JCPenney: Great New Ads, Overbought Stock

Shares of department store retailer JCPenney (JCP) have been on a tear this month (up 20% year-to-date, from $35 to $42) after the company unveiled a new advertising campaign (love it!) and shared with investors the details of its new retail strategy. I recently wrote that the stock made sense, at the right price, given the potential for Ron Johnson to start working his magic. That price never really materialized and now that the stock has jumped into the 40’s, it looks too expensive.

How can we value the shares given that business has not been great and the new CEO could really turn things around? It is not an easy task, but since Johnson turned Target into a hip retailer more than a decade ago, that seems like a good place to start. Let’s assume Johnson can get JCP’s margins all the way up to those of Target. That is a hefty assumption (and one that even if accomplished will likely take years, not months or quarters) but using optimistic projections can really help investors figure out what the upside could be. In 2010 Target earned 11% cash flow margins, versus just 7% at JCP, so Johnson clearly has some room to boost JCP’s profitability. However, that upside is largely negated by an expensive stock price after a 20% gain so far in 2012. JCP shares trade at 8 times trailing cash flow, versus just 7 times for Target.

Target currently fetches an enterprise value-to-revenue ratio of 0.75 times. If we assume JCP can match TGT’s profit margins (again, a very optimistic assumption) they too would fetch the same price. We can use EV-to-sales here because with the same level of profitability, sales and earnings multiples are interchangeable. Giving JCP a 0.75 EV-to-sales multiple puts the equity value at about $10.75 billion (excluding $2 billion in net debt), versus $9 billion today. The stock price at that level would be right around $50 per share.

So if Ron Johnson can turn JCP into a profit machine like Target, and we assume the stocks trade at similar valuations to reflect their strong businesses, JCP stock could rise another 20% or so, from $42 to $50 per share. It could be worse, of course, but with those numbers it is hardly an overwhelming attractive investment at current prices. That gain would be several years away, and assume Ron Johnson can live up to the hype he earned at Target and Apple, even though JCP is clearly in a more challenging competitive position.

As a result, I am steering clear of the soaring stock even though the TV commercials are great and the odds are good that Johnson will greatly improve the store experience over time.

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

Despite Cyclical Headwinds, Goldman Sachs Stock Is Still Too Cheap

Shares of Goldman Sachs (GS) are rising modestly this morning, to about $98 each, after the investment banking giant beat earnings estimates for the fourth quarter. Earnings for 2011 came in at $7.46 per share, down about 50% versus last year, as the business has been struggling through a cyclical industry downturn. Still, the company made a $4 billion profit, bought back about 8% of its shares outstanding, and grew book value by 1% in 2011. And yet, the stock is trading about 20% below tangible book value of $120 per share.

I have been making this argument for a while, and holding the stock has not been fun while it has been treading water far below tangible book, but even with a cyclical industry like investment banking, GS stock should not be at these levels. It is really hard to see how the company would face a scenario where book value dropped 20% from here (which is essentially what investors are fearing when the stock trades at $98). If the sub-prime mortgage meltdown barely hit book value at Goldman, I don’t see the European debt crisis doing far more damage. And even if the industry does not turn around as quickly as it has in past cycles, book value will likely go sideways or slightly higher, as we saw in 2011.

For investors to justify the idea that large, well-positioned, and profitable financial institutions should be trading far below tangible book value per share (and GS is far from the only one), one of two scenarios would need to play out. First, the companies would have to have huge unrealized losses already sitting on their books, which when realized would crush book value and wipe out the discount on the shares. Unlikely. Second, the business model would have to break down long term, rendering the firms unprofitable, which would result in a slow degradation of book value (again, narrowing the valuation gap to the downside). Again, unlikely.

Profit margins will likely drop permanently due to the Volcker Rule (no prop trading), but they should stay in positive territory (Goldman’s ROE in 2011 was 6%). That should result in lower price-to-book valuations for these banks versus prior cycles, but not below one. As a result, I think GS and their strong peers should trade for at least tangible book value, which means about 25% upside from here.

Full Disclosure: Long Goldman Sachs at the time of writing, but positions may change at any time