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:


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


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



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:


CLOROX – CLX – $67 to $90 in 1 year:

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



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 Probably worse than and, 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.


An Inside Look at the New Retail Strategy at J.C. Penney (Part 1)

On September 1st, J.C. Penney (JCP) debuted more new “shops,” bringing it about 10% of the way through a transformation plan aimed at having 700 of the chain’s 1100 department stores offer shoppers 100 distinct “store within a store” experiences by 2015. My wife and I used part of our Labor Day holiday to do some market research at a local Portland mall and check out the progress at one of these renovated JCP locations.

I have been doing a fair amount of work on JCP lately, trying to figure out if it is a turnaround story I want to play or not. For me, there are three essential questions to ask when making this kind of investment decision. One, do I want to make a bullish bet on a JCP turnaround under new CEO Ron Johnson? Two, at what share price do I feel the risk-reward is attractive enough for the stock? And three, since this is a multi-year turnaround story (renovating 700 stores while they remain open is not easy), at what point in the process would it make the most sense to start buying?

With much of the valuation work done already from my office, my in-person store visit on Monday was more about checking out how the renovations looked and how shoppers were responding to them. I went to one location, in the morning, on a holiday, so this is by no means enough observation to draw strong conclusions about customer traffic, but it was enough to get an idea of where these stores are heading over the next few years.

As soon as you walk into the store, you see the original “store within a store” concept, Sephora, that JCP introduced even before Ron Johnson took over as CEO:

The Sephora stores inside J.C. Penney have done very well. They look identical to actual Sephora stores, just with fewer square feet. The successes JCP has seen so far are often cited as a reason why the concept of converting the entire JCP store into dozens of specialty shops has huge potential. I would agree with that assessment, but it completely depends on what products you are selling. Sephora is very popular right now, so it would be hard for it to do poorly. What about other brands? That is the big question mark at this point.

Which brings us to the new shops JCP unveiled this month; IZOD, Liz Claiborne, and JCP (a generic house brand for basics). These are in addition to those already in place; Sephora, iJeans by Buffalo, Levi’s, The Original Arizona Jean Co, and MNG by Mango. You may have noticed something odd about that list already, but we’ll get to that shortly. For those who have not been in a JCP lately, here is what these new shops look like:




Notice there is nothing earth-shattering or particularly new here in terms of product. What they have essentially done is group product by brand and install upgraded fixtures and displays, so you feel like you are shopping at a smaller Gap or J Crew store within the mall, not at the enormous J.C. Penney anchor location. For instance, here is what most of the store’s floor at JCP still looks like:

Obviously, cleaning up the stores by making them less cluttered, adding better lighting, and displaying the clothes more effectively is probably an investment worth making, if you are trying to revamp a department store and position it for long-term survival. Still, the early response by customers has been poor. Making the stores look nicer has not counteracted the negative impact from JCP’s decision to reduce the number of sales they run and opt instead for everyday low prices on most items. Rather than paying $25 for a sweater originally marked $75 or $80 (although nobody ever paid that price), JCP has faith that shoppers will make the same purchase, even if it is marked $25 from the start with no discount. Shoppers are balking. The first quarter after the change (Q1 2012), sales dropped 19%. Last quarter they fell by 22%. I don’t think there is reason to think the current quarter will be much different.

The pricing issue was something I made a point to watch for during my store visit. Again, it was before noon on Labor Day, so there was not much traffic in the stores. However, you may have noticed that there weren’t any shoppers in the photos above. I was not the only one in the store, and I did not ask anyone to get out of the shots. So where were they? Well, look at that, there they are:

The clearance rack. Despite JCP’s goal of getting 80%+ of their sales from full price merchandise with their new everyday low price strategy, the store still has product it needs to move quickly, so the clearance racks have not gone away. Interestingly, the signs on these racks do not simply say “clearance” but rather “clearance – $5 and up.” Why put “$5” on the sign, which just signals you have really cheap sale merchandise (and gets you thinking that full price may be overpriced)? I don’t know. It seems counter-productive. My wife even mentioned that she saw a $20 sweater that she liked, but since it was positioned close to the sale racks, she instinctively looked up to see if it was on sale. When it wasn’t, she questioned whether people would think $20 was a good enough price (even though a $20 sweater, on its own, is quite inexpensive). This is what JCP is facing with their new strategy.

