J.C. Penney: Value Trap or a Good Turnaround Bet?

The shares of beleaguered retailer J.C. Penney gained a surprising 8.84% on Oct. 28, 2013, to trade at $7.39, after CEO Myron Ullman gave more indications that sales trends are definitely improving. This was the third time in just five weeks the giant retailer publicly declared its sales were on an uptrend.

J.C. Penney's troubles are well-known to all, and the firm's shares had dropped to a 30-year low of $6.24 just a week ago. In September alone, the company's market capitalization fell a staggering 50%.

What's the trouble at J.C. Penney?
Although it might look like there is a whole gamut of what's not right at J.C Penney, it all boils down to a poorly orchestrated sales strategy. After taking over at the helm, Ron Johnson abruptly scrapped the firm's ''dubious'' pricing policies, which involved marking up prices and then offering hefty discounts, heavy promotions and coupons. J.C. Penney's large customer base of bargain hunters revolted at the move, and store traffic nosedived. The retailer's attempt to reintroduce markdowns last year failed to reverse the damage, and sales fell a jaw-dropping 25% by end of fiscal year 2012/2013, depriving it of $4.3 billion in revenue. In short, J.C. Penney tried to institute too many changes too quickly, without first testing what the full impact would be. 

The biggest concern right now for its investors is the firm's high cash-burn rate through inventory investments, and the planned secondary offering of 84 million common shares at $9.65 per share. Goldman Sachs, which managed the transaction, has a right to buy a further 12.6 million shares.

Investor opinion on the company is torn at this point, and most are not sure if the stock is a great bargain or just another value trap. Let's try and take a more balanced view of the company by weighing its pros against its cons.

1. Improving fundamentals- As earlier noted J.C. Penney has issued three statements in the space of five weeks indicating that the firm's turnaround under CEO Ullman was gaining traction. Losses are also expected to decline dramatically come next year.

2. Back to Company Basics- Ron Johnson's disastrous shock therapy that involved changing the layouts at stores, adding upscale merchandise, and trashing discounts was too jarring for J.C. Penney's customers. Current CEO Myron Ullman has beaten a hasty retreat to the retailer's roots and reintroduced coupons and promotions.

3. Valuation- J.C. Penney is trading at around 0.15 overall sales. In comparison, Macy's and Kohls trade at 0.6 times overall sales. Well-known heavy hitters including George Soros, Kyle Bass and Richard Perry of Perry Capital are all long the stock.

4. Less liquidity problems- The firm's cash burn rate is expected to be much lower next year. J.C. Penney announced on Oct. 7 that it expects its liquidity to improve considerably by the end of this year.

1. Competitors- J.C. Penney faces intense competition from better-heeled competitors such as Macy's, Kohls and Target. A sluggish economy might induce these three to offer more discounts and put J.C. Penney's business in jeopardy. The secular trend of e-commerce shopping can send the firm's traditional value-driven customers to Amazon.com.

2. Leverage- J.C. Penney currently has $5.82 billion in total outstanding debt obligations. The heavy debt load not only increases the firm's risk of default, but also leaves it with fewer resources to devote to the development of new merchandising strategies, mobile and e-commerce marketing, and other marketing campaigns.

Not as bad as it looks
Although Bill Ackmann offloaded his J.C. Penney and Target shares from his hedge fund, the move was not inspired by a lack of confidence in J.C. Penney, but rather to gratify impatient short-term investors who demand quarterly returns come what may.

The 96.6 million secondary shares is not necessarily a bad thing in and of itself. J.C. Penney holds about $1.5 billion in cash and other cash equivalents, which works out to $6.95 per share. At the current trading price of $7.39, the company's market capitalization consists of 94% cash held on hand. Even after the anticipated share dilution, cash held on hand will still make up 65% of its market cap.

In Ullman's own words, J.C. Penney might have 30 things going wrong with its stores, but all can be fixed.

Bottom line
Investors have been quick to draw parallels between J.C. Penney and ailing Sears Holdings . Sears' case, however, is something else altogether, as I outlined in this bearish article. Sears' investors are counting on the firm unlocking value from its extensive real estate properties, which could be grossly overvalued. J.C. Penney's investors, on the other hand, are counting on an improvement in its retail fortunes, and there are good indications that the firm is already on a recovery path.

In this writer's humble opinion, J.C. Penney is a great turnaround bet that has been punished too harshly for declining store sales. The erosion in the firm's market cap is completely out of touch with the company's underlying fundamentals. This is a good time for bullish contrarian investors to up their ante in the stock, or take advantage of the fresh entry points offered by the ultra-low share price.

Could J.C. Penney ever rule retail?
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The article J.C. Penney: Value Trap or a Good Turnaround Bet? originally appeared on Fool.com.

Fool contributor Anthony Maina has no position in any stocks mentioned. The Motley Fool recommends Amazon.com. The Motley Fool owns shares of Amazon.com. 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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