Retailer Could Double as Transformation Continues

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

J.C. Penney's (NYSE: JCP) stock price is down significantly since Bill Ackman recruited former Apple retail star Ron Johnson to lead the company's transformation. Wall Street and its minions want to see quarterly improvements in a transformation that is supposed to take years, not months. As a result, the stock price may be under-handicapping Johnson's chances of succeeding.

Great Prospects

One of the most comforting aspects about J.C. Penney is its ability to generate cash flow. Despite a severely declining cash flow figure, the company still managed to produce $298 million in cash from operations over the last four quarters. The company has also shored up its balance sheet, which affords it financial flexibility during its transformation as well as protection should another economic downturn take hold in the U.S. In addition, even approaching management's targets for margin expansion should cause cash flow to rocket upward.

J.C. Penney's transformation was never going to be easy. When he took the job, Johnson warned investors that the first 12 to 18 months would be especially brutal. Wall Street's memory tends to be only a couple of quarters long, so it is no surprise that the stock has tanked amid expected operational turmoil at the company.

In reality, we haven't yet seen whether Johnson's ambitious plans will work. By all measures, the new stores are vastly outperforming existing stores and those of rivals. In addition, a full economic recovery in the U.S. has yet to take hold, which leaves additional upside for the new stores when a recovery does occur. But we may not have a good enough picture of J.C. Penney's true long-term earning power until the full new store roll-out is completed.

Stiff Competition

Retailing is a brutal business. J.C. Penney faces a host of competitors, but none are more worrisome than Macy's (NYSE: M) and Kohl's (NYSE: KSS).

Macy's has limited growth prospects, which hasn't been good for its stock price, but the iconic retailer competes directly with J.C. Penney in many of its product markets. In addition, the company has restructured its back-office to allow for greater efficiency in SG&A, thus raising its operating margin and allowing it more pricing flexibility. Finally, the company continues to increase its private-label offerings, a strategy that offers improving profitability despite less-than-stellar revenue growth. Macy's will always be a pain in the neck for J.C. Penney shareholders.

But Kohl's is the company that should be keeping J.C. Penney investors up at night. The company appeals to a customer base similar to that of J.C. Penney and it is executing its business model perfectly. Like J.C. Penney, Kohl's continues to offer higher-end and niche product lines to appeal to a wider constituency and raise margins. The company also has plenty of room to expand across the U.S. and Canada, giving it a long runway for growth. So, while many investors fear the ultimate blue chip retailer in Macy's, the company to really fear is Kohl's.

Final Thoughts

Long-time turnaround investors know that you can lose a lot of money if you back the wrong turnaround, but winners can make investors absolutely rich. If it were clear that J.C. Penney would successfully transform itself, the stock price would soar to an unattractive price. This opportunity exists because the market is afraid to commit one way or the other. Investors who believe that the new stores' early results are indicative of future results should pile into this stock and hold on until it doubles or triples.


Ted Cooper III has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. 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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