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2 Ways To Play J.C. Penney's (Failed?) Turnaround

Nikhil is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The bears have finally caught J.C. Penney (NYSE: JCP).

After a terrible quarter, shares have settled at around $17, down 50% from Jan. 1. I'm not going to be that bull who continuously clings to the J.C. Penney turnaround story despite the evidence, but whether the turnaround succeeds or fails, there is money to be made here. To really understand how to take advantage of the situation at J.C. Penney, you need to understand the whole story. If you've been following the J.C. Penney Saga and understand the backstory, feel free to skip the story section.

Before the extreme retail shifts that have occurred, J.C. Penney was the trashiest of apparel retailers. The retailer’s brand had become more about about heavy discounts and clearance sales, a strategy that emphasized quantity over quality, and J.C. Penney's stock languished.

Enter Bill Ackman. (See his investment presentation here.) 

What is business about? Profits. It's about increasing revenues and decreasing expenses. Ackman saw a potential turnaround situation because sales at J.C. Penney were lower than the value of their real estate would imply they could be, and expenses at J.C. Penney were higher than they should've been. In order to fix these problems, he embarked on a cost-cutting plan and a retail overhaul to increase sales per square foot.

The cost-cutting plan has been successful. Management wanted to cut $900 million in SG&A expenses that didn't interfere with customer activity, and they've been able to reach that goal as management stated that SG&A expenses in 2013 should be $4.2 billion compared with $5.1 billion in 2011. If cost cutting had been the only change in J.C. Penney's business, the stock would likely be doing much better right now -- $900 million in cost cutting, assuming a 40% tax rate, equates to adding $2.5 earnings per share. With J.C. Penney averaging around $1 per share beforehand, this change alone could've gotten J.C. Penney's earnings up to $3 to $4 per share and assuming a 10x earnings multiple, the stock price would be at $30 to $40. In fact, with that information alone, J.C. Penney's 52-week high was within that range. However, Ackman saw potential in a retail overhaul, and that complete retail change is where the trouble started.

Ackman believed that the replacement cost of J.C. Penney's real estate is more than $11 billion, and he decided that there was a lot more upside to be had in J.C. Penney if he could improve the business model to leverage this real estate. He got a completely new management team with Ron Johnson, the former Apple head of retail, as the star-studded CEO, and he worked out a brand new business model. To paraphrase his presentation, J.C. Penney's business was faltering because of "excessive promotions, commodity product, and a poor store experience" that limited their market to discount customers only.

I think the way that Bill Ackman looked at the business is that it was all about what kind of store took up the real estate. For companies like Kohl's (NYSE: KSS) or Macy's (NYSE: M), which are more comparable to the J.C. Penney of old, real estate was achieving $194 and $174 in sales per square foot, respectively, in 2011, versus J.C. Penney's $112. From 2007 to 2011, Macy's and Kohl's were able to maintain revenue with 0% growth or grow revenue by 14%, respectively, while J.C. Penney sales were last in their category, down 13%.

However, Ackman wanted a complete overhaul of the retailer to maximize sales per square foot. Ackman changed the J.C. Penney logo to symbolize the beginning of a new company, and totally rebooted the business model. His dream for J.C. Penney is a mall within a mall. Essentially, J.C. Penney will be giving store space to the products of a variety of specialty retailers like Sephora, Arizona Jean Co, and others to diversify its shelf space and increase sales per square foot. Specialty retailers like Gap (NYSE: GPS) or Aeropostale (NYSE: ARO) achieved $337 and $561 per square foot in 2011, and if J.C. Penney could become a collection of specialty retailers, Ackman believes sales per square foot could approach that of a specialty retailer as well. Ironically, Gap is at the end of a successful retail turnaround (up 100% this year) while Aeropostale stock continues to languish on market share worries, down 40% from this year's highs. I guess this just goes to show that anything can happen in the retail business.

