Conclusion: There's a tremendous amount of emotion in this one (almost all negative), and we think that JCP has tremendous support at its pre-market range of $18-$19. As surprised as we might be to the market’s reaction, we’re not going to argue with it – the same way we didn’t argue with the 24% peak-to-trough squeeze over the past 4-weeks. What we will do is prepare for an opportunity to get heavier in an name where our conviction is growing. Regardless of what the consensus thinks, the metrics that matter (cash, internet, eps) came in at or better than our model, and we remain confident in the cadence of shop rollouts needed to make this model work. This is definitely a ‘hold your breath’ name over the near-term. But we think it is in the high $20s in 12 months.
We’ve gotta say up front that we’re surprised to see the stock trading at the same level after hours that it was when we were seeing liquidity-fueled downgrades, $12-15 price targets on supposed equity offerings, and story-telling about Icahn buying JCP bonds as a backdoor way to push Ackman’s second-largest holding into bankruptcy.
Yes, the results were bad. But the comp was right in line with the -30%+ speculation that was widespread before the quarter. The only thing that was unexpected was the atrocious -640+bp decline in gross margins during the quarter. But let’s actually give RJ some credit (we have not given him any yet). He did what he had to in order to clean inventories to be ready for what will be a very big year for the company. Being heavy on legacy product while shops are being converted would be the end for him.
Also, as an aside, we liked the element of humility that Johnson brought to the equation (“last year’s pricing mistakes were all my fault”), which is a stark contrast to the hubris we painstakingly observed last year.
As it relates to shop rollout plans, he reiterated plans for 20 Home shops in over 500 (of the 700 being converted) stores by May. He highlighted what we already knew…that Home-related dollars in JCP stores are 25% of where they used to be (10% of square footage down from 20%, and productivity down below $100/ft vs prior levels nearing $200.) We’d only been modeling 30 shops added in 2013, and still come out bullish – now we’re thinking that they probably beat that (see our shop/comp algorithm math below).
Lastly, let’s not forget about the cash. That’s the first number we looked at when JCP printed. Despite management’s original goal of $1bn, we’d have been content (based on our liquidity math) with $500-$700mm. We got $850mm. On top of that, the company built up to a liquidity cache of $3.1bn. By our math, that will fund 2013’s operating loss, working capital, and 2 years of capex.
Could This Really Happen?
While we model all our names out 3-5 years in full detail (3-years is our TAIL duration), we never make an investment case based entirely on something that is likely to happen 5-years down the road. But for a name that looks so egregiously overpriced today on a negative earnings and cash flow base, we think it’s a must to at least understand the margin trajectory.
In the end, our model (which we’re happy to provide) gets JCP up to $3.15 per share in earnings (keeping in mind that JCP lost over $2 per share in 2012). Initially, that sounds outrageous to our ears. But we assume the following…
a) JCP adds 100 shops per our models in the tables below.
b) Sales per square foot only need to hit $166
c) Revenue gets to $18.7bn, a level it saw in 2008.
d) Gross Margins stay below 37% -- despite management’s 40% target.
e) SG&A gets to 26% of revenue. It starts growing again in 2014, but is leveraged by comps in ‘14-‘17
f) No financial deleverage.
g) No NOL carryforward usage.
What kind of multiple is fair on those results – keeping in mind that it will be on a parabolic margin and earnings recovery. Perhaps 15x earnings, or maybe 6-7x EBITDA? That suggests a stock price of about $47. Yes..we know. 2017 is an eternity away. But let’s discount that back annually by 15% and we get to a price of $27 in a year, and then $31, $36, $41, and $47 for 2014-17, respectively. We know that’s trying to get real cute with price scenarios. But we want to illustrate what this company could look like if management executes on the shop rollouts and regains share that it handed off to competitors like Macy’s Kohl’s, Gap, Target, and off price apparel retailers.