Why Retail Turnarounds Are Difficult to Pull Off

Buying shares of a company in the midst of a turnaround can be extremely lucrative if the efforts are ultimately successful. But if the turnaround fails, hopeful investors are often left holding the bag. Determining which companies have the best chance at turning things around is extremely important, and the price you pay for the shares has to be so low that even a barely successful turnaround leads to significant gains. It's easy to be too optimistic, paying a price which is reasonable only if the best case scenario plays out.

Troubled retailer J.C. Penney seems to be continually burning investors which hop on the turnaround bandwagon. At the beginning of the year, the stock was trading at around $20 per share, but bad news has been the only kind of news for the company since then. With the firing of CEO Ron Johnson, the departure of hedge fund manager Bill Ackman from the board and as a shareholder, and most recently the planned sale of nearly $1 billion of new shares, the stock has been hammered.

JCP Chart
JCP Chart

J.C. Penney data by YCharts

The Problem
J.C. Penney has been around for more than a century, and it still maintains a loyal customer base. But many of these customers abandoned the stores during the Johnson era, with revenue falling by 25% in 2012. As Warren Buffett has said, "It takes 20 years to build a reputation and five minutes to ruin it." It will be a long slog before J.C. Penney can restore the trust of the customers which it forsook, and the company is running out of time.

Retail turnarounds are difficult because it's challenging for a retailer to maintain a competitive advantage. Retailers like Wal-Mart and Costco, because of their immense scale, have bargaining power over suppliers, giving them a serious edge.

Companies like Starbucks have a well known and powerful brand name, making it difficult for smaller outfits to compete. J.C. Penney has a well known brand, but it was severely tarnished over the past few years, losing much of its luster. And since, for the most part, the company sells the same products sold by countless other retailers, there really isn't any competitive edge to speak of.

The Future
J.C. Penney is burning through cash, and with limited liquidity available its options are limited. With no cash flow to fund improvements or initiatives, it will be extremely difficult for the company to improve its results going forward. The announced sale of nearly $1 billion worth of stock gives the company more time, but the extreme dilution of existing shareholders makes investing in the company difficult to stomach.

Is there any price at which shares of J.C. Penney are attractive? Because I think that the chances of success are low, the price needs to be outrageously low. I'd consider J.C. Penney at a market valuation of $1 billion, which would represent a stock price of around $3.50 per share after the dilution of the new share offering. This is far lower than where the stock trades today, and it may never fall that low. But a 5% operating margin would put that price at about seven times earnings after taking interest and taxes into account, making it clear that the stock today is greatly overpriced.

A Tale of Two Turnarounds
To many, electronics retailer Best Buy looked very similar to J.C. Penney at the end of last year. The stock had tanked, valuing the company at just $4 billion, and nearly every article I read during that time predicted that the company would go bankrupt. But there were some key differences.

First of all, while J.C. Penney has been hemorrhaging cash, Best Buy never became unprofitable. Net income turned negative, sure, but this was due to write-offs and restructuring charges, and bankruptcy was never even a possibility.

Another thing Best Buy had going for it was uniqueness. While J.C. Penney competes against retailers like Kohl's and Macy's, all of which sell similar items, Best Buy had become the only major nationwide consumer-electronics retailer. Although there's also RadioShack (NYSE: RSH), which has thousands of small-footprint stores nationwide, the latter has failed to remain relevant with today's consumer. Best Buy's uniqueness gave the company a huge edge, even when facing competition from online retailers and other big-box stores.

At $4 billion, the company was being valued at less than one-tenth of sales last December. Clearly, even a middling profit margin would lead to huge gains. And indeed, it did.

BBY Chart
BBY Chart

Best Buy data by YCharts

RadioShack, like J.C. Penney, is in trouble. The brand, while well known, doesn't carry much clout these days, and having "radio" in the name probably doesn't help.

RadioShack is pinning its hopes on upgrading its image. The company has opened five upscale stores in Manhattan, with plans to bring 15 more online before the holiday season. These stores offer a cleaner, more modern look, and the company plans to remodel about 2,000 more stores over time. Reducing the number of stocked items is another initiative, welcome news as inventory has grown even as sales have declined.

The Bottom Line
Retail turnarounds are difficult, and looking for companies which have an edge is the key to investing in them. Best Buy had that edge, while J.C. Penney and RadioShack offer no competitive advantages to speak of. J.C. Penney needs to be far cheaper for an investment to make sense, and the new share offering, while necessary for liquidity purposes, drives this price down even lower. I wouldn't touch the shares unless they fall into the low single digits, and even then I'd be hesitant.

Which Retailers Are Poised to Thrive?
The retail space is in the midst of the biggest paradigm shift since mail order took off at the turn of last century. Only those most forward-looking and capable companies will survive, and they'll handsomely reward those investors who understand the landscape. You can read about the 3 Companies Ready to Rule Retail in The Motley Fool's special report. Uncovering these top picks is free today; just click here to read more.

The article Why Retail Turnarounds Are Difficult to Pull Off originally appeared on Fool.com.

Timothy Green owns shares of Best Buy. 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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