J.C. Penney: Heads I Win, Tails I Also Win?
Critics of J.C. Penney's (NYS: JCP) transformation say it's a gamble.
But I think it's a gamble that can win either way. I look at J.C. Penney, my newest CAPScall, is terms of Pascal's Wager.
If I'm right: The transformation at J.C. Penney works and the stock's intrinsic value goes up 10 times, as Bill Ackman and Whitney Tilson predict. Many of J.C. Penney's biggest costs -- including rent, marketing, and administration -- are fixed, so increases in revenue will have an exaggerated effect on the bottom line. That's what's known as operating leverage, and it's the reason McDonald's (NYS: MCD) was able to grow operating income fourfold since 2002 despite not selling 4 times as many hamburgers. The same force can work for (and against) Penney's.
If I'm wrong: The company brings back coupons, and shareholders get the company at 10 times average Great Recession free cash flow, plus whatever cost savings and working-capital improvements CEO Ron Johnson has put in place.
Or Johnson and Co. slowly liquidate the company and its real estate.
Bill Ackman -- whose fund, Pershing Square Capital, owns 26% of J.C. Penney -- claims the replacement value of the retailer's real estate is $11 billion. Since the enterprise value of J.C. Penney is around $7.5 billion, in theory shareholders come out ahead in a liquidation. This is where having Steve Roth and Vornado (NYS: VNO) on the board comes in handy.
Of course, we can't know what the real estate is really worth until the company tries to sell it -- *cough* Bruce Berkowitz and St. Joe *cough* -- but I don't think there's anything Johnson has done, or is planning to do, that is both offensive and could not be undone if necessary. The shoppers who have defected to Kohl's (NYS: KSS) and Macy's (NYS: M) because of allegiance to coupons will probably shop wherever they find the best deals, including J.C. Penney.
To be clear, J.C. Penney is not a risk-free investment. No investment, short of inflation-indexed U.S. Treasuries, can make that claim. The economy could sink to previously unseen depths; there could be another terrorist attack; the new merchandise may tarnish the brand; Johnson may burn through more cash than expected, issue more debt, or suddenly decide that every J.C. Penney needs a children's petting zoo featuring exotic snakes.
But alas, I think the probabilities favor the bulls.
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At the time this article was published Fool contributor Chris Baines is a value investor. Follow him on Twitter, where he goes by @askchrisbaines. Chris' stock picks and pans have outperformed 96% of players on CAPS. He owns no shares of the companies mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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