Invest in these Retail Chains over J.C. Penney

By Bill Edson - August 22, 2012 | Tickers: DDS, JCP, KSS, M, TJX | 0 Comments

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J.C. Penney (NYSE: JCP) is disappointing investors in its transitional phase under the leadership of new CEO Ron Johnson. His vision for the company involves making current customers give up nearly all promotions and coupons cold turkey. Investors should avoid this company because it is not priced low enough to compensate investors for the risk of adopting a new retailing strategy. Instead, investors can pick a few of J.C. Penney’s competitors, which are better deals at current prices.

Fast Times at J.C. Penney

At the end of January, J.C. Penney promised to turn a profit of $2.16 per share or higher, guidance which it stood behind as recently as last May. Now J.C. Penney has announced that it would not be able to attain that goal and expects  no great change in upcoming quarters.

These disappointments are the latest in a string of bad results that have surfaced as Johnson began reshaping the company into a new kind of department store concept he calls a “specialty department store.” Johnson warns that his strategic repositioning of J.C. Penney will take four years.

Even though J.C. Penney has suffered quarterly losses and decreasing sales, Johnson has convinced investors that J.C. Penney is on the up and up. Management had announced this aim with “extraordinary confidence” that it could be attained and promised that they would not “commit to anything that we’re not confident we can hit.” Investors were bailing on J.C. Penney until Johnson spoke about being in a stage of making over the company, including simplifying the way the retailer does promotional sales to make them more understandable and incorporating stand-alone specialty stores within the company much like stores in a mall. Despite news of a $147 million loss in the second quarter and its lowest sales in over 20 years, Johnson’s frankness with the public about not falling short and revealing his strategy for how to improve the brand stopped shares from dropping. Much to my amazement, Johnson’s statements actually resulted in the stock’s biggest one-day gain since the day Johnson set his goals for the company in January!  His assurances that everything is going according to plan and that this year was expected to be a rough one was enough to get investors on board despite the company’s underperformance compared with both what was projected and last year’s performance.

The company cited getting rid of its outlets and a lack of marketing strategies change as reasons for why it did worse than predicted. Management is not questioning the firm’s bold strategy itself.

Not everyone believes in the CEO’s vision. Retail analyst Howard Davidowitz predicted problems with J.C. Penney’s new leadership and direction. In an interview he stated:

“J.C. Penney didn't need a revolution, it needed an evolution. You can't take an old line company that's been operating the same way a very long time and throw everything out the window and say 'now we've reinvented the company.'"

Davidowitz questioned Johnson’s appointment as CEO of a department store because Johnson’s experience at Apple (AAPL) doesn’t translate directly to retail. Davidowitz’s concerns were later validated in a 20% drop in sales in J.C. Penney. He remains critical of the new CEO, and has stated, "He's caused incalculable damage.” In particular, Davidowitz is critical of Johnson’s abandonment of promotions and couponing.  “The customers are everything. They don't know what the hell he's doing."

Other investors have bet against J.C. Penney during this vulnerable time. Marathon Asset Management, a $10 billion hedge fund, bet against the company’s credit rating using credit default swaps. It is estimated that these bets paid out 15 times the hedge fund’s invested capital.

Valuation

What does all this mean for investors? Investors should require steeper discounts for firms that engage in strategy changes. Essentially, an old firm reinventing itself takes on additional risk, and investors should demand to be compensated more for more risk. Therefore, J.C. Penney should be trading at a risk-adjusted discount.

We can use the price-to-sales multiple as a measure the cheapness of department store stocks and profit margin as a measure of a firm’s quality. These metrics are appropriate since J.C. Penney’s trailing earnings are negative. A linear trend was calculated for the firms in this industry, and projected profit margin of each firm’s actual price-to-sales multiple are provided with actual values below:

Of these firms, Dillard’s (NYSE: DDS), Macy’s (NYSE: M), and Kohl’s (NYSE: KSS) have above-trend profit margins. The operations of these firms are better than would be expected based on their price-to-sales ratios. In particular, Dillard’s has a much higher 7.56% profit margin than the 1.95% that would be anticipated from pricing in other industry firms.

In addition to being better buys than J.C. Penney, these companies are likely to gain more and more customers from J.C. Penney as its new direction continues to drive them away.

Notice that J.C. Penney is actually overpriced based on its trailing twelve month performance. This high price-to-sales valuation relative to profit margin reflects the faith many investors have in the vision of its new CEO.

The TJX Companies (NYSE: TJX) are also richly valued based on the company’s positioning as a low-cost clothing provider. As such, investors should avoid this company because it is currently popular among investors seeking defensive stocks.

Conclusion

Rational investors demand higher returns for higher risk, yet the valuation of J.C. Penney translates into a lower return for a higher risk relative to Dillard’s, Macy’s, and Kohl’s. Investors should invest in these firms (especially Dillard’s) before investing in J.C. Penney.

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