CEO Hire from Apple Gives New Life to JC Penney

I can’t recall another time when a stock has risen 17% the day the company announces the hiring of a new CEO. But that is exactly what happened Tuesday after department store chain JC Penney (JCP) landed Apple retail head Ron Johnson to lead the company. Johnson’s track record building up Apple’s retail store network over the last 11 years, plus a 15-year stint at Target prior to that, has investors clambering for JCP shares, which jumped from $30 to $35 as soon as the news was announced. So should we go out and buy some JC Penney stock too? Maybe, at the right price (not after a $5 jump).

There are a few things that one should point out when evaluating this management change. First, while the stock price increase indicates that JCP has become more valuable overnight, this will be a long term turnaround story, if it materializes at all. Johnson doesn’t even start his new job until November 1st. After that it will likely take him six to twelve months to assemble a hand-picked team, review JCP’s operations, and formulate a plan for making changes. Adding on another year for those changes to be implemented company-wide is not an unrealistic assumption. As a result, we might be waiting until 2013 before we really see if Johnson’s magic will work at this department store chain. And don’t forget, we are not selling MacBook Air’s and iPads here. Despite who is running the show, JCP is still in the business of selling Van Heusen shirts and St John’s Bay shorts to middle income folks shopping in aging shopping malls, not an easy task for anyone in today’s highly competitive retail environment.

Also of note is the pay package that Ron Johnson accepted to come over to JCP. He will receive a base salary of $1.5 million and be eligible for an annual bonus of up to $1.875 million if certain milestones are reached. But the big component of his compensation plan is in stock. Johnson gets $50 million in restricted stock because he was set to have that same amount of Apple stock awards vest in 2012, had he not left the company. And by far the most interesting aspect of his pay plan is that he has agreed to buy 7.25 million warrants with a strike price of $30 per share directly from JCP, for $50 million. The warrants cannot be exercised for six years and he paid about $7 each for them.

That means he is investing $50 million of his own money into JCP stock for the next six years at what is essentially a price of $37 per share. As a result, he loses $7 million for each dollar below $37 the stock fetches six years from now, and if the stock is below $30 at that time he loses the entire $50 million. On the flip side, if the stock goes to $50 per share in the next six years, his $50 million investment will be worth a cool $362 million.

This warrant plan tells us a few things about Johnson’s reasons for taking the CEO job at JCP. One, when he says he has wanted to lead a retailer as CEO for a while, he’s not kidding. There was plenty of money, job security, and minimal reputational risk by staying at Apple. He really isn’t doing it for the money either, because although JCP matched his previous Apple stock grants, he is putting up his own cash to try and profit from his future progress at JCP. The cash salary and bonus payment, while not immaterial to the average person, are fairly meager by today’s CEO standards. And JCP isn’t paying that much for his services given that the $50 million in restricted stock grants will be completely negated by the $50 million Johnson is paying the company for 7 million warrants.

So should investors buy the stock? As a value investor, I would never want to buy it after a $5 one-day pop, although the shares have dropped to $34. Compared with other department store chains JCP stock is neither cheap nor expensive, at their current multiple of 6.2x trailing cash flow. That valuation compares to Kohls and Macy’s at 5.5x, Target at 6.2x, and Wal-Mart at 6.9x. If someone believes JCP is not already a dead retailer, and has enough faith in a guy who helped make Target cool and led the hugely successful Apple retail strategy, then maybe buying the stock makes sense, provided you take a multi-year outlook. What price would be attractive in that scenario? Judging from Johnson’s warrant package, I would think $30 (or something close to it) would be an excellent entry point. At that price you can be invested alongside him, at around the same price, without having to fork over $50 million of your own money.

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

Pandora IPO Reminds Us What 1999 Felt Like

We have a long way to go before another bubble in Internet stocks emerges but the recent IPO of LinkedIn (LNKD) and today’s debut of Pandora (P) serve as reminders of what the late 1990’s brought us. Back when Yahoo! (YHOO) was worth more than Disney (DIS) and AOL (AOL) was worth more than (and bought) Time Warner (TWX) there were plenty of bullish pundits arguing why the dot-com versions were indeed worth more because they had far more growth opportunities. While plenty of Internet companies proved to be worth those sky-high valuations, many more did not, including the aforementioned duo.

This morning Internet radio sensation Pandora has seen its stock jump nearly 50% from an IPO price of $16 per share. As a result, Wall Street is valuing the company at a stunning $3.75 billion despite revenue estimates for 2011 of only about $250 million (and more importantly, no profits). How does that compare with some non-dot-com radio competitors? Both Cumulus Media (CMLS) and Sirius XM Radio (SIRI) are valued at about 3 times revenues (including net debt). Cumulus, the more traditional radio play, has about the same annual revenue as Pandora (but has positive cash flow) and carries an enterprise value of around $700 million, approximately 80% less than Pandora.

