Last Thursday, famed investor George Soros filed a disclosure with the SEC, stating that he had acquired 7.9% of J.C. Penney . Soros' investment comes at a time of substantial turmoil for J.C. Penney, after former CEO Ron Johnson's plan to transform the company into a "specialty department store" led to a steep sales decline and heavy losses last year. Johnson was replaced with his predecessor, Mike Ullman, who is expected to undo many of the recent changes to J.C. Penney while maintaining some elements of Johnson's strategy.
While Soros is a savvy investor, ordinary investors probably should not follow him into J.C. Penney stock. Penney is still a very speculative investment, because there is no guarantee that Ullman will be able to win back enough shoppers to return the company to profitability. Competitors such as Macy's made a strong effort to win business from disgruntled J.C. Penney shoppers last year, and Macy's will work hard to keep those consumer dollars. Soros has a net worth of nearly $20 billion, so he can afford to risk losing a significant amount of money in a long-shot bet on recovery. For most investors, though, it would be unwise to invest in a company as risky as Penney.
Since Ullman returned as CEO, J.C. Penney has gained breathing room through a five-year, $1.75 billion term loan announced on Monday, secured primarily by the company's real estate. This provides a much more stable source of long-term liquidity than Penney's revolving credit line, from which the company recently borrowed $850 million to fund working capital needs. With this additional financing, Penney should have enough cash to fund operations and necessary capital expenditures for the next year or two, which mitigates the threat of bankruptcy (for the time being). On the other hand, it now seems unlikely that Penney will be able to create value through the sale or spinoff of real estate assets, because those assets are now being used as collateral.
However, improving liquidity only addresses one of J.C. Penney's symptoms; it does not cure the company's fundamental problems. Penney experienced a 25% drop in sales last year, while total U.S. retail sales grew slightly. As a result, the company lost significant market share to mall-based competitors like Macy's. Unfortunately, bringing back coupons and returning to a "high-low" pricing strategy is probably not enough on its own to bring back former customers. J.C. Penney experimented with using more promotions during the fourth quarter last year, but still experienced its worst sales decline in that period.
Moreover, J.C. Penney has a long road to climb to bring revenue up to a point where the company could break even. Most analysts expect revenue to decline again in the first half of fiscal year 2013, reflecting the further erosion of traffic late last year and extensive renovations in the home section, which have closed off a significant amount of floor space. The average analyst estimate for fiscal year 2013 revenue is $12.26 billion, almost 30% below the fiscal year 2011 total, and nearly 40% below the all-time peak before the Great Recession.
By contrast, J.C. Penney probably needs to generate revenue of $15 billion at a gross margin of 36% (in line with fiscal year 2011 gross margin performance) to break even. This reflects additional cost savings compared to last year, offset by higher depreciation expense due to the company's heavy capital spending and higher interest expense from J.C. Penney's recent borrowings. Given the level of competition in the department store segment, it will be very difficult for Penney to close that gap in less than three years. Moreover, the company's customers tend to be very price-motivated, which could force the company to discount especially heavily in the next few years in order to recapture previous customers. This could push gross margin even lower than 36%, making it harder to break even. Thus, while J.C. Penney has some breathing room, it is by no means out of the woods yet.
Foolish bottom line
Soros has not publicly stated why he purchased J.C. Penney stock, and the investment appears to be a high-risk gamble. Penney now has adequate liquidity to execute a turnaround strategy, but even after its recent cost cuts, it will need to regain a significant portion of the revenue it lost last year just to reach breakeven. Even in a best-case scenario, this will take several years to play out, and failure could lead to substantial losses. For most ordinary investors, the risks far outweigh the potential rewards of investing in J.C. Penney.
More Foolish perspective on Penney
J.C. Penney's stock cratered under Ron Johnson's leadership, but could new CEO Mike Ullman present the opportunity investors have been waiting for? If you're wondering whether J.C. Penney is a buy today, you're invited to claim a copy of The Motley Fool's must-read report on the company. Learn everything you need to know about JCP's turnaround -- or lack thereof. Simply click here now for instant access.
The article George Soros Is Buying J.C. Penney Stock: Should You? originally appeared on Fool.com.
Fool contributor Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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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