The 2013 IPO Bubble Is Here, And Companies Are Lining Up Quickly Before The Window Closes

From Yahoo! Finance:

Zulily, Inc. operates as an online flash sale retailer in the United States, Canada, the United Kingdom, and internationally. It provides various merchandise products to moms purchasing for their children, themselves, and their homes, including children’s apparel; women’s apparel; children’s apparel products comprising infant gear, sports equipment, toys, and books; and other merchandise, such as kitchen accessories, home decor, entertainment, electronics, and pet accessories.”

Yes, Zulily (ZU). One of the latest hot initial public offerings. The company description above might sound fancy, but it’s a shopping site targeted at moms. Think of it as a specialty boutique store, with just an online presence. I don’t mean to minimize it, but there is no special sauce here. It’s a retailer, plain and simple. And a very popular one at that. For the first nine months of 2013, the company’s sales totaled $439 million, which generated $29 million of positive cash flow (7% cash flow margins).

So, how much is Zulily worth? $5 billion. And I’m not joking. The company went public last Friday at $22 per share and now trades at around $37. The initial expected price range for the IPO was set at $16-$18 but investors were willing to pay more than 35% above that before the stock even began trading. After it opened, the price was bid up another 70% on the first day.

Zulily is the perfect example of why the current IPO frenzy has gotten out of hand (and likely won’t last too much longer). The company is targeting what is likely an under-served niche within specialty retail (moms), and it has been very successful thus far. In fact, they are based here in Seattle and I hope they continue to make their customers happy. But the price of the stock makes no sense. And that’s where the IPO market, and many retail investors who are gobbling up any newly issued stock they can, will wind up having a problem.

There is nothing new here in terms of Zulily’s business model (at least with Twitter (TWTR) you can argue they created something new and were a first-mover, so perhaps they will be a unique case). They are a retailer. We have a good idea of how that business works and what kind of profit margins one can expect. Accordingly, we should be able to determine what kind of market valuation makes sense. We might not be able to pinpoint it exactly, because Zulily is growing very fast (2013 sales are running double those recorded in 2012) and its exact growth trajectory is difficult to predict, but at this point they are simply taking market share from existing retailers, both online and off. Moms across the country aren’t all of the sudden dramatically spending more on their children. There is not a retailing renaissance more generally throughout the U.S. The consumer economy has not suddenly taken off. Zulily, if they continue to execute well in the marketplace, will see its growth rate slow over the next few years and then find itself just like any other retailer vying for consumers’ discretionary dollars.

And that is why the company should not trade at 150 times cash flow. The business model at it currently stands does not justify a $5 billion valuation. Heck, even Amazon (AMZN) trades at 34 times cash flow and it is one of the few companies that can barely turn a profit (7% profit margins on a cash flow basis — same as Zulily’s interestingly enough) and not face any objections by investors. Is every dollar of sales generated by Amazon really worth 75% less than a dollar of sales booked by Zulily? That is what the market is saying right now.

And because of that other internet start-ups are preparing to test the IPO waters. Just in the e-commerce space we have heard rumblings that Gilt.com, Wayfair.com, and Fab.com are itching to cash in, and I don’t blame them. So I would caution everyone to stick to a valuation discipline when you pick stocks for your portfolio. The last time we had companies being valued based on a multiple of sales (not profits), or saw P/E ratios reach triple digits, or saw analysts justifying prices by using financial projections five years into the future, was the late 1990’s. And we all know how that turned out.

Full Disclosure: No positions in the stocks mentioned, but positions may change at any time

Sears Holdings Transformation Picks Up Steam, But Will Still Take Years

It’s been nearly ten years since Sears Holdings (SHLD) CEO and majority shareholder Eddie Lampert pulled off the Kmart/Sears merger that had investors salivating over the potential for enormous realization of the company’s real estate value. Since then however, real estate monetizations have been meager and Lampert has instead attempted the impossible task of turning around the retailing operations of Kmart and Sears. Predictably, he has failed. Take negative free cash flow and no real hope for a reversal, and throw in a few billion in debt as well as an underfunded pension plan (to the tune of about $1.5 billion), and you have a stock market disaster. Why then has the stock perked up strongly in recent weeks, as the chart below shows?

shld-sept-2013

 

Well, a little-known firm based in California called Baker Street Capital Management recently put out a 100+ page presentation making the case for why it believes Sears Holdings shares are dramatically undervalued (the midpoint of its estimated sum-of-the parts valuation range is $13.9 billion or $131 per share, more than double the current stock price of $58). The slide deck provides detailed research showing that the Sears asset monetization plan that investors have been clamoring for since 2005 may very well be starting to take shape. Most interesting are bits of information regarding the company’s real estate portfolio, which is where the majority of the asset value within Sears lies.

