Critics of J.C. Penney's (NYSE: JCP) transformation say it's a gamble.
I agree.
But I think it's a gamble that can win either way. I look at J.C. Penney, my newest CAPScall, is terms of Pascal's Wager.
If I'm right: The transformation at J.C. Penney works and the stock's intrinsic value goes up 10 times, as Bill Ackman and Whitney Tilson predict. Many of J.C. Penney's biggest costs -- including rent, marketing, and administration -- are fixed, so increases in revenue will have an exaggerated effect on the bottom line. That's what's known as operating leverage, and it's the reason McDonald's (NYSE: MCD) was able to grow operating income fourfold since 2002 despite not selling 4 times as many hamburgers. The same force can work for (and against) Penney's.
If I'm wrong: The company brings back coupons, and shareholders get the company at 10 times average Great Recession free cash flow, plus whatever cost savings and working-capital improvements CEO Ron Johnson has put in place.
Or Johnson and Co. slowly liquidate the company and its real estate.
Bill Ackman -- whose fund, Pershing Square Capital, owns 26% of J.C. Penney -- claims the replacement value of the retailer's real estate is $11 billion. Since the enterprise value of J.C. Penney is around $7.5 billion, in theory shareholders come out ahead in a liquidation. This is where having Steve Roth and Vornado (NYSE: VNO) on the board comes in handy.
Of course, we can't know what the real estate is really worth until the company tries to sell it -- *cough* Bruce Berkowitz and St. Joe *cough* -- but I don't think there's anything Johnson has done, or is planning to do, that is both offensive and could not be undone if necessary. The shoppers who have defected to Kohl's (NYSE: KSS) and Macy's (NYSE: M) because of allegiance to coupons will probably shop wherever they find the best deals, including J.C. Penney.
To be clear, J.C. Penney is not a risk-free investment. No investment, short of inflation-indexed U.S. Treasuries, can make that claim. The economy could sink to previously unseen depths; there could be another terrorist attack; the new merchandise may tarnish the brand; Johnson may burn through more cash than expected, issue more debt, or suddenly decide that every J.C. Penney needs a children's petting zoo featuring exotic snakes.
But alas, I think the probabilities favor the bulls.
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