Holiday Shopping has Never Been this Cheap
Nikhil is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
In my mind, holiday shopping has never been this cheap. It's well known that retailing is a cyclical business. Sales are often much much higher in the fourth quarter than in the rest of the year, and this bit of knowledge is well priced into the shares of most retailers. The defining quarter is the holiday season. So, with that in mind, where is the best retail stock to stick your holiday ambitions upon?
That honor rests with J.C. Penney(NYSE: JCP).
J.C. Penney has been the subject of much controversy in recent quarters. Currently in the process of a complete turnaround, the business world's opinions on J.C. Penney have become extremely polarized. Either you like the retailer's turnaround efforts and believe in the stock or you're sure that in its attempt to turn itself around, J.C. Penney sent its core customers running, dooming itself forevermore.
I'm personally an optimist, but in recent quarters there has been some pessimistic news. First of all, sales levels are crashing with Q1 comparable store sales down 18.6% and Q2 comparable store sales down 21.7%. Second, in Q1, J.C. Penney cut their dividend which at that time was a solid 2%-3% yield. Depressing store sales and the dividend cut sent contrarian investors and yield investors fleeing and on May 16th, J.C. Penney was down to $26 from $33 the previous day, a 20%+ fall. About a month ago, an analyst released this article expressing concerns about the future quarter and saying that Q2 wouldn't be any prettier, and as I said before, Q2 with its comparable store sales down 21.7% was just as bad as expected.
However, J.C. Penney's 2nd Quarter results, while clearly showing no major improvements, created a sudden rise in J.C. Penney shares, with shares up 11% at its highs on Friday and ending the day up 5.8%. When bad results cause a stock to rise, it's pretty clear that the shares are priced for bad news, and at these prices I think J.C. Penney is easily the cheapest holiday shopping play out there. Here's the thesis:
1. Follow the Leader
Renowned Value Investor Bill Ackman is leading this turnaround. His fund, Pershing Square Capital, holds a 20% stake in J.C. Penney, and with support from another fund's 10% position, Ackman effectively controls 30% of J.C. Penney's stock. With that power, he has made significant changes in the company. First and foremost, he hired a new CEO, Ron Johnson, who after changing the retail experience at Apple, believes he can do the same at J.C. Penney. The stated goal is to make Penney "America's favorite store" and while that seems to be a longshot, if there was anyone who could get the job done, it would be Johnson.
2. Share Price Movements Thus Far Are Just Silly
I don't mean to be rash, if J.C. Penney's turnaround doesn't workout well, Penney's stock deserves to crash. However, I really don't think you can judge J.C. Penney's turnaround yet. Until construction stops and old inventory is completely off the shelves, we won't be able to see the true earnings power of the new J.C. Penney, so I don't think we'll get a good look at the actual business until 2013. That being said, I think it's a bit dumb of the market to judge the business on sales declines that were expected to happen. As Ron Johnson said in his recent conference call, (to paraphrase) he made the expectations of a fall pretty clear, but for some reason it was as if no one heard him.
J.C. Penney is in a state of uncertainty. There just isn't a good way for investors to measure the value of the new business without seeing some real financials. Luckily for us, uncertainty in the market has generally been deemed to equal a loss in value and plenty of volatility, so if you do plan on picking up shares, you should have plenty of opportunities.
3. Margin of Safety
In any case, I think there is a significant margin of safety implied by today's prices. While core customers are being driven away by the new model, a new looking fun retail experience in Penney's new stores should attract a new customer type as well, and net of all of that, I think it's safe to say there won't be a heavy loss of sales. In any case, Ron Johnson plans on cutting at least $900 million in SG&A this year. Looking at comparable companies, in the long term he believes he can cut costs to levels of competitor, Kohl's Corporation (NYSE: KSS), which would indicate potential for $1.8 billion in cuts. In conference calls thus far, management has been extremely confident about their ability to cut above $900 million in costs, and a $900 million SG&A cost reduction would result in an increase in EPS of $2.50. With shares around $23, that's a multiple of 10x the increase in EPS, ignoring earnings power that will be resumed inherently in the business once the turnaround is complete. With comparables at multiples of around 13x earnings, prices currently imply an inherent margin of safety regardless of Penney's ability to actively grow revenue.
Bill Ackman believes that "if JCP becomes a collection of specialty stores, why can't its sales reach specialty store levels?" With Gap (NYSE: GPS) and American Eagle Outfitters (NYSE: AEO) at $337 and $436 per square foot respectively, J.C. Penney has a lot of room to improve if this comes true. Currently, J.C. Penney brings in $132 per square foot annually. Ackman believes that if sales approach specialty store levels, J.C. Penney's value will dramatically improve. And he's right of course. If J.C. Penney hits its goals for gross margins and manages to bring in $300 of sales per square foot, EPS will be $18 per share. That would imply a share price of at least $180, a 9x increase.
With lots of upside, a margin of safety, and an activist value investor on your side, this seems to be the best holiday retail investment I've seen thus far. Even so, don't assume that with Ackman on your side risk has been eliminated. There is still the risk that change might drive away current customers and fail to attract new ones, erasing sales to such a level that cost cutting can't stop value destruction. That's the cloud currently hanging over shares, so if you plan on investing in J.C. Penney, you better do your own research and come up with a good reason why the new J.C. Penney will be able to attract traffic to replace at least the customers it has already alienated.
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