First, store closings have accelerated in recent quarters. This could very well signal that Lampert is getting fed up with his unsuccessful attempt to make Sears and Kmart stores more profitable (or profitable at all). I decided to look at the historical data on Sears and Kmart store closings and it does appear that the company is shutting down money-losing stores at a faster pace lately. However, as you can see from the chart I put together below, the acceleration in that trend is both noticeable and relatively small compared with what many investors would prefer.

sears-store-counts

Second, Lampert has actually taken more than 200 properties and placed them into a newly formed wholly-owned entity called Seritage Realty Trust. Not only that, but a seasoned real estate executive has been brought in to run Seritage and the company is publicizing its plan to redevelop a property in downtown St Paul, Minnesota. An artist rendering for the mixed-use project (taken from the Seritage web site — yes, this subsidiary even has its own web site with no mention of its relationship to Sears) is below:

st-paul-office

Okay, so as a former believer in Sears Holdings as an investment, you might be thinking that I am getting into the stock once again. Well, not exactly. I still have some huge issues with the equity right now (though I do hold a position in the bonds). First, although nobody can refute that there is tons of value within Sears’ real estate portfolio (billions of dollars), we can not ignore the fact that the retail operations are still bleeding cash. And as you can see from the pace of store closing shown above, there are still more than 2,000 of these stores open. Each day that passes brings with it more red ink. Even if Eddie Lampert decided to eventually shut down the retail stores completely, that process would take years. It could take a decade to transform Sears Holdings, in an orderly fashion, into a pure-play real estate company.

The reason that is a problem for would-be equity investors is that the time value of money shrinks how much that real estate is worth today. Let’s take Baker Street Capital’s estimate of Sears’ real estate portfolio; $8.6 billion. Even if this number is in the ballpark (given that they own the stock we can assume this figure is on the high side), if it takes 10 years for Sears to unlock this value through property closings, divestitures, redevelopments, etc. then the present value of these properties is actually a fraction of $8.6 billion. It’s not like they could just sell them all to somebody tomorrow.

The second problem I have with the stock is the supposed value ascribed to the company’s other assets. About half of the value of the company is outside of the real estate portfolio, according to Baker Street. The bulk of those assets include the Kenmore, Craftsman, and Die Hard brands, Lands End, the Sears online business, and the Sears home services and extended warranty businesses. Baker Street contends these assets taken together are worth another $6.8 billion. Keep in mind that the stock market values the entire Sears company at $6.2 billion today.

The core issue here is that Kenmore, Craftsman, Die Hard, Lands End, Sears Home Services, and Sears Extended Warranties all derive the vast majority of their revenue from Sears and Kmart stores. But what happens to these stores if Eddie Lampert decides to monetize the real estate by closing down stores, selling others, subleasing others, and redeveloping others? The value of all of these others brands declines dramatically. Good luck selling Lands End for a good price if you are in the midst of closing down Sears stores. Same goes for Kenmore, Craftsman, and Die Hard. Sure, those brands could be sold in other retail stores if they were independently owned, but the revenue gained would just be offset from the fact that Sears and Kmart stores were disappearing. In my view, Sears can either become a real estate company and shut down its money-losing stores, or it can continue to operate as a retailer with multiple owned brands. What it can’t do is realize the full value of both at the same time, and yet that is exactly what Baker Street Capital (and other bulls on the stock) claim.

