Will J.C. Penney Really Transform Retail?

Some have hailed the recent J.C. Penney Company, Inc. (NYSE:JCP) rally as a one supported merely by technicals, thereby pressuring J.C. Penney management to justify the stock to investors. On September 19, J.C. Penney had its much-anticipated analyst day, complete with a long spiel by CEO Ron Johnson, former marketing executive from Apple Inc. (AAPL). We have been looking for more color as to the nature of the alleged turn-around, and the analyst day provided investors with a greater idea of the future of the beleaguered retailer.

J.C. Penney Company, Inc. (NYSE:JCP)

For the sake of transparency, though the author is an investor in J.C. Penney, he is also a long-time shopper at J.C. Penney—a position of skeptical optimism. We have been particularly interested in hedge fund activist Bill Ackman’s confidence in J.C. Penney (view his portfolio here). Ackman indicates that 2013 might be sunnier as 2013 earnings are compared with sluggish quarterly earnings from 2012.

In his presentation at the J.C. Penney Analyst Day, Johnson emphasized how stores will begin to sport aisles that are wider by 5 feet. He notes that stores sell the “same product” while engendering a “different perception of the merchandise.” The store-within-a-store model, what J.C. Penney is calling a “specialty department store,” is reminiscent of successful concepts long adopted by Nordstrom, Inc. (JWN). Nordstrom is famous for having semi-autonomous sales areas staffed by associates who assist clients with a specific set of merchandise. For J.C. Penney, each boutique will be like one of many “apps” on a phone, which Johnson hopes will both increase sales per square foot, excite collaboration with a number of brands, and increase the presence of sales associates in each mini-store.

We noted elsewhere that Johnson had, seemingly, started to discard the idea that he was selling a “lifestyle” as opposed to merchandise. After this press conference, that seems incorrect. Johnson invoked his Apple transformation at length, claiming that he has to “dream” in order for the J.C. Penney turnaround to work. The Street, a forthcoming town-hall concept within the J.C. Penney stores, is a “new interface for retail,” says Johnson, that allows customers to “continue on with their lives” without ever leaving the store. “We’re not selling stuff. We’re transforming retail.” The moral here is that Johnson has abandoned any hint of conservatism to his approach. Thus, though this is an opportunity for growth, we note that a ‘start-up’ mentality inherently increases the risks associated with an investment in J.C. Penney.

A simple list of some adjectives taken from the test group of shoppers, who toured the new J.C. Penney specialty store mock up, provides data about the consumer perception of the new stores. Shoppers were asked beforehand about their preconceptions and were asked afterwards about their new impressions.  Data was collected from a third-party research firm, with remarks including:

  • “Upscale”
  • “Trendy”
  • “Sophisticated”
  • “Colors more vibrant”
  • “More advanced than Kohl’s”

Here’s a slide from Johnson’s presentation that presents this forcefully:

Johnson also provided some direct data about the performance of the new J.C. Penney concept. In all, the new shops are comping 20 percent better than the rest of the store, says Johnson. He indicated that 40 specialty stores will be done next year, and that presently about 90 percent of stores are still the “old” J.C. Penney.

Wednesday morning, the Walt Disney Company (NYSE:DIS) and J.C. Penney announced a retail partnership. Disney will be placing 750 to 1,100 square foot shops into J.C. Penney department stores. Johnson said that his fair-pricing strategy allowed the company to make a deal with such a popular brand as Disney.

Shares hit $32 during the analyst day presentation, then mellowed to slightly around $30 after Johnson explained his cautions about the future. With 90 percent of each store yet to be changed over to the new concept, investors became more guarded in their estimates. “It ain’t gonna be easy” to transform the store’s concept away from a discount retailer, Johnson cautioned, though, he likewise notes, “there was no choice” given the poor state of the company.

Present valuation does not reveal an obvious entry-point for J.C. Penney shares. One commentator notes that J.C. Penney’s EV/EBITDA of 10.1 is above that of Macy’s, Inc. (NYSE:M) and Kohl’s Corporation (NYSE:KSS), both of which are valued at 5.5 times EBITDA. At the end of November 2011, J.C. Penney stores generated sales of only $130 per square foot, whereas specialty stores regularly realize over $300 per square foot. Macy’s and Kohl’s had sales per square foot of $171 and $194, respectively. Though Johnson is committed long-term to gross margins of over 40 percent, J.C. Penney gross margins stand at only 34 percent. Shares are priced at 47 times earnings, which, again, is reminiscent of a retail start-up, not a longstanding traditional retailer.

There was a brief silence in the room as Bill Ackman mentioned the Stone Briar store location, asking Johnson during the Q&A to reveal more about how it was performing. Though Johnson was cautious about revealing sales data, citing the possibility that it would mislead investors about the company’s overall performance, he seemed to imply that its numbers were promising. Bill Ackman’s question was certainly, from his and Johnson’s perspective, a rhetorical one in the first place—Ackman’s hedge fund, Pershing Square, owns 17.9 percent of the company.

In a CNBC interview, Oppenheimer Analyst Brian Nagel says that those shorting J.C. Penney should be “nervous.” Counter intuitively, Nagel notes that negative results are promising in the sense that they indicate how aggressive the J.C. Penney transformation has been. He notes, however, that the nearly 50 percent increase over the past four months in J.C. Penney’s shares is not indicative of a “50 percent” fundamental improvement. We have the same cautious view on J.C. Penney: it is an interesting and promising idea for investors, but it comes with a fair amount of risk, rough waters ahead, and shares that are, for the short-term, richly valued.

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