(By Paul Swinand) We believe J.C. Penney's (JCP) turnaround will work for three principal reasons: the speed at which the company has been able to change, including cutting around $1 billion in costs; the increased productivity of the early merchandise installations suggests store productivity can be dramatically improved; and we believe merchandise is the real driver of retail success. Our early assessments of new merchandise and the shop-in-store concept are quite positive, and we believe that when the company has spent a year or two being merchants instead of sale coordinators, customers will respond positively.
Going Slowly Was Not an Option
The speed of change has been the most impressive part of J.C. Penney's transformation. Given the new everyday-low-price strategy needed to attract the national brands--which don't want to see red "70% off" signs on their merchandise--it is clear to us that the plan had to be implemented quickly. Management's turnaround timeline is already fairly long (four years), so a delay would have made the transformation potentially more painful, not less. National brands, new brands, and companies that can help differentiate the new JCP have noticed the speed of change, too, and the impression that management's commitment has made on them is a strong contributor to the hundreds of companies interested in signing on for the new shop-in-store concept.
J.C. Penney has taken around $1 billion in costs out of the system, both in stores and at headquarters. To do so, a dramatic change in how the company does business had to take place. We think the promotional strategy of the past served to hide many sins, and the abrupt change in strategy was key to sending a message throughout the organization that the old way had to be left behind.
Productivity of Transformed Space Is Compelling
To us, the stores already feel different, even if the company has actually transformed only a small fraction (roughly 10% as of November) of the square footage. Sales are up an average of 33% for the eight shop-in-store concepts implemented in 2012. Management made smart, simple, and inexpensive moves such as changing signage, taking clearance racks out of the aisles, enhancing existing shops such as Sephora, adding new shops, and even changing the music.
One change that can't be underestimated, in our view, is the absence of big red sale signs cluttering the store. The decluttering of the store and the avoidance of cheapening the merchandise is necessary for better national brands to agree to have their products sold by J.C. Penney. In addition, the new strategy asks customers to decide first whether they like a product; then they discover the price. The previous promotional strategy encouraged customers to cherry-pick the items with the biggest percentage off. Indeed, while gross margins have been under pressure, everyday-price selling has lifted average margins nearly 4%, although the increase in clearance caused by the sales declines has more than offset the improvement.
Merchandising Is Improving
Even in the untransformed stores, we've noticed some differences already in merchandise and the feel of the stores. While our store checks may only be anecdotal, customers seem to like the product once they've discovered it.
We believe this improvement will continue. First, the stores now have more of a seasonal theme than in the past. Some of this is through marketing, signs, and advertising, but it goes a long way to make customers feel there is new and exciting merchandise to discover. While the recent slow sales volume probably put some sand in the gears of this strategy as old inventory is still clearing, the stores are using themes as simple as coordinating colors and buys across categories, emphasizing colors and themes in advertising, and then adding signs and featured merchandise of the same colors and themes in the stores. This is not a new strategy in retail, but it contributes to the feel that something has changed at J.C. Penney.
The merchandise turnaround is only in the early stages, in our opinion. Previously, merchants were not thinking about customers and how they shopped, or how they might coordinate outfits. Now, they are being asked to think more holistically and aren't focused on the depth of the sale promotion and coordinating the percentage-off signs. Already, JCP-branded merchandise has comped positive in some cases, despite the traffic headwinds and the addition of more national brands.
We've also seen what we think are positive signs in women's footwear and apparel. Previously, shoppers we've interviewed did not believe J.C. Penney had any fashionable shoes and apparel for younger, more trend-oriented people. Now, the merchandise looks are younger and the people we see shopping the departments are younger, too. The addition of new national brands (such as Joe Fresh, Bodum, and many others) will help the entire store up its game in merchandising.
Not Out of the Woods Yet, Though
Despite these improvements, declines in traffic and increases in clearance will throw a wrench into the gears in the near term. The clearance problem is going to persist and could damp sales and margins for at least the next few quarters. Sales declines in the first three quarters, and now forecast in the fourth quarter, were generally worse than expected, and buyers' great ideas will be hampered by a lack of open-to-buy dollars to invest in new inventory. As a result, customers will be tempted to buy clearance instead of full-priced items, which isn't ideal for margins or for buyers' exciting new merchandise plans. We'd expect this unvirtuous cycle to continue for at least the next two quarters, until comparable-store sales and traffic begin to improve and open-to-buy dollars loosen up.
We don't expect meaningful comp gains until 2014-15. In 2013, we assume small-store comps improve at half the rate of the main stores, and then at 5% onward (from better traffic and a halo effect). Holding everything else constant, including the 33% average sales lift for transformed space, and using a 25% lift for the following year on last year's newly transformed space, J. C. Penney would only do a 7% comp gain in 2013. We calculate the comp sales gain would be approximately 12% in 2014 and just over 12% in 2015. We project that each year, the initial productivity of newly transformed space declines, as we assume the highest-impact brands positively implement the shops first. We also forecast that each year the transformed space from the previous year comps at a decelerating growth rate. Finally, we bake in no potential synergy impact from increased traffic or cross-shopping among shops or as new customers discover the JCP brand.