If you ask me, Sears should go the real estate route. It may take a long time, but shareholders should see some tangible benefits over time. Consider Seritage Realty Trust, the new company within Sears that holds 200 properties (or about 10% of the total). According to the Seritage web site, those properties control about 18 million square feet of space. Let’s assume they are redeveloped and can generate $30 per square foot, on average. That equates to $540 million of annual net operating income. If Seritage was IPO’d it could be worth about $8 billion (at a 7% cap rate). That is why Sears shareholders have a margin of safety in the stock and why it is not going bankrupt. However, since that process would take so long to implement, it is also the reason why Sears stock today is not anywhere near the $100+ per-share valuations the bulls claim it is worth in a break-up scenario.

Full Disclosure: No position in Sears stock and long Sears bonds at the time of writing, though positions may change at any time.

Hedge Funds Move In As Ackman Sells, But JC Penney Still Far From Running At Break-Even

For some reason Pershing Square’s Bill Ackman decided to bail on his near-20% stake in struggling retailer JC Penney (NYSE: JCP) at a 50% loss after being instrumental in the company’s recent troubles. Classic buying high and selling low (when the pain becomes too great) case here. As has been the trend lately, hedge funds are coming in and buying what Ackman is selling (Herbalife being the most recent example). Glenview Capital and Hayman Capital have announced large stakes in recent days and now a handful of hedge funds (adding in Soros Fund Management and Perry Capital) own about a third of the company’s common stock. At $14 per share, JCP’s equity is worth about $3 billion, excluding net debt of more than $4 billion.

I have written quite a bit about JC Penney over the last year or two, since Ron Johnson was hired as CEO and then fired after implementing a disastrous plan, and I am baffled as to why these hedge funds are so bullish on JCP at this point in time. The seeds for a turnaround have certainly been planted with Mike Ullman’s return as CEO, but from what I can tell from the numbers, it is going to take a while before they really start to grow. Perhaps these funds are playing JCP for a quick trade to the upside, which would make sense given that Ackman’s sale represents capitulation at its best (or worst, depending on your perspective), but it appears premature to bet on a sure-thing turnaround at JCP longer term. Let’s look at the numbers.

Thanks to Ron Johnson’s blunders, JCP’s sales this year should come in around $12 billion, down from $17 billion a few years ago. Operating costs (SG&A) for the prior four quarters came in at $4.4 billion, and have been slashed lately to preserve cash. Although the company’s gross margins are nowhere near their historical average of 37% today, CEO Mike Ullman is making the right moves to reach those levels again, in 2014 if you are optimistic.

Retail companies are not that hard to analyze and from these few figures we can figure out what level of sales JCP needs to reach cash break-even again, a crucial goal post if you are going to see a prolonged turnaround in the company’s share price performance. With 37% gross margins and $4.4 billion in annual SG&A costs, JCP’s operating break-even point is $12 billion at first glance, but the company is losing lots of money right now due to elevated capital expenditures and a huge debt load, which has only risen as the company’s sales have plummeted. Throw in $300 million of annual capital expenditures going forward (guidance from management) and $500 million of annual interest costs, and JCP actual cash break-even level is $14 billion of annual revenue. That means sales would have to rise 15% from here just to reach break-even. Could that happen in 2014? It could, but that seems quite optimistic. 2015 is probably more likely.

But even if you assume that sales rebound and the company stops bleeding cash, I don’t think JCP shares are that exciting at today’s $14 price. Macy’s and Kohl’s are very good department store comps for JCP. Both trade at about 6 times cash flow. Let’s assume JCP’s sales continue climbing and reach $15 billion by 2016. Assuming margins hold steady, JCP will have annual cash flow of about $1.1 billion. Multiply that number by 6 times and net out $4.3 billion of net debt and the equity would be worth about $2.3 billion, or $10 per share. In order for JCP stock to zoom back into the 20’s and stay there, the company has to be cash flow positive and begin paying down some debt (every $100 million of debt repayment would boost that $10 fair value price by 50 cents). Given that it will take a year or two for JCP to reach break-even, it looks to me like these hedge funds might be too early to the JCP stock turnaround party.