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Enter Cruel Reality

Unfortunately, for Bill Ackman and Ron Johnson, not much went according to plan. Ackman expected sales to be back on an uptrend by now, but same-store sales have been dramatically declining every quarter. More disturbing? Even online sales are experiencing dramatic declines. With such high capital expenditures necessary to build out its planned new business, J.C. Penney is facing the risk of simply running out of cash. They've had to cut their dividend, causing income investors to flee, and even now, Ackman has acknowledged that current trends would burn cash far too quickly.

Ackman, however, counters that obviously management won't simply run the business into the ground and that management will adapt as business conditions change, but bears have been wondering how much of this is in management's control. Many bears believe that J.C. Penney's dramatic retail shift -- removing their heavy discounts and changing to a "Fair and Square" pricing model -- has resulted in a a large loss of customers rather than the increase that management expects, and gaining back the customer base they had before may be more difficult than it seems.

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What Now?

The big issue now is that management is running out of time and shareholders are running out of patience. While Bill Ackman is urging investors to be patient and wait for the clear skies of 2015 when the new J.C. Penney will be almost completely built out, investors are wondering if J.C. Penney will have the funds to get there. The result? The stock price is at $17 and declining. For many investors, however, J.C. Penney is a don't touch situation. If they succeed, investors at these prices would likely get a double or higher, but if, as many bears have been calling out, J.C. Penney goes bankrupt in the process, investors could lose all of their money.

2 Ways To Play J.C. Penney

The Debt

If you're an investor with no taste for the kind of risk that J.C. Penney's equity gives you right now, why not check out the debt? A stake in J.C. Penney debt is higher on the capital ladder than Bill Ackman's Pershing Square Capital's position in the common stock, so the only way for you to lose money is for Ackman to take a 100% loss. With Ackman on the board and so heavily invested in the company, there's very low risk of an outright bankruptcy, and while that's still not very comforting to equity investors, investors in the debt should still be very comfortable. At any threat of bankruptcy, management, under the pressure of the large investors on the board, will make dramatic changes. Moreover, if Bill Ackman is right that J.C. Penney's real estate is worth more than it is stated on the balance sheet, even in the event of bankruptcy, debt holders should still have plenty of downside protection. 

If interested, here are the bonds to look at.

The Option 

Ultimately, however, for investors willing to take some informed risk, J.C. Penney's turnaround presents a nice opportunity. While you cannot be sure that J.C. Penney's turnaround will succeed or fail at this point, it is clear that by 2015, J.C. Penney will either be much, much higher or much, much lower than it is now. Therefore, instead of taking a stock position, it makes a lot of sense to take a long-term option position in the stock if you believe there is value. That way if you lose, you lose only a bit more than in a stock position, and if you win, you make a lot more. J.C. Penney has call options that go to 2015, if you're interested.

Ultimately, however, don't take an option position unless you believe J.C. Penney's turnaround will succeed. Shares currently are priced for the worst from J.C. Penney, and unless you honestly believe full-on bankruptcy is a real risk (a situation I don't think management would ever let occur), there isn't nearly enough upside for the risk you're taking.

However, if you're able to find out if J.C. Penney is successful or not, there is plenty of upside on the long position. Here's where you may have an advantage. A major turning point in the company's shares will occur in the holiday quarter, as shoppers are exposed to J.C. Penney in masses. If sales declines still don't recover, there is an obvious flaw in J.C. Penney's operations. The easiest way to get a feel for the next quarter is to go to the store. Instead of diving into financial statements like loads of fund managers everywhere, do your own holiday shopping and get a feel for customer impressions of J.C. Penney and how much traffic their stores are getting. Ask your friends, and do your own informal research, and you just might figure out what J.C. Penney's earnings will look like before anyone else.

To be clear, I don't think J.C. Penney is doing very well right now, but it is a turnaround and I still think it is plausible that its customer base could change. Either way, with J.C. Penney, you only have to take the amount of risk with which you are the most comfortable.


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