing to part with big bucks to get their hands on the newest iToy. The two companies could hardly be any different. J.C. Penney is a 100-year-old department-store brand that serves a much older, price-sensitive demographic -- they're looking for savings over quality, unlike Apple's consumers, who want the best product on the market.
The verdict may still be out on Johnson's shops-within-a-store strategy, but his attempt to change the retailer's pricing model to an "Everyday Low Prices" strategy from the more traditional "high-low" markdown-heavy strategy failed. Johnson hoped to train his customers to see the value in the new model, calling it "fair and square," but his shoppers didn't understand it and didn't like it, instead fleeing to rivals such as Macy's. Notoriously, Johnson refused to test the strategy, a standard industry practice, and he paid the price as a result. After dialing back the new pricing model in incremental steps, J.C. Penney fully reversed course last month, but it won't be easy to get those customers back.
Who is Myron Ullman?
While some investors may have been eager to see Johnson go, the decision to bring back former CEO Myron Ullman, a bit like going back to your first wife, couldn't have been the most inspiring to investors, and the 12% drop in the share price the day of the announcement would seem to indicate so. Ullman, 66, was CEO at J.C. Penney for seven years, from 2004 to 2011, before retiring and being replaced by Johnson. Penney considered promoting a current or former executive to the post, as well as an outside hire, to step in for Johnson, but the retailer did not find anyone eager to take on such a daunting task. Starbucks CEO Howard Schultz summed up the difficult path ahead, saying, "The biggest challenge is the significant headwinds of the marketplace and some of the damage that has been done to the J.C. Penney brand," according to The Wall Street Journal.
During Ullman's seven years as head of the company, shares climbed to more than $80 in 2007, before falling back to the $30 range that shares were at when he took control in 2004. Before he joined Penney, Ullman's retail career took him to Macy's in the '80s and later Louis Vuitton Moet Hennessy before he retired in 2001 due to health concerns. He came out of retirement when J.C. Penney tapped him in 2004 to be chief. As CEO, he rolled out the mini-shops strategy, which Johnson built on, and brought in well-respected brands such as Sephora, MNG by Mango, and Liz Claiborne. Looking at the chart below, we can see that revenue under Ullman's direction grew slightly in the run-up to the financial crisis, and then declined when the recession hit, essentially ending with zero net growth over the seven years.
Profits followed a similar trajectory but, as usual, were more sensitive to general macroeconomic conditions.
Penney's struggles in the post-recession era help explain why management brought in an innovator like Johnson in the first place.
If it were easy, everyone would do it
Needless to say, the road ahead for Ullman and Penney will be tough. Retail is a notoriously competitive industry, and once lost, customers are not easily won back. Rivals such as Macy's and Kohl's smell blood and are offering steep markdowns to lure Penney's customers.
Ullman has said he has not yet made any decisions as to which of Johnson's strategies to continue and which to dispense with. Penney is in the middle of rolling out the "shops" strategy, and a reversal would damage the brand, confusing consumers, as stores would not have the consistency shoppers expect from a well-known chain. Continuing to implement the shops strategy would be expensive, however, as revamping the stores would require cash flow for real estate improvements that the company is not currently generating through operations. Free cash flow -- operating cash flow minus capital expenditures -- was negative $820 million in the last year. Operating cash flow alone was negative $10 million.
We may not see any sudden moves from Ullman, as he has said only that his first move will be to meet with company leadership before making any major decisions. But the clock is ticking. Early reports on Penney's current quarter show the ship is still sinking, with same-store sales down more than 10%, even after last year's catastrophic drop. The current macroeconomic climate, with high unemployment, the payroll tax hike, and federal budget cuts, does the struggling retailer no favors as well. As of the retailer's last report in February, it had just $930 million in cash and nearly $3 billion in debt on its balance sheet. Continuing to bleed cash could mean a share offering filled with share dilution, real estate sales, or taking on new debt, which would likely come at a high interest rate and with tight restrictions. Bankruptcy, of course, is also a possibility.
What to do now
Despite the panic, Penney is not without its supporters. Hedge fund manager Bill Ackman, Penney's biggest shareholder and a strong advocate for hiring Johnson, is standing by his investment. He recently called Ullman "the right guy at the right time" and said Penney's shares are worth $75 instead of the $15 at which they're currently valued.
But Ackman's calculations are based on a fantasyland scenario in which Penney's real estate is in high demand, customers forget last year's debacle and flock back, and the retailer's debt magically disappears.
I see little upside potential here, and compared to other struggling retailers, J.C. Penney's shares are not even cheap, and they will only get more expensive as losses rack up and sales disappear, as we're seeing in the current quarter. Believers in a turnaround may want to consider investing in Macy's or another one of Penney's competitors as a hedge. Macy's shares just hit an all-time high and look poised to move higher as J.C. Penney's follies have been a surprise windfall for the retail stalwart.
As for Penney itself, shares may be near a natural bottom, as they're essentially priced at its liquidation value. However, the company has no plans to liquidate, and that parity should be of little comfort to investors as the company continues to burn cash at a rate near $1 billion a year.