Full Disclosure: Long JCP senior notes maturing in 2018 at the time of writing, but positions may change at any time

An Inside Look At Why Sears and Kmart Never Turned The Corner

Longtime readers of this blog will remember that for a while I was a believer in Eddie Lampert’s ability to breathe new life into Kmart and Sears by more efficiently allocating capital within the companies. I started writing about the investment idea in 2005 and followed up probably a dozen or two times over the years. Although the investment was a profitable one for me and my clients (I sold long ago after it was obvious that Lampert was not going in the same direction as many of us had expected), it was also one of the most frustrating investing situations I can remember because so much potential was squandered. Had Lampert used the profits from Kmart and Sears (yes, they actually did make decent money for a while under his ownership) to diversify into other, more attractive businesses, Sears Holdings could have been a huge success. Instead, he honestly believed that a hedge fund manager could run a retailer (from his office in Connecticut) better than retailing veterans could from the company’s headquarters outside Chicago (he has not).

If you are interested in some of the behind the scenes that has gone on at Sears and Kmart in recent years (it’s been an absolute debacle), Bloomberg BusinessWeek has published an excellent article that can be found at the link below:

At Sears, Eddie Lampert’s Warring Divisions Model Adds To The Troubles

It’s a great read. And no, the stock is not a bargain today. At the current price ($45 per share), the company has an equity value of $5 billion and another $3 billion of net debt. I can’t see how the enterprise is worth $8 billion. That said, the company’s debt looks interesting (I think it’s money good).

Full Disclosure: Long Sears Holdings bonds at the time of writing, but positions may change at any time

Sears: The Break-Up Plan Continues Without Any Payoff For Equity Holders

Sears Holdings (SHLD) continues its unofficial, informal break-up plan as it struggles to maintain adequate liquidity amid a money-losing core business. The company’s stock is the largest loser in the S&P 500 today as first quarter results showed EBITDA of about break-even. Chairman and majority shareholder Eddie Lampert has assumed the CEO position, but without any direct retail experience even a very smart investor is unlikely to lead a successful turnaround.

The latest tidbit from Sears is that they are contemplating a sale of their asset protection business. Sears is one of the only large retailers that actually offers extended warranties in-house (as opposed to partnering with a financial services company), giving it another asset it could sell or spin-off in order to realize value for shareholders. The company publicly stated yesterday that it believes the business to be worth in excess of $500 million. While breaking up Sears Holdings is the right decision for shareholders, several of the company’s first moves in that realm have not really helped boost the share price, mainly because the underlying business is so bad that all sale proceeds (Sears Hometown and Outlet Store spin-off, Orchard Supply IPO, Sears Canada share sale, etc) are merely offsetting those losses and not adding any value on a per-share basis.

Even after today’s drubbing, Sears’ stock still has a total market value of $5 billion. Add in nearly $3 billion of net debt and I simply cannot justify an $8 billion enterprise value for Sears Holdings in its current form. Not only that, but the company keeps selling off its most profitable segments (because the other ones aren’t profitable, read: valuable), which leaves them with a set of even more unattractive assets on a relative basis.

While I do not want to invest in SHLD common shares at $48 a share (it would have to drop into the 30’s for me to become even mildly intrigued), I think the company will slug along for many more years. As a result, the company’s debt may be a much smarter investment than the common shares. Long-term debt excluding leases totals about $1.6 billion. The majority of that consists of $1.24 billion of 2018 senior notes that pay a coupon of 6.625% per year. At current prices, Sears’ long-term debt yields about 7%, which is a very solid return for a five-year debt security.

Full Disclosure: Long Sears long-term debt securities at the time of writing, but positions may change at any time

Netflix and Tesla: Early Signs of Froth in a Bull Market

It is quite common for a bull market to last far longer than many would have thought, and even more so after the brutal economic downturn we had in 2008-2009. Only just recently did U.S. stocks surpass the previous market top reached in 2007. Although it does not mean that a correction is definitely imminent, the current stock market rally is the longest the U.S. has ever seen without a 5% correction. Ever. Dig deeper and we can begin to see some froth in many high-flying market darlings. Fortunately, we are not anywhere near the bubble conditions of the late 1990’s, when companies would see their share prices double within days just by announcing that they were launching an e-commerce web site. However, some of these charts have really taken off in recent weeks and I think it is worth mentioning, as U.S. stocks are getting quite overbought. Here are some examples:

TESLA MOTORS – TSLA – $30 to $90 in 4 months:

tsla

NETFLIX – NFLX – $50 to $250 in 8 months:

nflx

GOOGLE – GOOG – $550 to $920 in 10 months:

goog

 

