The Fastest-Growing Retail Startup in History is Priced like It's Going Out of Business

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It's time to jump on the Ron Johnson bandwagon. After revolutionizing electronics retailing at Apple, Johnson is revolutionizing a different kind of retailer and leading the industry into the 21st century. But the market hardly gives him credit for the historic turnaround currently underway.

After an initial surge in share price when Johnson joined the company, investors in J.C. Penney (NYSE: JCP) have become jittery as a result of continued declines in same-store sales.

<img src="/media/images/user_13490/jcp-comps-2012q3_large.png" />

Same-store sales and in-store traffic have accelerated their declines throughout the year, but Johnson and activist investor Bill Ackman planned on a sharp initial decline in sales as the company began its transformation. The transformation will not be easy; the company's profit margin has plummeted since the beginning of the Great Recession.

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But JCP has more than the recession to blame for its woes. Under poor leadership from 1990 through 2011, the company became a promotional department store with low-quality merchandise. As a result of this poor image, JCP was unable to attract the higher-quality brands it needed to increase margins.

The Turnaround

Ron Johnson has completely re-thought JCP's strategy and has committed to a plan that will transform the company from a promotional department store to a specialty store-within-a-store. The company will essentially turn its stores into a mall, with 100 branded tenants occupying the new layout by the end of 2015.

The first phase of the turnaround has already been accomplished; JCP has fixed its pricing, in-store presentation, brands, and promotional strategy. The elimination of perpetual discounts and customer confusion with the new pricing strategy caused the sharp decline in sales seen in the first three quarters of 2012. But new brands like Nike, Izod, and Martha Stewart Home are now in place and should improve the company's image and margins in the coming years.

By the end of 2015, the company plans to have transformed 64 million square feet of the old J.C. Penney layout into the new JCP specialty stores with 100 stores (brands) in each. So far, the company has transformed 7.2 million square feet (11% of total) into the new format. Sales per square foot increased from $134 in the old format to $269 in the new format. By comparison, Gap (NYSE: GPS) had $337 in sales per square foot in 2011 and Aeropostale (NYSE: ARO) had $561 in sales per square foot. Since the new JCP layout will essentially be 100 specialty stores in one big box store, sales per square foot will likely approach that of Gap and Aeropostale.

Valuation

If you assume 64 million square feet at the end of 2015 and $250 in sales per square foot with a 10% pre-tax margin, you get $1.6 billion, or $7.31 per share, in pre-tax earnings for 2016. At 10x pre-tax earnings, shares would trade for $73.10 in 2016.

In addition to rapid sales growth, investors can also count on $900 million in expenses that will be cut by the end of the transformation. If you add $900 million to 2011 pre-tax earnings of $581 million, you get 2016 pre-tax earnings of $1.48 billion. At 10x pre-tax earnings, that's a value of $67 per share.

But Ackman is even more optimistic. In a presentation given in March at the Ira Sohn Investment Conference, the activist investor laid out a base-case scenario for a $191 value per share at the end of 2015 and an optimistic case of $315 per share.

I wouldn't count on a twenty-bagger, but JCP could easily be a five-bagger if Johnson is anywhere near successful at implementing his vision for the company. Given the complete transformation from the old J.C. Penney low-quality stores to the new store-within-a-store layout, it's no wonder Ron Johnson calls his company the "fastest-growing startup in retail history."


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