Even bigger than pricing strategy is that shoppers are still gravitating to the sale racks, even with these new, upgraded specialty shops. That is where the customers were on Monday, which jives with the trend they have seen so far this year; less traffic, fewer sales, and lower gross margin on each sale. Shoppers are still fixated on sales, and if you don’t have as many, they will either leave the store, or only buy the cheaper stuff. Not a good recipe for a retail turnaround (given that JCP is trying to do the exact opposite).

After my in-store visit to JCP this week I was hoping to shed some light on the first of three questions I mentioned at the outset of this post; do I want to make a bullish bet on a JCP turnaround? When you listen to Ron Johnson articulate the ideas he has, they make sense and you can’t help but be inclined to think he just might make it work. And he might. However, I had mixed feelings after seeing the store. The shops look nice, but so far customers have not responded, in large part due to pricing. They still flock to the sale racks.

I think JCP can fix this problem to a large degree by offering unique product (like Sephora) in order to differentiate themselves from other stores like Sears, Kohls, and Macys. I am not sure that the Levi’s, Arizona Jean Co, and JCP brands do that. Even Liz Claiborne, which is exclusive to JCP, might not be different enough from other similar brands found in competing stores to make people want to go to JCP first.

Not only that, but did you notice the odd choice for the initial set of new specialty shops? Levi’s, the Original Arizona Jeans Co, and iJeans by Buffalo are all among the first eight shops. How many choices of jeans does one need? And is that really the best way to use their concept, by duplicating product so much? And you know there are other brands of jeans in the store already (I saw Lee jeans right next to the Levi’s shop, for instance). In fact, while we were there my wife overheard a female shopper ask for some help finding a pair of new jeans. The employee walked her over to the Levi’s shop, but then told her, unfortunately, that there were jeans scattered around the store, so although this was the best place to start, she would have to walk the entire floor to see everything they had.

That type of shopping experience is exactly what you would expect from a large, disorganized department store; the exact model JCP is trying to get away from. If you are aiming for a wonderful shopping experience (Ron Johnson is aiming low — trying to becoming “America’s favorite store”), you probably don’t need three denim brands in your first eight shops. And if you do, at least put them close together and remove the other jeans from the rest of the store. First impressions are everything, as new shops are going to be added periodically over the next three years.

As you can see, this is still very much a work in progress. So, I remain skeptical and will likely want to see some proof of changing customer behavior in future quarters before I take a bullish stance. Right now it is more about the potential for success (if executed better in the future) and less about solid progress thus far.

More thoughts on JCP are coming shortly, so stay tuned.

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

Consumer Debt Paydown Crimps GDP Growth

It’s election season so both candidates would love for you to think that the POTUS has a lot of control over economic growth, but this week we got a report that sheds light on one of the major reasons the U. S. economy is growing at around 2%, down from its long-term average of around 3% per year. The New York Federal Reserve reported that credit card debt balances last quarter dropped a $672 billion, a level not seen since 2002. It also marks a 22.4% decline from the peak we saw in the fourth quarter of 2008.

So how exactly has this de-leveraging trend negatively impacted GDP growth? Well, consumer spending represents about 70% of GDP, so a drop in credit card balances of $200 billion over the last few years represents a lot of money that was sent off to pay bills, not spent on goods and services. Toss in another $100 billion of spending that would normally be incremental over that time period due to overall growth in the underlying economy, and you can see that about $300 billion of consumer spending has been absent from the system, compared to what would have been normal.

With annual U.S. GDP at around $15 trillion, this consumer credit card de-leveraging represents about 2% of GDP growth lost. Over 3-4 years, that comes out to about 0.5% GDP impact per year. In a world where GDP growth has dropped a full percentage point from its long-term normalized level, consumer debt repayments account for a major portion of that slowdown. You aren’t likely to hear much about that on the campaign trail, but politicians rarely deal with facts and truths when it comes to hot-button issues like the economy.

