Bill Ackman and Pershing Square Give This Retailer a Vote of Confidence

Bill Ackman continued to defend his J.C. Penney Company, Inc. (NYSE:JCP) position at the Value Investing Congress last week, commenting that at current levels, the company is trading at nothing more than its asset value. At the end of 2Q, Ackman and Pershing Square owned nearly 39 million J.C. Penney shares—12% of Pershing’s 13F portfolio and over 17% of J.C. Penney’s outstanding shares (see other Ackman ideas from the Value Investing Congress). However, we are concerned about Penney’s ability to execute its grandiose plans going forward.

Bill Ackman PERSHING SQUARE

J.C. Penney announced another round of planned rehabs for the company a couple weeks ago. This time, CEO Ron Johnson is remodeling Penney’s stores to make separate shops that highlight certain brands, as well as a host of other big moves. The remodeling initiative is to transform around 700 of Penney’s 1,100 stores into a collection of around 100 specialty stores apiece—featuring brands such as Martha Stewart, Disney and Levi’s. Other key changes include features such as Lego tables in the kids’ department, coffee shops, lounge sofas and chairs, and high-speed Internet—turning J.C. Penney into a town-square-type of environment.

In addition to the remodeling, Johnson, whose background includes time at Apple, plans to turn J.C. Penney into a technology wonder. Part of the plan includes implementing mobile checkouts and replacing barcodes with RFID chips. This includes every item in over 1,100 of Penney’s stores. Although the initial outlay will be expensive, Penney expects that the tags will make inventory management easier and reduce costs, with the RFID tags being about ten times cheaper than traditional bar codes. At the same time, many of its competitors are merely testing out RFID tags in select departments. Another change will be that all store associates will carry iPods and iPads to ring up customers; also Macs and iPads will be available for customer use in ‘entertainment’ areas. The company plans to roll out Wi-Fi to all stores and also transition to mobile and self-checkout. The switch to RFID tags will allow shoppers to check out anywhere, anytime.

As customers become more and more frustrated with J.C. Penney’s failed attempts at reinvigoration earlier this year, customers are finding other stores to shop at, with sales and traffic have both taken a hit since the company scrapped coupons. Sears Holdings Corporation (NASDAQ:SHLD) reported a double-digit increase in its apparel and footwear businesses during the first quarter when Penney implemented its no coupon-no markdown strategy. However, Sears has seen its own shares take a roller coaster ride this year, having been as low as $30 at the beginning of the year before spiking to $85. Shares are now trading around $56. Sears is also seeing increased competition in its appliance business. Sears has a solid investor base backing the company though, with Eddie Lambert and Bruce Berkowitz owning almost 60 million shares collectively.

Macy’s, Inc. (NYSE:M) and Nordstrom, Inc. (NYSE:JWN) are at the higher-end of the diversified specialty department store market, but even in the face of a slow economy these two companies have outperformed J.C. Penney, with Macy’s up 23% year to date and Nordstrom up 12%. Both of these companies also pay the highest dividends of their peers at around a 2% yield; Penney suspended its dividend in May to reinvest cash into the company. Macy’s has its own remodeling initiative called My Macy’s, where the company is tailoring certain Macy’s stores to meet the specific needs of its core customers in the surrounding location.

The reason for Nordstrom’s insulation and strong price performance so far this year has been the fact that their customer base has been less affected by the general economy. The company will likely only see modest growth in the near future as it embarks on heavy investment spending to help grow its Rack brand; it is opening 15 new Rack stores in 2013 and 24 in 2014.

Dillard’s, Inc. (NYSE:DDS) is a lesser-known name than Penney’s other competitors, but is up over 60% year to date and caught the attention of Steven Cohen, Ken Griffin and D.E. Shaw in 2Q, with all upping their 1Q stakes. The company is expected to grow 2013 EPS to $6.03, up from 2012's total of $4.21. The company is benefiting from successful turnaround initiatives and still remains competitive with larger department store chains. The company posted same store sale increase of 4% last quarter, now having posted positive quarterly same store sales growth for over two years.

Since Johnson hosted the prototype tour for J.C. Penney’s new layout a few weeks ago, the stock is down over 17%. It would appear that investors had a false sense of hope that a turnaround of J.C. Penney could be accomplished in a matter of months. The company’s stock was up to around $30 last month, before being brought back to reality—the company now trades less than $24. After the tour, Johnson indicated that the company still expects the second half of this year to be similar to the first half, implying a decline in comparable sales of around 20%.

Penney is down over 30% year to date after Johnson’s first announcement in January to cut out coupons and specials in lieu of sustained lower prices. With everything that Johnson has slated for J.C. Penney, we agree with Ackman that investors are likely faced with a 5-7 year timeframe before the company can start seeing returns on the CapEx spending it is about to undertake.

Ackman noted that customers used to go to J.C. Penney because of the coupons, but going forward, it will be about the in-store experience. We do admit that Penney’s plans will make for an appealing store—especially in an industry that has little brand loyalty. Yet, our worry is whether the initiatives will successfully turnaround the company, or has the damage been done? The capital outlay to get some of the more appealing aspects implemented are a bit more complicated than simply cutting out coupons and lowering prices. We would like to see one of Penney’s initiatives show traction before going all-in, and would like for the company to do the same. We currently do not see the reward justifying the risk, with the company’s forward P/E of 17 already at the high end of the industry, compared to Nordstrom (18x), Macy’s (12x), and Dillard’s (8x).

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