J.C. Penney: Valuation Perspectives On A Battleground Stock

J.C. Penney Company (JCP) is a battleground stock. Bill Ackman went long JCP's stock for approximately $1,000,000,000, at an average cost for his 39 million shares of $25.90, then less than three years later he sold at $12.90 for a huge realized loss and claimed in Pershing Square's Q3 2013 investor letter that he was "bearish" on the company's prospects. Similarly, Kyle Bass of Hayman Capital Management went long a large chunk of JCP in mid-2013, only to turn around and sell his entire stake a few months later. Quite a few other hedge funds have dipped their toes in the JCP pool. Even the CEO of JCP has publicly placed his bet on the company. This raises the following questions: How can so many smart investors -- some long and some short (and some both) -- be completely flummoxed by JCP? And what is the company actually worth?

With respect to the first question -- "How can so many be so confused by JCP?" -- I believe that several factors have played a role. First, there was Ron Johnson and the "Apple mystique." Simply put, Ron Johnson was the supposed "genius" behind Apple's (AAPL) retail stores, handpicked by the icon Steve Jobs; Apple's retail plans succeeded beyond anyone's wildest dreams; thus, Ron Johnson became in the public's eyes a visionary who could revitalize JCP where others had failed. Bill Ackman bought this theory hook, line and sinker. Many others bought into the myth as well, such as Vornado. Unfortunately, Johnson proved to be as far from a genius as one could imagine in running JCP -- and he promptly ran it straight into the ground. With Johnson's plans to re-imagine JCP in tatters and Ullman back in the fold as CEO in place of the disgraced and deposed Johnson, other supposed geniuses -- such as Bass -- tried to pick a bottom in the stock. One can imagine how smart these masters of the universe must have thought they were in getting Mr. Ackman's shares, originally bought in the mid-$20s, on the cheap for under $13 - only to be subsequently burned by JCP's share offering. Understandably, those who bought prior to the share issuance promptly jettisoned their shares after being heavily diluted.

Second, retail is a brutally tough market sector, success or failure being subject to whatever tomorrow's fashion trend happens to be; today's heavyweight is tomorrow's weakling (and vice versa). For example, witness the recent decline of logoed teen brands and the volcanic rise of Michael Kors. One might as well read tea leaves (as opposed to SEC filings) in trying to guess what the next retail trend will be. Moreover, the rise of Internet retailing has further clouded the picture. Amazon sells everything under the sun -- and often it's a lot easier to order goods from the comfort of home rather than schlepping out to the nearest mall. Thus, it is no wonder that even the best investors have trouble figuring out how much any given retailer is worth.

This brings us to the second question: What is JCP actually worth? If so many highly intelligent investors can be fooled by JCP, is there any way to value the company with a reasonable degree of certainty? I believe that we can pursue several different paths in order to reach an answer as to whether JCP, at slightly over $9 per share (as of Dec. 31, 2013), is currently undervalued, fairly valued or overvalued. Specifically, we can look to the following metrics for JCP and see how these measure up to the same metrics for JCP's competitors: Estimated price-to-sales ratios and price-to-earnings ratios for the upcoming 2014 fiscal year based on current analysts' estimates, as well as the current price-to-book ratios and enterprise value-to-EBITDA ratios using most recently available financial statements.

For comparable companies to JCP, I have selected Macy's (M), Kohl's (KSS) and Dillard's (DDS). As a further estimate of valuation for JCP, we can make an educated guess as to the present value of JCP's future net cash flows by constructing a base, bear and bull case scenario for the company. (Please note that the following data were sourced from Yahoo Finance.)

Price-to-Sales (P/S) Ratio for FY 2014 (Estimated):

JCP = 2.77B / 12.91B = 21.4%

M = 19.61B / 28.78B = 68.1%

KSS = 12.13B / 19.38B = 62.5%

DDS = 4.23B / 6.82B = 62.0%

Conclusion: Based on this metric, JCP is extremely undervalued. If JCP had a P/S ratio equal to the average of its peers (64.2%), JCP's stock price would be approximately $27 per share, or ~3 times the current price.

Price-to-Book (P/B) Ratio (Current Through Q3 2013):

JCP = 2.77B / 2.64B = 1.05X

M = 19.61B / 5.44B = 3.60X

KSS = 12.13B / 5.92B = 2.05X

DDS = 4.23B / 1.87B = 2.26X

Conclusion: Based on this metric, JCP is severely undervalued. If JCP had a P/B ratio equal to the average of its peers (2.64X), JCP's stock price would be approximately $22.85 per share, or ~2.5 times the current price.