Real Estate Environment Has Changed
When Bill Ackman's Pershing Square and Vornado first took stakes in the company in 2010, we argued the difficulty of the real estate investment trust play and problems in monetizing undervalued real estate. At issue is what rent payment would the old JCP make to its own REIT, and at what multiple would the market value the cash flows to that REIT trade under the new structure, given that such cash flows were purely derived from a single retail tenant? The risks to the new JCP REIT's cash flows would include all the risks that the single department store bears, plus additional leverage. While the tax shield JCP receives is value-creating, we believe the REIT would take on debt to lower its overall cost of financing and the additional leverage created by the REIT could also increase the probability of financial distress, which could depress multiples of both the REIT and old JCP. A REIT also adds additional operating overhead on the REIT side.
However, there is a major difference now in the marketplace; the retail real estate market has turned and REIT valuations are up and still rising. Although discount department stores aren't growing very quickly compared with the market, and A malls are doing the best, rents in B and C malls are now improving. J.C. Penney owns roughly 39% of its real estate and has another 10% with ground leases. It also owns significant distribution center space, and as we've seen with Sears Holdings, the possession of long-term leases on key properties can also be valuable. While a true asset-based valuation would have to look at each property on a case-by-case basis, it is not difficult to conservatively arrive at an estimate of $17-$20 a share under a REIT structure. Ackman has said that he believes J.C. Penney's real estate could be worth $30 per share, a number that isn't too hard to back into.
To run through the REIT exercise using rent of $12 per square foot on the 39% of the real estate that is owned, we calculate a $520 million payment to the REIT and a $200 million annual tax shield. By applying a fairly conservative REIT operating ratio of 60% (which would imply some capital expenditure transfer), the JCP REIT would have net operating income of $312 million. A single-tenant REIT, with a retailer that posts declining sales and carries meaningful debt on the balance sheet, would require a high yield. So, despite capitalization rates falling and implying higher valuations, we'd assign a base-case cap rate of 7%. This equates to roughly a $4.5 billion valuation for a JCP REIT, which is above the current market capitalization of the entire company.
Our preliminary analysis excludes other real estate such as the 10% of stores with ground leases and the 60% of distribution centers J.C. Penney owns. The remaining J.C. Penney shares would have to fall by the present value of the rent payment transferred to the REIT, but would be offset by the positive cash flow of the tax shield and any other cost transfers absorbed in the REIT's 40% operating expenses. In round numbers, the tax shield could be worth around $2 billion at the company's cost of capital and the additional rent minus expenses would be a reduction of just over $3 billion in market cap. Added together, at $17 a share, the retail operations can be had virtually for free, and at $20 a share, investors are essentially getting a call option on the retail operations for buying the real estate.
There are practical matters on a site-by-site basis that make these deals harder to realize in practice, such as available alternative tenants, which properties would actually go into the REIT portfolio, and how much debt the REIT would take on. The additional annual cash outlay of more than $300 million is above the cash flow required to run the company in the leanest of years historically and would imply zero capital spending and emergency operating measures if the U.S. economy were ever to experience another 2008-09-style recession. Alternatively, one could structure a deal differently with contingent rent or a portfolio of low-rent properties, all of which would imply a lower valuation for the REIT. Still, the REIT environment should continue to improve, even if housing and real estate have only just bottomed. Investors worried about inflation should also be attracted to a long-term play on real assets such as this, and we don't believe the current travails of the price and merchandise strategy have done anything to permanently damage the brand or the desirability of the locations.
We See Upside, but Growth Is Back-End Weighted
Our fair value estimate remains $38, and we believe that shares are fundamentally undervalued. We acknowledge that the near-term picture isn't encouraging, as the firm's cash flows are depressed and falling, accounting earnings are not just negative but also filed with charges and one-time items, and the top line has shrunk more than 20% thus far this year. Our discounted cash flow model assumes significant operating losses, steeper accounting losses, and roughly neutral cash flow this year after inventory reduction, depreciation addback, and asset monetization, despite the huge accounting loss being booked. However, long range the valuation remains compelling, and we believe that our model is conservative in that we neither model EBITDA returning to anywhere near prerecession levels of around $2 billion until January 2021, nor do we model EBITDA over the 2008 level of $1.6 billion until 2015. Our projections are backed by modest revenue growth assumptions over our forecast period, averaging less than 4%, with same-store sales recovering only gradually over the next three-plus years. This implies that much of the top-line and margin expansion occurs in the back half of our explicit forecast period. We estimate annual earnings before interest but after tax to average $600 million over the next decade, which translates into an implied multiple of approximately 11 times normalized average cash flow.