The JCP print was yet another event boosting our confidence that there is a severe duration mismatch between expectations for most institutional investors vs. Activists, vs. Management. We think that understanding the different durations is especially important with JCP given that it is a reasonably well-hated name (22.4% of the float is short) in retail with management incrementally investing capital into the model to transform the business.
In other words, the Street is beating up the company for doing the right thing. Usually, we love stories like this, as they tend to lead to share gain and margin growth on a disproportionately smaller operating asset base. This was RL, LIZ, NKE, to name a few. And yes, we think that it will ultimately be JCP as well.
But as we’ve been saying since our July 28th Black Book (JCP: What the Ackmanists are Missing), before JCP becomes the best stock in the S&P, it’s likely going to be the worst stock in the S&P. The company is investing today to make changes. But as Johnson openly states, he needs to completely overhaul this company to make it ‘America’s Favorite Place to Shop.’ JCP has bad real estate where it is captive to mall traffic, below-average brands, very little pricing power despite its clout – even at the factory level given its near-vertical positioning, and a competitor in KSS that simply has better stores in just about every way, and as of this year reached 50% overlap with JCP as it relates to footprint (stores within a 5-mile radius).
Valuation Considerations
Unless you are blessed with a mandate to Outperform over a 7-year time period (like Ron Johnson is), the biggest thing to consider with valuation is that it takes a distant back seat to actually understanding what the earnings levers are, and how and when the company gets there.
Let’s look at them over several durations.
TRADE (3-Weeks or less): JCP’s 4Q guidance is absolutely not a slam dunk. With Ullman getting up there and saying that comps will be flat to positive slightly and GM% will be flat to down slightly after six quarters of inventory growing an average of 5% faster than sales – we can’t simply give this company a free pass there. Here’s another consideration, in looking at year/year discretionary spending, over the past six months we’ve had a positive influx of 4-5%spending in non-essential categories on the part of the consumer. For the next five months – barring a collapse in oil or the unemployment rate – we’re looking at -2-3% yy. That’s a -5% sequential turn, and like most retailers, there’s very little chance that JCP can avoid this. We’re still shaking out below $1 in EPS assuming a 2% decline in comp compared to the company’s guidance of $1.05-$1.15 in Q4.
In the end, it’s easy for Ullman to throw out targets to the Street…because he won’t be on the call in January to defend why he missed.
TREND (3-Months or more): Ron Johnson will be coming out of his protective shell in late January at an analyst meeting in New York. That’s where he’ll roll out his strategy for reinventing the company. We can’t imagine that people will walk away uninspired…but we also think that this is the market expectation right now. One thing that RJ cannot do is roll out his plan without telling everyone how much it will cost. That’s when we think there will be sticker shock.
Do we know the dollar amount? No. But in adding up all of what we think is deferred maintenance over time, we can get to a number anywhere between $1-3billion. I realize that’s a range wide enough to drive a truck through. But the reality is that he’s going to pick a number he thinks he needs, and then he’s going to gross it up to a number that he wants. There’s a difference. Again, his $50mm in warrants get him paid based on what happens 7-years out. He’ll has a free pass with the Board to take a whack out of CASH earnings (every $1 billion is $2.50 per share) to get the company to a best-in-class retailer.
Some will argue that people will look through any special charges. We disagree. Remember that Johnson has absolutely no problem disappointing the shorter-term agenda on the Street – as was the case in his early days at Apple – in favor of building long-term value. While we’ll be the first to admit that this is the right thing to do, the reality is that this is a MAJOR execution story, and there will be bumps and bruises along the way. Earnings will matter, and it will be tough to simply ‘look through’ such big items. All honeymoons must end at some point. Eventually, Johnson will not be viewed as ‘the guy from Apple,’ but rather ‘the guy at JCP.’
TAIL (3-Years or less): This is one where the TREND meshes with the TAIL, as the announcements will be near-term, the execution will be intermediate-term, and the results will be long-term. The problem here is that JCP’s definition of long-term is 7-years. Over ‘3-years or less’, which is our long-term duration, JCP is still likely to be in execution mode. It is unlikely too see any of the real benefits of Johnson’s actions until after 2015. In other words, it’s a long time away…
Brian McGough
Managing Director