Price-to-Earnings (P/E) Ratio for FY 2014 (Estimated):

JCP = Not meaningful (negative earnings expected for FY 2014)

M = $53.3 / $4.32 = 12.3X

KSS = $56.7 / $4.54 = 12.5X

DDS = $96.2 / $8.02 = 12.0X

Conclusion: Based on this metric, we can conclude that if JCP were to regain profitability in the future, it should trade at a multiple of approximately 12X earnings, or perhaps somewhat less given its relatively high debt levels. Since JCP is currently losing money -- and is expected to lose money during FY 2014 -- its current price level does not appear to be too low based on this metric.

Enterprise Value-to-EBITDA (EV/EBITDA) Ratio (LTM as of Q3 2013):

JCP = Not Meaningful (negative EBITDA for the last 12 months)

M = 6.8X

KSS = 6.0X

DDS = 6.1X

Conclusion: Based on this metric, we can conclude that, if generating positive EBITDA, JCP should trade at an EV/EBITDA multiple of approximately 6.3X. Since JCP currently has negative EBITDA, its current price level does not appear to be too low based on this metric.

Present Value of Future Net Cash Flows: If we posit that JCP's adjusted earnings for its 2014, 2015 and 2016 fiscal years will be minus $2.50, breakeven and $1, respectively (for our purposes, adjusted net income will serve as a rough proxy for net cash flows), using the "NPV" function in Excel we can calculate JCP's discounted net future cash flows (DCF) for a base case, a bull case and a bear case scenario, using the following assumptions:

Base Case

FY 2017-21: 10% EPS growth; FY 2022-33: 3% EPS growth; 10% discount rate; $3 terminal value = $12.25 per share

Bear Case

FY 2017-21: 5% EPS growth; FY 2022-33: 0% EPS growth; 10% discount rate; $1 terminal value = $7.18 per share

Bull Case

FY 2017-21: 15% EPS growth; FY 2022-33: 5% EPS growth; 10% discount rate; $5 terminal value = $18.12 per share

Conclusion: Clearly, the present value of future cash flows depends heavily on the assumptions used in the calculation. As recently as JCP's FY 2010 under Ullman (i.e., the fiscal year that concluded just prior to Ackman joining JCP's board of directors), JCP earned $513M from continuing operations on an adjusted basis (or $2.16/share) on $17.8B of revenues (see press release here). If JCP can increase its revenues 15% in each of 2015 and 2016 from a base of an expected ~$13B in 2014 and get back to around the $17B level in revenues in 2016 with normalized gross margins, at least $1 per share in net income (excluding non-recurring items) in 2016 looks feasible, after adjusting for the increased share count and higher interest expense the company is paying versus 2010 (on the other hand, note that JCP reported in its 10-Q for Q3 2013 that it had $2.5B of federal net operating loss carryforwards that do not expire until 2032 and 2033, so the company, if profitable, would not owe any federal income taxes for quite a few years). Thus, under the base case DCF estimate ($12.25), as well as the midpoint between the bear and bull cases ($12.65), JCP appears significantly undervalued.

Overall Conclusion

Based on the P/S and P/B ratios, JCP is severely undervalued vis-a-vis its peers. In addition, JCP appears to be undervalued based on a calculation of its estimated DCF (using the above assumptions). However, based on the P/E and EV/EBITDA ratios, JCP does not seem to be undervalued vis-a-vis its peers. If we assume that JCP can regain profitability on an adjusted basis within the next 2 years without any further substantial dilution, I believe that we can also assume that JCP will gradually close the P/S and P/B gaps with its peers, as well as the gap between its current stock price and its base case estimated DCF.

A price per share for JCP of around $12.50 (approximately 50% of the average of the target prices for JCP based on the P/S and P/B metrics and slightly higher than the base case estimated DCF) looks achievable in the next year or so, assuming that JCP continues to evidence progress on its turnaround efforts (note that over the past four months, JCP has seen sequentially increasing same-store sales against the same months in 2012, including a 10% SSS gain in November). A stock price of $12.50 for JCP would represent nearly a 40% increase from the current price.

Source: J.C. Penney: Valuation Perspectives On A Battleground Stock

Disclosure: I am long JCP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. (More...)

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