You can even find some overly bullish trading activity in slow-growing, boring companies that do not have “new economy” secular trends at their backs, or those that were left for dead not too long ago:

BEST BUY – BBY – $12 to $27 in 4 months:

clx

CLOROX – CLX – $67 to $90 in 1 year:

clx
WALGREEN – WAG – $32 to $50 in 6 months:

wag

 

Ladies and gentlemen, we have bull market lift-off. My advice would be to pay extra-close attention to valuation in stocks you are buying and/or holding at this point in the cycle. While the P/E ratio for the broad market (16x) is not excessive (it peaked at 18x at the top of the housing/credit bubble in 2007), we are only 15-20% away from those kinds of levels. Food for thought. I remain unalarmed, but definitely cautious to some degree nonetheless, and a few more months of continued market action like this may change my mind.

Full Disclosure: No positions in any of the stocks shown in the charts above, but positions may change at any time

J.C. Penney To Customers: We’re Sorry

A good sign for those investors who think J.C. Penney can reverse course and fix most of what Ron Johnson screwed up:

So let’s be optimistic for a moment (I still believe these bullish assumptions are possible but far easier said than done), and assume the company can get back half of the sales it has lost over the last two years and also boost profit margins back up to 2011 levels now that Mike Ullman is back at the helm. In 2011, JCP’s revenue was $17.3 billion, gross margin was 36%, and EBITDA margins were 5.6%, for cash flow of $967 million.

Under a “recovered” scenario, JCP’s sales get back to $15 billion, gross profit is $5.4 billion, SG&A is $4.5 billion, and EBITDA is $900 million. Macy’s trades at 6x cash flow so we’ll give JCP the same multiple, which equates to an equity value of $3.3 billion (net debt is $2.1 billion). Crunch all those numbers and you get a stock price of $15.50 per share, below where it trades today. So you can see why I am not loading up on the stock. That said, the bonds look like a great way to play the thesis can JCP survive without thriving.

Full Disclosure: Long JCP’s 2018 senior notes and JCP Jan ’14 $20 puts at the time of writing, but positions may change at any time

Even With Ron Johnson Out As CEO, No Closer To JC Penney Turnaround

Less than 18 months since he was hired to lead JC Penney (JCP), Ron Johnson has been replaced by his predecessor, Mike Ullman. Given that many industry people thought Johnson would be given all of 2013 to show signs that his store transformation plan was starting to bear fruit, the fact that he was fired in the first quarter tells me that customer traffic and same store sales have not improved this year. It also indicates that the highly publicized Joe Fresh launch was unimpressive as well. As a result, I do not think JC Penney will see sales stabilize this year, after falling 25% in 2012 (from over $17 billion to under $13 billion). First quarter same store sales are likely to fall by double-digits, making $12 billion in sales this year a reasonable estimate. As was the case last year, at that level of sales JCP will continue to lose money every quarter for a while.

Perhaps even worse for the stock, which I have been bearish on for a while now, the company is seeking to raise more money to continue refreshing their store base. Market chatter this week indicates that JC Penney is in discussions to raise anywhere from $500 million to $1.5 billion of new debt, and that comes after the company decided to tap $850 million of its $1.85 billion credit line in recent days. Add those borrowings to the $3 billion of long-term debt already on the books and it is entirely possible that by mid-year JCP will see its total debt nearly double to between $5 billion and $5.5 billion.

That amount of leverage is just as problematic for the company’s equity investors as is the deteriorating retail results. Troubled retailers often trade at an enterprise value equal to a fraction of annual sales. For instance, fellow money-loser Sears Holdings (SHLD) trades at 0.2 times revenue, compared with 0.8 times revenue for a well-run department store chain such as Macy’s (M). With annual sales trending towards $12 billion and more than $5 billion of debt, there is not much value left for the equity holders (at the current $15 share price, JCP’s equity value is still quite high, at more than $3 billion). The company’s near-term cash infusion will take a short-term liquidity event off the table, but if the retailer continues to pile up red ink, that cash will slowly bleed out, leaving the company with no way to reduce its debt load in coming quarters. That is how things could really begin to spiral out of control.

