5 Myths Among J.C. Penney Bears
May 23rd 2012 7:08PM
Updated May 23rd 2012 7:10PM
What a difference a quarter makes! One moment Ron Johnson is hailed as the savior of the Street and retail, and the next moment he's the delusional devil who's going to drive J.C. Penney (NYS: JCP) into the ground.
So without further ado, here's why the shorts are misguided. I'm backing my CAPS rating with it ... and probably my wallet later this week.
Myth 1: This is just like Eddie Lampert and Sears
No, it's not -- unless you believe Microsoft is just like Apple. J.C. Penney is not like the flagship department-store chain of Sears Holdings (NAS: SHLD) . In fact J.C. Penney is the anti-Sears.
What Eddie Lampert has done at Sears is deprive the stores of necessary reinvestment to fund share buybacks. J.C. Penney CEO Johnson, by contrast, is pumping $800 million into his stores in lieu of a dividend. Polar opposite strategies.
Yes, Johnson is focusing on cost-cutting, just as Lampert is. But so does Coca-Cola or Berkshire Hathaway. Heck, any good business -- including The Motley Fool! -- tries to cut costs.
Another difference: The whole deal with Sears back in 2004-2007 was that Lampert was the "next Warren Buffett." The plan was that Lampert would extract cash from the crummy retail business (which he has) and invest it in great businesses (which he hasn't), a la what Warren Buffett did with Berkshire's textile mills.
By contrast, there is no talk of having J.C. Penney become "the next Berkshire Hathaway." The plan is to run it as a retailer and become America's favorite store.
And unlike his opinion on Lampert, Jim Cramer hates Ron Johnson and is doing everything he can to get people out of J.C. Penney stock. His rant against Johnson on Mad Money was classic Cramer.
Myth 2: The department-store industry is a bad business that Buffett would never invest in
This one I have some sympathy with. Retail is hard. Very hard. But that doesn't mean there are no opportunities to invest in retail. Berkshire owns both Nebraska Furniture Mart as well as shares of Wal-Mart.
The secret to winning in retail is having a structural advantage. And J.C. Penney does. It pays less than $5 per square foot of rent and generates about $132 per square foot of sales. J.C. Penney also owns about 400 of its stores outright.
By contrast, specialty shop Gap pays about $40 per square foot yet generates about $300 per square foot of sales.
There is no reason paying so little per square foot of rent is incompatible with generating sales of $300 per square foot. The two things aren't mutually exclusive. And Johnson's shop-within-a-shop concept seeks to arbitrage the difference.
Bill Ackman, whose hedge fund owns 26% of the company, points out that the share price could go to around $200 if Johnson can execute on the difference. That would be thanks to operating leverage, a powerful force I've written about before.
Furthermore, it's not as if J.C. Penney was that broken to begin with. It's generated positive free cash flow in the past few years, even through the Great Recession.
It's a testament to the competitive advantages of the department store that it can be run so horribly, and be so irrelevant in the mind of the consumer, yet perform well.
Myth 3: Ackman is a media hack who leads his shareholders to slaughter
The bears will tell you that Ackman has a horrible record in retail. Witness the collapse of Borders and his unsuccessful venture into Target, which led to the collapse of Pershing Square IV, a leveraged hedge fund that invested only in Target call options.
On Borders, Ackman is guilty as charged, and he has called it his worst investment ever. But J.C. Penney is nothing like Borders. People still buy clothes from stores, not from Amazon.com. They like to try things on.
As for Target, let's remember that Ackman was fighting management. He lost his proxy contest. If he had won the proxy contest and effectively given himself control of the company, things probably would have turned out differently. After all, Ackman's activist funds have handily beaten the market since inception. As it was, Target didn't turn out to be that "activist."
By contrast, Ackman and Vornado Realty Trust's (NYS: VNO) Steven Roth are firmly in control of J.C. Penney with their collective 28.8% stake in shares outstanding. They hand-picked Johnson from Apple. There was no bloody boardroom conflict, and activist measures (e.g., the entire management) have been allowed to go through.
And when Ackman gets his way in retail and real estate, it tends to pay. Witness his foray into then-bankrupt mall owner General Growth Properties, where he has made 3,000% on Pershing's investment.
Myth 4: J.C. Penney's pricing scheme has never worked before and will never work
Tell that to Carmax (NYS: KMX) , whose used-car pricing scheme is very similar to what J.C. Penney uses. Sure, you can probably get a used car for slightly cheaper from a private buyer or even a dealer, but Carmax offers an unparalleled selection and a fair no-haggle price along with a great return policy. Berkshire's Lou Simpson thought it was good enough to buy. And Carmax sells a commodity product, just like J.C. Penney.
Now, let's imagine for a second that Carmax didn't have this policy. Let's say it was just like any other used-car dealer. Would it be where it is today?
No, of course not. It makes Carmax different in a brutally competitive market, as I think it will with J.C. Penney.
After all, as Johnson has pointed out, customer-satisfaction surveys are at an all-time high among buyers. That should breed loyalty.
And for all the hoopla over the quarter and same-store sales, traffic was down only 10% despite a radical change in policy. For all we know, that could have simply been fallout from the One Million Moms controversy.
Myth 5: The stock is too expensive
I think we can all agree that 2008 to 2011were some of the hardest years to be a company, let alone a retailer. Yet J.C. Penney generated an average of $530 million per year in free cash flow to owners. That's after you adjust capital expenditures for new store openings, which aren't necessary to maintain present levels of cash flow.
So the stock is trading around 10 times Great Recession free cash flow. That's a 10% free cash yield in a terrible economy. When the economy improves, that free cash should explode because of operating leverage.
Johnson is predicting that operating cash flow will be around $1 billion this year, despite the terrible quarter. While the company is putting $800 million in the stores, judging from the past, only $500 million is required to maintain present cash-flow levels. So again we're looking at about $500 million in free cash in a terrible economy.
Follow the money
Rest assured that if someone has gone to the effort of purchasing 26% of a company and getting on the board, as Ackman has, that person probably has good reasons. I wouldn't dismiss those after one quarter.
If you're not sold on this retailer, though, there are other incredible opportunities out there. The Motley Fool's Top Stock for 2012 is an emerging-market opportunity that Wall Street hasn't caught up to yet. You can learn more about our chief investment officer's top pick.
At the time this article was published Fool contributor Chris Baines owns shares of Berkshire Hathaway. Follow him on Twitter, where he goes by @askchrisbaines. Chris' stock picks and pans have outperformed 96% of players on CAPS. He owns no shares of the companies mentioned. The Motley Fool owns shares of Microsoft, Berkshire Hathaway, Amazon.com, Apple, and Coca-Cola. Motley Fool newsletter services have recommended buying shares of Microsoft, Berkshire Hathaway, Amazon.com, Apple, and Coca-Cola, creating a diagonal call position in Wal-Mart Stores, and creating bull call spread positions in Microsoft and Apple. The Motley Fool has a disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.
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