Beleaguered department store chain J.C. Penney (JCPN.Q) received a nice boost in shares after an analyst proposed the latest department-store-gone-REIT pitch, implying that J.C. Penney's top locations warrant $40 per share in enterprise value. While certainly an interesting proposition, it would be a complete shift from management's current effort, which is to restore core customer faith while reaching out to a new, younger, more affluent audience. The rise in stock price is overhyped, in typical market fashion, but does it highlight the (very) hidden values of the company? Let's take a closer look at the proposal to see if this is the vote of confidence J.C. Penney needs to move forward.
A rare sound
Most investors and analysts, along with its old customer base, have abandoned J.C. Penney and saved it a space in Retail Stock Hell. This week, though, ISI analyst Omar Saad suggested there is value, a lot of value, in J.C. Penney's biggest asset -- its real estate.
This isn't the story Ron Johnson would prefer shareholders to hear. But it's a positive spin, nonetheless.
In short, Saad believes J.C. Penney's top 300 locations are worth $40 per share in enterprise value, with the remaining spots worth another $6 per share. That would imply a share price nearly three times that of today's, including the 6.2% intraday gain. How would this be possible?
According to Saad, J.C. Penney has a remarkably low cost per square foot -- $4, compared with an average of $70 for other tenants in those 300 mall locations. If the company organized that real estate into a REIT, it could then sublease its space to retailers at a discount to surrounding rents, but still at a sharp premium to the company's cost. In addition to generating more than $1 billion in rental income, this would allow the company to shift away fashion and inventory risk -- letting its tenants control the items for sale, the on-site personnel, and fixtures. It sounds like a reasonable enough alternative to the company's current plan.
However appealing it may look on its surface, though, I don't see this happening.
About-face
J.C. Penney has poured billions into its transformation. This means millions in new fixtures, mannequins, brand relationships, employee training, and inventory management systems. Abandoning this plan, regardless of the compelling alternative, is admitting total and complete failure by Ron Johnson and the entire J.C. Penney management team. And, not to sound contradictory, but this about-face would also incur the same difficulties that the store is currently coping with -- a core customer base that doesn't understand the new concept and new shoppers that are reluctant to give it a chance. Other retailers, whose managers have probably kept a close eye on J.C. Penney's stores-within-a-store experiment, may be hesitant to take on the location risk.
Addressing the cash-flow crisis
One of the main concerns currently is liquidity to fund the recovery, given that J.C. Penney is the only department store worth more than $1 billion that has a net debt-to-market cap ratio greater than 50%. Cash flow is hurting big time, but I trust CEO Johnson's claim that 2013 will be a return to the black for the company. The big, upfront expenditures are already incurred, and the company does have a good revolving credit facility that should keep it comfortable for the next couple of years. As cash flow turns around, I believe we will see liquidity fears erode.
The beginning of a rally?
This week's rise in stock price may be no more than market speculation. With 2012 results behind it, J.C. Penney management has an opportunity to turn things around in first-quarter earnings results, but I fear it still may be too early. If the company delivers another double-digit drop in comparable sales figures, that stock price may sink below its $14 low.
The company's recent launch of Joe Fresh in some of its transformed stores has been trending well, according to an Oppenheimer analyst. Overall, J.C. Penney's return to growth may be hinged upon how quickly it can convert stores and get these newly introduced brands on the racks. I'll be looking for this to show up in the latter half of the year, giving bears a few more months of ammunition and, likely, extreme stock-price volatility. Investors shouldn't focus on an entry point for the stock, because if it's able to even slightly turn around its numbers, then today's valuation remains dirt cheap. Investors also shouldn't buy on analyst Saad's opinion, as I don't see the company following suit.
J.C. Penney remains a deep value play with a minimum two-year holding period for the turnaround to take place. Invest only if you have the risk tolerance and are confident in Johnson's model.
Editor's Note: An original version of this article incorrectly stated a JP Morgan analyst as supportive of the company's Joe Fresh launch. The supporting analyst is with Oppenheimer. The Motley Fool apologizes for this error.