Even with its old CEO back at the helm, JC Penney is likely to struggle for a while. Bringing back coupons and heavy discounts could win back some of its old customers who left during Johnson’s tenure, but then you have the problem of all of this new merchandise. The assortments in the stores were meant to be higher end and attract a different customer. JCP’s old customer base does not know and/or care about Joe Fresh or Michael Graves. Not only that, but Johnson was able to sign on more fashionable brand names because he promised not to devalue their brands by offering huge discounts. No matter what the JCP strategy is going forward, it is hard to see how they can really reach profitability anytime soon.

If Ullman keeps the nicer product offerings with the high price points, the suppliers will be upset and the goods will continue to sit on the shelves. If they discount them heavily to move them out, JCP won’t make any money anyway. If they go back to the old merchandise and pricing strategy, many of the store’s previous customers may simply ignore them and keep shopping at the stores they now visit instead of JCP. I really don’t see any reason to be optimistic here and there have been no signs from the company that things are improving at all. Johnson’s abrupt firing only confirms that view.

As for the stock, there is no doubt that it is far cheaper now than it was at $42 when I first wrote a negative piece about it (JC Penney: Great New Ads, Overbought Stock). That said, it is hard to get a price target above the current $15 quote based on current fundamentals. Given how depressed the stock is and how many people are betting against it, there is upside potential on any business improvements whatsoever (and such a reaction would likely be sharp and swift), but until there are any silver linings in the company’s results, I would not feel comfortable making a bullish bet on that outcome. Remaining negative here is not without risks, as things could hardly get much worse, but if they don’t get any better I am fairly certain that traditional valuation metrics could easily dictate a stock price of $10 or less. Another bad quarter or two and even patient, long-term investors might decide to bail. As a result, bottom-fishers should tread carefully and watch for any signs of improvement in the actual financial results.

Full Disclosure: Long JCP put options (strike price of $20) at the time of writing, but positions may change at any time

Until JC Penney CEO Ron Johnson Admits Reality, It’s Hard To Be Bullish

The entire premise of the JC Penney (JCP) turnaround effort, led by former Target and Apple executive Ron Johnson, has been to do away with sales and just give consumers everyday low prices, a la Wal-Mart (WMT) and Target (TGT). That all sounds well and good, unless you actually learn anything about the core JCP shopper, who comes to the store for bargains. Sure, a $50 shirt that sold everyday at 60% off really is not a $50 shirt. But if the consumer pays $20 for it, they feel like they got a great deal, even if the shirt’s quality is on par with a $20 comparable item at Wal-Mart or Target.

So it was not surprising to learn that as soon as JC Penney started to get rid of sales and instead just marked their products at the “real” price ($20 in the above example), consumers fled. Comparable same store sales in Q1 2012 dropped 19%, the first quarter the changes went into effect. Q2 comps dropped 23%, then -26% in Q3, and earlier this week JCP reported Q4 comps of -32% (which must be a record decline for any retailer in history that was not facing some sort of natural disaster or other event preventing people from making it to the store).

The first solution a CEO in this position should make is to bring back sales. If you are going to get $20 for a shirt either way, you may as well mark it such that someone buys it. And in yesterday’s conference call, JCP CEO Ron Johnson announced that the company will bring back sales once a week. Sounds great for JCP bulls, right? Well, not exactly. You see, on one hand he announced that he is bringing back sales (because the consumer is demanding them), but on the other he still seems to be insisting that consumers don’t need “fake” prices to understand the value proposition JCP is offering them. Consider the following quote from Johnson during Wednesday’s conference call:

“So we learned she prefers a sale. At times she loves a coupon and always, she needs a reference price. Whether there’s a manufacturer suggested price on a branded item, a comparison on a private label item or a sale, she needs to feel she added value to her family through the saving she got from being a savvy shopper. So we have brought back sales. We have brought back coupons for our rewards members, although we still call them gifts and we’ll offer sales each and every week as we move forward. But we will do it differently than we did in the past.”

