Editor's note: This research note was originally published November 21, 2013 at 08:14 in Retail by Hedgeye Retail analyst Brian McGough. JCP is up 4.5% since then.
The list of ‘what’s changed’ to our thesis on JCP in the wake of its print is a very short one. In fact, it’s nonexistent. Were there questions that emerged that we need to get answered? Of course there were. That’s what happens when a company loses $1.94 per share. But far more questions were answered than were raised. Here are some of our thoughts.
- EPS of ($1.94) missed the Street’s ($1.70) but the reported number includes a $0.73 loss associated with a tax valuation allowance. We don’t think EPS was the most relevant statistic this quarter as share count estimates were all over the place given the mid-quarter equity offering. Nonetheless, on an adjusted basis, we’d say that they probably beat.
- By now everyone knows that JCP voluntarily repaid $200mm on its revolver. It’s worth reiterating as that’s not behavior one would expect from a company about to file Chapter 11.
- Guidance for 4Q includes; a) additional sequential improvement in top line and gross margin – and both positive vs last year, b) DOWN sg&a versus last year, and liquidity to be in excess of $2bn. We don’t think that down SG&A is sustainable for any extended period of time – nor do we want it to be. But for now, we’ll take it.
- That point on liquidity guidance is the most important. The big bears out there had estimates for year-end liquidity of $1.5bn to $1.8bn. Again, companies with stocks going to zero don’t take up liquidity expectations.
- One of the biggest factors we had to rectify is the fact that gross margins were weak at the same time the company brought back higher-margin private label. But what we did not consider is the fact that JCP is still dealing with merchandise that was ordered under Johnson’s regime – brands that the consumer simply does not want. This is product that is going out at a gross margin in the 15-20% range. That’s seriously offsetting the high-40% GM JCP realizes on private brands like Arizona, Worthington, and St. John’s Bay. We did extensive consumer survey work around these brands – and although most people reading this note might not want them, the average American definitely does.
In the end, this is going to be the quarter where people look back and say “yeah, that was the point where I realized JCP wasn’t going under”. We know that this isn’t a major bullish statement, but it certainly removes the most bearish case being throw around – and that’s the case that nearly every short is banking on (and yes, JCP remains one of the most heavily shorted stocks in the S&P). People are still going to have to buy in to the premise that this company can see an acceleration in sales/square foot to a level that can sustain a respectable earnings level. We think JCP pierces through $120/ft in 2015 – which will mark its break-even year. That might not sound too enticing – after all, we all like for companies to make money instead of simply not lose money. But the consensus is at a loss of $1.18 that year, and we think that estimates will need to come up materially.
See our note below for more details about our call, or contact us for our recent Black Book. Also look out for our updated survey the week following Black Friday.
Here are some of our recent clips from HedgeyeTV. Comments are welcome, as always.
HERE’S WHAT WE SAID WE WERE LOOKING FOR OUT OF THE QUARTER.
11/19/13 11:49 AM EST
JCP: Buy The Event
Takeaway: There are many possible outcomes from JCP’s print. But there is virtually nothing JCP can say to suggest that it is not 100% fixable.
Conclusion: One of two things will happen, either we’ll get tangible evidence of the turnaround – which will make JCP worth buying even if it’s up. Or the company will ‘pull a JCP’ and scare the Street with the print, as it has grown so accustomed to. We think that’s unlikely. But we think one thing is clear, there is virtually nothing the company can or will say to suggest that this company is not 100% fixable. We’re buyers on the event.
First off, let’s be clear about where we stand on JCP. Our positive call is based on our view that not a single thing currently ailing JCP is beyond repair. This company is not broken. Johnson bullied and bruised a few dozen critical functions at the company, and though he may have tried to break them, he failed at that too. We don’t think that Ullman is the right person to rehabilitate JCP, but he is the right guy to take it off life support and administer CPR if necessary. We expect to see a new CEO announced by Spring 2014.
Another important point..we’re not arguing that JCP is a great retailer, a great brand name, or in any way deserving of the right to exist as a go-to source for consumers.
But let’s keep an important factor in mind…it’s operating at $100 per square foot. That’s embarrassing. Kohl’s, which we think has structural issues and has been at the top of our short list – is running close to $210/sq ft. Before Johnson worked his magic, JCP peaked out at $190 per foot.
Our point here is that we don’t have to assume that JCP becomes a great retailer. We don’t have to even believe that it will be an average retailer. It can remain in the lower quartile – a notch above Sears even – and operate at $140/square foot. And it can get there by simply fixing some of the factors that Johnson damaged during his triumphant reign.
Alongside the $140/ft, our other key assumption is that Gross Margins get back to 37%, which we think is very doable – despite the severe pushback we get on this assumption. Note that Ron Johnson’s decimation of JCP’s private label brands cost the company about $1bn in gross profit – that’s what happens when you remove $2.5bn in sales at a 48% gross margin and substitute with $900mm at a 33% gross margin.
All in, those assumptions get us to $1.30 per share, which is meaningfully above the high end of where even the most vocal bulls (if there are any) are posting their estimates. Will it get there tomorrow? No. But it’s math that people will begin to run within 12-month’s time. Keep in mind that over the past few years there has always been a debate alive about what the ultimate earnings power of JCP actually is. That debate today is absolutely dead. And we’re not talking about an unachievable Ackmanist-driven Hail Mary $12-EPS power. In all our travels and phone calls, we can’t find anyone that is willing to acknowledge that JCP can actually earn money. That will change, and we think it happens within 12-months.
So, what are we looking for in the quarter?
- First off, this is literally a three-year turnaround – it won’t be fixed in a quarter. What we’re looking for this quarter is a mere two or three wins on the road to fixing several dozen problems. That might sound like a shameless hedge – perhaps it is. But there’s going to be a mix of noise and good news in this quarter. That’s upside from the past two years where it’s been all bad news.
- We’re looking for about a -5% comp. The company already reported a 0.9% store comp and 38% dot.com comp for Oct. Based on commentary by virtually all retailers, October was the best month of the quarter. -5% seems about right, but could be 2-3% +/-.
- Gross Margin change is going to move inversely to comp. We have it modeled +100bps vs. last year – which would mark the first GM improvement in about 10 quarters. Our bias is to the downside on that one, as Ullman told the whole world that he’d end the quarter with positive comps, and he did a +0.9% in Oct. Sounds like he stretched. More likely than not, he told his selling and merchandising team to drive a positive comp come hell or high water. That usually does not come alongside a healthy gross margin. Nonetheless, they’re coming off such low numbers that Gross Margins could be down 100bp and still post a 150bp sequential improvement on a 2-year run rate – which is what we’ll really be looking to see.
- We’ve got an operating loss of -$292mm, which compares to the Street at -$384mm. Our number might be on the aggressive side due to gross margin, but we’re reasonably confident that JCP won’t miss the consensus.
Usually, we don’t leave EPS for last, but the company’s print relative to expectations will be relatively meaningless due to the timing of the company’s offering and inconsistency in how people are modeling the fully-diluted share count. The Street is at -$1.70 this quarter, but the range is from -$2.36 to -$1.11. We have JCP losing a little over a buck. But again, share count is uncertain. We’ll look at the operating loss delta as the best way to gage our estimates versus consensus.