Saturday, 21 July 2012

JCPenney - worth considering

I initiated a small position for myself in JCPenney yesterday at $20.50. If Bill Ackman is correct, investors stand to make 15-20x their money at the current price (see Pershing Square's May 2012 presentation here). 

Just for those hailing from outside North America, JCPenney is a department store chain in the U.S. with ~1,000 locations.  It was at one point (in the 1960s) the 2nd largest company in the U.S. by market capitalization, but has since fallen into disrepute because of mismanagement and intense competition. The following points outline why I believe this could be a good investment:

1) Downside protection from real estate value.  If we take Ackman's statement that the replacement cost of the real estate is $11 bilion, then after subtracting the $3 billion of debt (not even considering the company's ~$800 million cash balance), we arrive at $8 billion for net asset value.  This would work out to a little more than $36.50, or 77.5% above the current price. Using $36.50 as the floor price, of course, assumes that in a worst case scenario of bankruptcy and liquidation, we will be able to realize market value in a bankruptcy sale (which is unlikely).  I have come up with something a little more conservative for my own crude calculations.   Given JCP's outright ownership of 49% of its stores, this works out to ~55 million square feet of ownership.  Using Sears' sale of 11 stores to General Growth in April 2012 as a precedent transaction, the price per square foot was $150 ($270mm paid for 1.8mm sq ft).  Applying $150 to 55 million square feet gives us a value of $8.25 billion.  Now subtract $3 billion of outstanding debt from the $8.25 billion and you get $5.25 billion ($24/share), which is still a 16.5% premium above the current price.

2) Strong insider ownership.  With Pershing Square's 26% ownership stake, we have patient money backing the company's new strategic initiatives, which would have no chance of success if a quarter-by-quarter investor were to be in control.  Bill Ackman (founder of Pershing) actually sought out and effectively installed Ron Johnson, who is the current CEO of JCP.  Upon taking the helm, Johnson invested $50 million in warrants with 7.5 years to expiry that are not excercisable until year 6.  He paid approx. $8 per warrant with a strike price (market price at the time) of $29 - thus his break-even point is $37.  Hence an investor entering in today would experience ~80% capital appreciation just to get to the point where Johnson breaks even in year 6 of his investment!!   This compensation structure, which no doubt gives the CEO a leveraged outcome (and leaves no room for error on the downside) is unique and present in only one other company I know of called the Howard Hughes Corporation, where Bill Ackman serves as the company's chairman.  While this warrant ownership scheme is no guarantee of success and by no means protects you against management misjudgement, one thing is for certain:  the CEO is more likely to think for the long term versus appeasing investors quarter-to-quarter. 

3) Management's reasoning makes sense.  While JCP's earnings are likely to continue hurting for the next few quarters, Johnson's new intiatives make a hell of a lot of sense. I would encourage you to read the presentation (linked to above), as it walks through what management plans to do over the next few years.  In a nutshell, JCP was terribly mismanaged by previous leadership through extreme couponing (average of two sales per day at up to 60% off normal price) which led to the perception among suppliers of a lack of price integrity.  As a result, most brands refused to sell their wares in JCP and this led to a cycle of decreasing price points.  Johnson's strategy is to use JCP's structural advantage, being its low cost ($4 per sq. ft.) leases and direct ownership of stores, to offer incoming (and higher value) brands the opportunity to set up their own mini-stores within each location and thus acheive nationwide distribution.  He labels this his "mall within a mall" concept. Secondly, Johnson has targeted $900 million of cost cuts.  Considering that $1.8 billion of costs would need to be chopped in order to reach Macy's efficiency level, $900 million hardly sounds unreasonable. 

I would argue that the current valuation is already pricing in a grave level of pessimism.  However, giventhe fact that this turnaround will take time, I would not be surprised if the share price tanks again on August 10th when the next quarter of earnings is reported.  This of course depends on how disappointing sales are.  Sales were down 20% in the most recently reported quarter; if an even greater decrease is reported in August for Q2, it could be a sign that the situation is getting out of control and that JCP's previous customer base is running for the exits. In this scenario, Johnson may be pressed to sell some stores to raise cash for working capital to make ends meet until his plans work out.  If however the year-over-year sales decrease is less than expected, we could in fact see the share price pop as investors decide to price in a lower level of pessism.  The truth is that I don't know whether we have reached the bottom on JCP... if the next quarter is worse than expected, I wouldn't be surprised if the stock crumbles another 50%.  However, as I believe the odds of doing well (from the current price) on this bet over the next 5-6 years are good, I have decided to invest ~50% of a full position now vs. speculating over the next earnings release.  In other words, I am not letting my long term speculation to be influenced too much by my short term speculations.

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