Today’s announcement that JC Penney is granting board seats to two of its largest shareholders, activist Bill Ackman and real estate guru Steve Roth, is certainly something for the bulls to chew on. Or is it? After all, these are the guys who are supposedly going to “shake things” up at the middle-market department store at time when margins are headed south and sales growth remains in a holding pattern. Additionally, the company announced a series of “strategic” moves aimed at improving profitability (over time). The key here is the “over time” part. This is neither a quick fix, nor a near-term margin and/or sales enhancing strategy. Instead, this is an example of addition by subtraction.
JCP plans to do the following over the course of 2011:
- Close 5 under-peforming stores.
Closing just .0045% of the store base is hardly worthy of a press release let alone a conference call. Importantly, management remains convinced that the rest of the store base meets acceptable performance hurdles. In other words don’t expect a major store closing effort. The focus from management remains on growth. Recall that the company’s April analyst day set out a 4% CAGR for comps over the next 5 years.
- Finish the wind-down of the company’s legacy catalog business, including the closure of 19 catalog clearance centers.
For a company that was early in building out e-commerce it has been slow to let go of its legacy. Perhaps this is because of an aging customer demographic or a reluctance to let any more sales walk out the door. Either way, this is a good move albeit one that is three years too late.
- Close two call centers by consolidating operations into the remaining three facilities.
We’re not sure many people even realize JCP was operating 5 call centers nationwide to deal with customer service issues stemming from an aging catalog division. For fun, try calling Zappos and then JC Penney. Compare and contrast.
- Re-org the custom decorating business, which includes focusing on key markets (300 studios down from 525) as well as consolidating fabrication facilities into one location.
We know that JCP has long been known as a destination for window treatments (thanks to Sears for exiting the biz a few years back as well) but decorating too? This announcement makes us wonder what other 1960’s era efforts are still being performed within the organization. We understand that “vintage” can be a retail strategy, but we’re pretty sure that is not the intention here.
- These efforts are expected to generate $0.07 in EPS in 2012, after cumulative costs of $0.13 over 4Q10 and F2011 to exit the abovementioned businesses.
On current earnings of $1.47 or the Street’s consensus of $1.71 for next year, these savings barely amount to much. Yes they help, but the company by its own admission is still a long way from peak EPS earnings of $4.75 in 2007.
Management’s conference call to discuss these (minor) tweaks to the company’s operations over the next twelve months as well as any insight into the “expertise” that Mr. Ackman and Mr. Roth bring to the boardroom were scant on details. In fact, the biggest take-away from the call was not what might be on the horizon in terms of big strategic moves (like a DDS REIT structure?) but rather what’s not on the horizon. The message continues to be that the organization needs productivity improvements (i.e sales) to leverage a legacy fixed cost infrastructure (i.e 1,100 stores) at a time when the company’s core middle-income consumer remains under pressure from many different angles. So to paraphrase, it’s all about topline.
As such, with sales on the forefront and real estate and financial engineering near the bottom of the CEO’s priority list, we believe the fear of being short has been alleviated substantially with today’s announcement. The newest board members, in our view, will have little impact on mitigating rising costs, accelerating the topline via merchandising prowess, or figuring out a way to jumpstart the company’s large but largely stagnant e-commerce businesses. There is no doubt that new influence is better than no influence, but the big event that many have been waiting for seems to have occurred. It’s now time to focus on the company’s earnings, which even in a great year are unlikely to approach $2.00 in the near term. To get even close to $2.00, we would need to see a 120bps improvement in EBIT margins to 5.7% driven by sales growth. Recall that 2010 will mark a peak gross margin year for the company as we head into the first year of apparel inflation in the modern era. Even at $2 we would argue a multiple of 16x on the current share price seems rich for a no-growth department store. In our view, the shares appear to be overdone on hope that this is just the beginning of big things to come, be it some hugely accretive sales driving plan or one in which the company shrinks it’s 1,100 store base to a meaningfully smaller size. We don’t see this happening.
Instead, we believe that 2011 for JCP will be a year in which the Street realizes there is actually little that can be done in the near term to drive earnings measurably higher, or at least high enough to justify the current share price. We’re modeling $1.33 for 2011 driven primarily by a flat topline and modest gross margin erosion equating to 24x earnings. If there is one company that truly needs a job-driven macro recovery it’s JCP. Unfortunately, this is not a scenario we can predict with any confidence, any time soon.
Eric Levine
Director