Could J.C. Penney Really Become an 18-Bagger?

One prominent investor thinks so.

Steve Symington
Steve Symington
Feb 5, 2013 at 9:41PM
Consumer Goods

More than two years ago, activist investor Bill Ackman disclosed he had acquired a 16.5% stake in J.C. Penney (NYSE:JCP) through his hedge fund, Pershing Square Capital Management.  All in all, he had spent more than $900 million for 39 million common shares, including about 4.15 million options.

By June, 2011, he looked like a genius as the investment had risen more than 50% after J.C. Penney tapped Apple operations guru Ron Johnson as its CEO. To be sure, few people seemed more suited to right the beleaguered retailer's wrongs than Johnson. In addition to creating the Apple retail store concept and helping the outlets exceed $1 billion in annual sales within two years of their debut, Johnson was previously Target's vice president of merchandising. 

Unfortunately, the good times didn't last as J.C. Penney embarked on one of the most ambitious retail turnaround plans ever enacted. After hitting a fresh 52-week high of $43.18 last February, shares have fallen 55%, with the company badly missing expectations for both revenue and earnings per share for three consecutive quarters

J.C. Penney the multibagger?
Even so, just a few months ago and with shares trading near today's levels, Ackman boldly proclaimed his optimism for the struggling company by stating that his firm could make 15 times its money on the investment. He also claimed that it was the only stock in Pershing's portfolio capable of such returns. Given Ackman's cost basis, that would put J.C. Penney's shares near $350, assuming the company could achieve the feat absent dividends or splits.  When all's said and done, this means investors who buy now would enjoy a solid 18-bagger from Monday's close at $19.34 per share.

With those kinds of returns on the line, now might be a great time to dig deeper to see if J.C. Penney deserves a spot in your portfolio. First, let's see how it stacks up next to two of its most significant publicly traded peers:

  J.C. Penney  Macy's (NYSE:M) Dillards (NYSE:DDS)
 Market Capitalization   $4.24 billion  $15.31 billion  $3.97 billion
 Debt-to-Equity Ratio   0.85    1.25   0.41 
 Current Ratio  1.67  1.37  1.71 
 Trailing P/E Ratio  N.A.  12.00  13.21 
 Est. Forward P/E Ratio  N.A.   10.27  11.80 
 Dividend Yield  N.A.  2.00%  0.20% 
 Payout Ratio  N.A.  22%  3.00% 
 Return on Invested Capital  - 8.10%  10.90%  13.90% 
 PEG Ratio (5 yr expected)  - 0.50  0.88  2.42

Source: Yahoo! Finance.

At first glance, J.C. Penney's balance sheet looks solid with $525 million in cash and a reasonable debt-to-equity ratio of 0.85. However, we still can't assign trailing or forward P/E ratios because of brutal losses in each of the last five quarters. In addition, after reporting its first-quarter loss last year, the retailer suspended its $0.20-per-share dividend. While this gave many otherwise patient investors one more reason to jump ship and buy the shares of comparatively rock-solid competitors, it also freed up $175 million per year to be used for financing the planned transformation. Unfortunately, J.C. Penney's ROIC is currently a dismal -8.10%, reflecting its current inability to create shareholder value by reinvesting that cash in its business.  

Finally, because analysts expect earnings to continue declining, the company has a negative PEG ratio of -0.48. This might not be a bad thing if free cash flow showed dramatic improvements as earnings decreased, but significant capital expenditures have helped FCF stay significantly negative in four of the last five quarters.

The turnaround plan
To Ackman's credit, expectations for J.C. Penney are undeniably low and its stock price reflects that sentiment. Given the unsettling number of N.A.s and negative ratios in the table above, however, it seems investors have every right to be scared.

Initially, J.C. Penney completely abandoned its traditional coupon-centric approach in favor of everyday low prices on high-quality merchandise. While management expected to lose business from fanatic deal seekers in favor of a more Target-esque, upper-middle-class crowd, they admittedly underestimated just how much revenue would be lost. Still, they stubbornly stayed the course until just last week, finally announcing they would bring selected sales back after revenue took a larger-than-expected tumble during the holiday season. Johnson was quick to point out, however, that this wasn't a "deviation" from their plan as much as an "evolution" of it. 

Aside from pricing strategies, the company is replacing the age-old "racks of clothing" concept in favor of a new mini-boutique shop idea with plans to roll out 100 such shops in all its 1,100 locations by 2015. While this might sound strange at first, it becomes much more intriguing when we note the existing shops consistently post 20% higher comps than the rest of the store space. Further lending credence to the idea, even Macy's seems to be quietly taking notes given its recent announcement of a deal with Finish Line to open branded shops within 450 of its stores by the end of 2014.

Foolish bottom line
To be honest, I'm slightly terrified at the thought of owning shares of J.C Penney, even at today's depressed price. I even started writing this article as a skeptic and expected to finish by opening an "underperform" CAPSCall on the company.  

In the end, however, while I'm not holding my breath for an 18-bagger anytime soon, I find myself cautiously optimistic that J.C. Penney might be able to dig itself out of this hole.  Heck, if it can show any concrete signs of improvement in the coming quarters, patient long-term investors could be handsomely rewarded as the stock returns to normal valuations.