Sirius XM may be the more relevant comp given that just a few short years ago they were considered the new age upstart in the radio business (and they adopted the subscriber model that many believe holds the key to Pandora’s future success). Sirius XM does have a public market enterprise value of $10.4 billion, three times that of Pandora, but with that comes annual revenue of $3 billion (12 times more than Pandora) and over $800 million in annual operating cash flow. Put another way, Sirius’s operating profits trumps Pandora’ operating revenue by a factor of three.

As was the case back in the late 1990’s, some of these new Internet companies will grow into their valuations and not leave early public market buyers hanging out to dry. That said, nearly $4 billion for Pandora seems more excessive than even LinkedIn, which is currently valued at $7 billion. I would not buy either one at current prices, but given their addressable markets, business models, and competitive landscapes, LinkedIn seems to have more relative promise at current valuations. Time will tell.

Full Disclosure: No positions at the time of writing, but positions may change at any time

Goldman Sachs Targeted Again, Entire Rebound Post-SEC Settlement Gone

So much for nailing that call on Goldman Sachs (GS) after the company settled with the SEC last year. The investment bank agreed to pay a $550 million fine last year on charges that the company engaged in fraud while selling mortgage-related investment products. The stock fell to around $130 per share at the height of the scare last July before rebounding nicely to the $175 area early in 2011. And yet here we are nearly a full year later and other lawyers are looking to get into the game. Unrelenting articles in the financial media from publications such as Rolling Stone don’t help either.

Unfortunately, I thought we had gotten past this issue, at least to the same magnitude as in 2010. Wishful thinking on my part. Most of the GS stock I bought for clients last year remains in their accounts, so this latest sell-off related to additional fraud investigations by the New York U.S. Attorney’s Office and the U.S. Justice Department has been painful. And with the 2012 election cycle ramping up, what better time to go after the big Wall Street banks yet again?

The interesting thing is, the issues haven’t changed much since last year. It is still fairly difficult to proof Goldman Sachs committed fraud because the clear evidence that they lied directly to those buying their mortgage-related products in 2007 and 2008 is scarce. People assume that since Goldman identified a bubble about to burst, while others didn’t, means that Goldman must have broken the law. And maybe they did, although the evidence I have seen is flimsy (even experts agreed that the SEC didn’t have a strong case). It could just be that Goldman Sachs is smarter than most of the other players in the marketplace (a theory that has been born out for years, by the way). Every transaction requires a willing buyer and a willing seller, which means there will be a winner and a loser in every trade. Just because Goldman was the winner does not mean that they defrauded the other party in the transaction.

As was repeated numerous times during the Congressional hearings prompted by the SEC investigation last year, Goldman Sachs acts as a market maker and a securities underwriter in these deals, not as a fiduciary. As a result, they are not required to put their customers’ interests ahead of their own when selling securities. All they must insure is that the investors know what they are getting and how much they are paying. Whether or not it is a good investment for them is up to the buyer to decide, not Goldman Sachs to advise them on. If there is evidence that Goldman lied to the buyers about what they were getting, then clearly the legal issue is only going to get worse for them, but again, there is hardly any evidence of that.

Even the SEC case, which resulted in Goldman agreeing to a large settlement,  revolved around Goldman omitting data pertaining to which people structured the deal. All of the details of the security, including what exactly the buyer was getting, were disclosed and known by all parties involved. There has to be personal responsibility, right? If you choose to buy something and are told exactly what it is ahead of time, it should be your responsibility to decide if it is a good investment or not, and if it turns out not to be, you should expect to lose money.

Now, I am not going to pretend to know exactly what evidence will lead to what legal outcomes over the next year regarding these mortgage-backed security transactions. All I can say is that Goldman stock is now all the way back to where it was during the height of the SEC worries last year. It has given back the entire 40-point gain that was recouped after that case was closed. The company continues to have the smartest people in the investment banking universe and be the premiere firm to do business with. Their profits remain strong and the stock trades near tangible book value after the recent correction. Goldman Sachs since their IPO in 1999 has proven again and again they can create shareholder value in all market cycles. Consider the chart below, which shows GS’s book value per share growth since the company went public more than a decade ago. As you can see, the company is run superbly well, which usually warrants a sizable premium to book value.

For long term investors it appears to be a great buying opportunity, the same conclusion I made at about this time last year. Of course, if the stock should rebound 40 points again after more lawsuits are resolved, perhaps it would be wise to take some more money off the table, as this issue doesn’t seem like it will be going away anytime soon.

Full Disclosure: Clients of Peridot Capital were long shares of GS at the time of writing, but positions may change at any time