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