This Retailer Is in a Very Tight Spot

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Investors were caught by surprise when Ron Johnson, the CEO of J.C. Penney (NYSE: JCP), was let go in the midst of the company's massive turnaround. Though the departure was unexpected, the results of his revamp have been pretty close to disastrous. Yearly sales dropped from $17.3 billion in 2011 to around $13.0 billion in 2012, and Penney shares have dipped from a 2012 high of around $43 to a recent low below $14.

Now, the company is in a very tough spot. New management will have to deal with two critical problems where the slightest misstep could push the firm toward insolvency.

The problem of corporate strategy

Mr. Johnson’s plan was to remake the company into more of a specialty department store. Substantial changes were made to merchandise by introducing more high-end global brands, and the store layout was re-organized into separately partitioned specialty brands. Merchandise was not discounted, but offered at everyday low prices. Unfortunately, it seems a significant number of customers rejected the new look and that decimated results.

Now with Johnson gone, the company has to decide whether to continue on with the remake or try to go back to its previous strategy. Neither option will be easy.

If they continue with the remake, it will go on without its chief architect and backer. New management will have to take ownership of a plan that hasn’t shown any success and is not of their own creation. They will also need to sell it to employees and stakeholders who must certainly have doubts.

The other choice is to return to Penney's original way of doing business. This means spending a lot of time and money just to dismantle the changes already made. One example is Penney's short-term merchandise dilemma. It's probably too late to change the company's ordered merchandise for this back-to-school and holiday selling season. So, even if the company decides to return to its former strategy, their product obligations may not allow it for at least another year.

The problem of liquidity

Regardless of the strategy, they will need the funds to see it through. Penney’s biggest risk is insolvency due to a lack of liquidity. (More about the need for liquidity in retail turnarounds is in this earlier post.)

Penney's starting from year-end 2012 cash reserves of $930 million. If results are comparable to last year, expenditures for capital improvements could be around $600 million through the first six months of this year. Additional inventory outlays of about $200 million would leave cash levels of around $130 million, when funding would be needed for key selling season inventory. Given they typically buy around $400 million of merchandise in their third quarter, it looks like tapping their line of credit (LOC) in the back half of the year might be necessary. Luckily, their LOC makes 85% of inventory liquidation value available, and that might be around $1 billion or so.

Though they might have the liquidity to get through this year, Penney still faces a couple of hazardous circumstances. In such a weakened state, they are at a significant risk of vendor whim as my earlier post explains. They could also be in serious trouble for next year. For example, Penney usually generates around $750 million in fourth-quarter cash. Assuming they expend about $400 million for inventory and a minimal $200 million for capital expenditures in their last six months, they will be left with something close to $280 million in cash reserves to start next year. An extremely slight sum.

Lottery ticket versus investment

Given its circumstances, Penney's stock might be best viewed as a lottery ticket where one might hope for a windfall, but certainly shouldn't expect it. However, there are a couple of competitors that may be worth considering for those interested in the sector:

Macy's

Macy's (NYSE: M) is a direct Penney competitor, and they have shown a very successful strategy over the last couple of years. Through the company's "My Macy's" initiative, customers surrounding each store find merchandise assortments and marketing programs custom-tailored to their needs. The company also has an omnichannel strategy, that allows customers to shop seamlessly in stores, online, and via mobile devices and a selling program that helps the company better understand the needs of customers.

These programs have helped comparable sales increase 3.7% in the last year and diluted earnings per share, excluding certain items, increased 20% to $3.46. The company is also shareholder friendly -- repurchasing 35.6 million shares for $1.35 billion in 2012, and doubling its dividend rate to $0.80 per share.

The company’s fair business value, based on expected cash earnings times a market capitalization multiplier, looks to be around $56 per share. This calculation assumes revenues of $28 billion and average cash earnings of $1.8 billion at a slightly discounted retail 12x multiplier.

Target 

Target (NYSE: TGT) competes with Penney through its home essentials and fashion offerings. A consistent profit generator, the company reported adjusted earnings per share of $1.65 in the fourth quarter 2012, up 10.1% year-over-year. Full-year adjusted earnings per share were $4.76, up 7.9%. Sales increased 6.8% to $22.4 billion in the fourth quarter, reflecting a 0.4% increase in comparable-store sales.

Target also seems shareholder friendly. In the fourth quarter, they repurchased about 10.4 million shares for $645 million. The company also paid out dividends of $234 million.

Expecting $72 billion in sales and $3.6 billion in adjusted earnings at a 12x multiple produces a fair intrinsic value for Target around $67 per share.

Conclusion

Penney is in a bad situation. It doesn’t have many good strategic choices and its cash status is precarious. The stock may be best viewed as a long shot gamble, but there are investment-worthy competitors that may be worth considering as a play in the retail space.


Bob Chandler has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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