Okay, fine. But then here was the very next thing out of his mouth:

“We don’t need to artificially mark up prices to create the illusion of savings. We can offer the industry’s best everyday prices and deliver even more exciting value through our promotions. Let me give you an example through our recent experience with jewelry at Valentine’s Day. Forever customers have asked the question, what is this piece of jewelry really worth? While we want to show the customers the value we offer, so we had nearly all of our jewelry appraised by IGI, the world’s largest gemological institute and provided our customers with a true appraisal of our jewelry for insurance purposes. We then price the jewelry below the appraised value. During Valentine’s Day we offer the customer an additional 20% savings and our rewards customers a onetime box of See’s Candy with every purchase over $75 and it worked.”

I nearly fell off my chair when I heard Johnson say this. The first paragraph is an admission of what we have learned over the last year at JCP; consumers will only buy their items when they get a marked down price, even if the original price on the tag is never what anyone ever actually pays. And then, in the very next breath, Johnson says “We don’t need to artificially mark up prices to create the illusion of savings.” Excuse me? You just said that you have learned that your customer needs a reference price (such as a tag with a MSRP), which is an artificial mark-up by definition (since nobody ever pays the full price), and at the same time that you do not have to create the illusion of savings. But that is exactly what the entire business model of constant deep-discounts and couponing requires!

So, yes, when other commentators call Johnson delusional, I can’t help but think they might be right. And he even takes it one step further. When he gives the jewelry example he states “We had nearly all of our jewelry appraised by IGI, the world’s largest gemological institute and provided our customers with a true appraisal of our jewelry for insurance purposes. We then price the jewelry below the appraised value.” He must think every consumer is an idiot. Anyone who has ever had a piece of jewelry appraised for insurance purposes knows that the appraised value is always higher than the price you actually paid. Johnson is married, so surely he bought an engagement ring and had it insured, so he knows this. And yet he wants us to think that getting JCP’s jewelry pieces appraised and the selling them at 20% off that price is not an “artificial price that creates the illusion of savings?” That is exactly what it is (which, by the way, is perfectly fine since it works in the store).

If you are an investor in JCP, 2012’s financial results quarter-by-quarter, combined with Johnson’s comments during the latest conference call, have to make you wonder what on earth is going on inside his head. He acts and talks like he is a marketing genius and smarter than everyone else but his customers are voting loud and clear by shopping elsewhere.

So what about the stock? It traded down 15% on this latest earnings report and is once again in the high teens. Management has lost credibility and has proven they do not have a handle on the business. Last year they publicly predicted that the second half of the year would show improvement after a first half comp store sales decline of 21%. This statement baffled me and I even wrote in my last JCP post that I thought the fourth quarter would be their worst of the year since the holiday season depends on discounting the most and that was exactly what they were abandoning . I postulated that sales could drop 30% in Q4 (read that article here: “An Inside Look at the New JC Penney“) and many JCP bulls thought that was far too pessimistic. It turns out that I was 2% too optimistic, as sales fell 32% during the holiday quarter.

Until JCP’s sales stabilize, I cannot any reason to invest in the stock. We simply do not know where the floor is and management has no clue either. In fact, considering that Q1 2012 comps were down 19% and Q4 2012 comps were down 32%, even if sales stabilize, you are still looking at further comp sales declines for the first 9 months of 2013 (dropping 13% in Q1, followed by a 9% drop in Q2, and a 6% drop in Q3, leading into flat sales in Q4). One could also try and project Q1 2013 sales by looking at the Q4 to Q1 sequential drop off from last year (-42%). Using that same sequential decline for 2013, Q1 sales would actually fall by 28%. I think -13% is closer to the right number, but only time will tell.

Full Disclosure: No position in JCP at the time of writing but positions may change at any time.

An Inside Look at the New Retail Strategy at J.C. Penney (Part 2)

As was discussed yesterday, the much-talked about turnaround strategy at J.C. Penney (JCP), being led by Ron Johnson, is going to take a lot longer than many initially thought. Renovating two-thirds of their store base will take 3-4 years. Getting customers to understand and appreciate their new pricing model will take time, if it happens at all. If you contemplate the finished product in 2015, as Johnson has outlined it, the new JCP is likely to be very unique and intriguing for a large subset of shoppers. One hundred specialty shops, with large well-known brands such as Nike and Martha Stewart, connected by a “street” complete with food and beverage stations, comfy couches, free wi-fi, seasonal services such as Santa and gingerbread cookies for the kids in December or yoga classes and smoothies for moms to kick off the new year… it sounds great in theory. And that’s just it, in theory.

The end product won’t be completed for three more years. Until then, the stores will constantly have areas being boarded up and redone. With so many other choices in the typical mall, will shoppers leave JCP and have little reason to come back, even if the store in 2015 looks cool? And that’s another problem… the cool factor. It was obvious when I was at JCP on Monday that a large chunk of their core customers are women 50 years and over. Is that customer going to care that there is free wi-fi or nice couches in the store? Will they shop for denim fits and dyes at an iPad station? Are they going to warm to the RFID-enabled self-checkout kiosks that Johnson is planning? Sure, placing your shopping bag on the table and having the checkout station automatically read its contents and ring up the purchase is nice (all you have to do is swipe your card, no bar code scanning required), but is that too tech-heavy for the older generation? Can’t you envision the line at the cashier backing up pretty quickly if there is only one actual human operating it?

It seems this new prototype JCP store is geared towards a younger audience and I am not sure that crowd will head over to JCP even if it is designed for them. Again, you might have 100 shops in your JCP, but there are at least that many in the mall itself, and that is where most of these people already loyally shop. He won’t say it directly, but Ron Johnson probably knows that he really is launching a completely new store here, and will have to market it heavily so people know it exists and will give it a try.

Which brings us to the timing aspect of the investment story for JCP shares. The stock went from the high 20’s to the low 40’s when Johnson was hired, merely based on his previous retail successes. After Q1 2012 same-store sales dropped nearly 20%, the shares cratered to below $20 each. They have since rebounded to the mid 20’s, as investors hope for a rebound as more newly renovated shops are added. Second quarter comps fell by more than 20%. I don’t think an IZOD shop and a JCP house brand shop are going to move the needle in Q3, so I would expect similar results again this quarter. Whether they are down 16%, 20%, or 24%, though, is anyone’s guess.

When we get to the holiday season, then it really gets interesting. Wall Street analysts are an overly optimistic bunch, and typically project sales improvement slowly over time, regardless of the situation. The same is true of JCP today. Fourth quarter sales estimates right now are for a drop of 11% year-over-year, so the consensus is that revenue losses will be cut in half within a couple of months from now. Possible? Sure, maybe better sell-through of Levi’s jeans, from the new, fresh shop design, will offset a lot of the negatives from the older areas of the store.

But what if the holiday season for JCP actually gets worse? After all, they are trying to cut down on sales and offer everyday low prices. If customers balked at buying full priced items (regardless of the actual price level) over Memorial Day, why would their buying patterns change in November and December? In fact, would they not be even more inclined to look for sales over the holidays? JCP cutting back on sales should hurt them the most when everybody else is running Black Friday doorbusters. JCP already had a TV commercial making fun of long lines outside stores at 4am. Now they will be competing against them. How will sales be on Cyber Monday at jcp.com? Probably worse than macys.com and kohls.com, right?

I know it is not the consensus view, but one of the reasons I have not bought a single share of JCP is that I think it is reasonable to think sales could get worse, not better, during the fourth quarter. If the first nine months of 2012 see sales declines of 20%, on average, why couldn’t a lack of Black Friday and Cyber Monday doorbuster specials result in a 30% decline during the ever-important holiday shopping season? Seems possible, in which case investors are in for a rude surprise when Q4 sales results come out early in 2013. Another round of selling may very well occur.

At that point, though, maybe it will be a better time to dip one’s toe in, if in fact you want to place a wager on the long-term future of JCP. Next year the company will be lapping an absolutely horrible financial performance from 2012. The bar will be low and expectations will be uninspiring. Even if 2013 brings more of the same; more renovations and little in the way of increased customer excitement, it is hard to imagine sales falling another 20% from 2012 levels. While a meaningful turn might be a ways off, 2012 might still mark the bottom for sales losses, and for the stock. And we all know the stock market is forward-looking, so even if we won’t see material improvement until 2014 or 2015, investors will bid up the stock ahead of time, just like they have in recent weeks on hopes that things will get better very soon.

Full Disclosure: No position in any of the companies mentioned at the time of writing, but positions may change at any time.