Bubble Bursting 2.0 (Part 2): Isn’t Groupon Worth Something?

Last November, in a post entitled “Numbers Behind Groupon’s Business Warrant Caution After First Day Pop”, I cautioned investors that the IPO of daily deal leader Groupon (GRPN) looked sky-high at the initial offer price of $20 per share, which valued the company at an astounding $13 billion:

“It is not hard to understand why skeptics do not believe Groupon is worth nearly $13 billion today. To warrant a $425 per customer valuation, Groupon would have to sell far more Groupons to its customers than it does now, or make so much profit on each one that it negates the lower sales rate. The former scenario is unlikely to materialize as merchant growth slows. The latter could improve when the company stops spending so much money on marketing (currently more than half of net revenue is allocated there), but who knows when that will happen or how the daily deal industry landscape will evolve in the meantime over the next couple of years.

Buyer beware seems to definitely be warranted here.”

A few things have happened since then. First, Groupon has cut back on marketing spending and is now making a profit (free cash flow of $50 million in the second quarter). Second, the post-IPO insider lockup period has expired, removing a negative catalyst that the market knew was coming. Third, and most importantly, Groupon’s stock has plummeted from a high of $31 on the first day of trading ($20 billion valuation) to a new low today of $4.50 ($3 billion valuation).

Here is my question, as simply as I can put it; “Isn’t Groupon worth something?” The stock market seems to be wondering if many of these Internet IPOs will exist in a few years. Today’s 8% price drop for Groupon was prompted by an analyst downgrade to a “sell” and a $3 price target. Here is a company with $1.2 billion in cash, no debt, and a free cash flow positive business that will generate over $2 billion of revenue this year. That has to be worth something. How much is another story.

I would argue that it is too early to write off companies like Groupon as being “finished.” It is far from assured that they will be around in 3-5 years, but many of them have huge cash hoards ($2 per share in Groupon’s case), no debt, and a business that is making money today. My most recent blog post made the point that many of these Internet companies are going to survive, and in those cases bargain hunters are likely to make a lot of money. Will Groupon be one of them? I don’t know, but if an investor wanted to make that bet, at $4.50 per share, they are paying about $1.8 billion ($3 billion market value less $1.2 billion of cash in the bank) for an operating business that is on track for more than $2 billion in sales and $200 million in free cash flow in 2012. And who knows, with this kind of negative momentum, the shares could certainly reach the analyst’s $3 price target in a few more days.

Bottom line: these things are starting to get pretty darn cheap. If they make it, of course.

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

J.C. Penney Stock: Back to Earth

It has been less than four months since my bearish post on J.C. Penney (JCP). Since then the $42 stock has fallen nearly 40 percent to $26 per share. It turns out Ron Johnson does not have magical pixie dust to sprinkle on his 1,100 stores. As the retailer slashes prices on old merchandise, initiates an everyday low pricing strategy, and begins shifting towards its “stores-within-a-store” concept, sales and profits are plummeting. Same store sales fell 19% last quarter, a figure almost unheard-of in the retail sector. The stock is below its level on the day Ron Johnson was hired.

So what now? Well, the stock is no longer clearly overvalued, as it was four months ago. In the mid-twenties, it now has material upside if Johnson’s plan bears fruit. It will still take a long time, so investors need not rush in if they still believe in the new management team. That said, it is probably time to start formulating a game plan if you want to get in. The first quarter results were really the first in what may be a series of bombs as the company right-sizes its inventory and pushes forward with its revamp. The year-over-year comparisons early next year will be very favorable for the company. And who knows, maybe Johnson can drum up some excitement over the holiday season. He does have another six months or so to make a strong push there.

For investors who want to get in on the Ron Johnson JCP experiment, it seems reasonable to scale in slowly with an understanding that Q4 2012 and Q1 2013 may be when we start to see the sales and profit figures turn around. Between now and then we really don’t know how bad it will get. The stock could certainly drop to the low 20’s or even high teens depending on how 2012 progresses and if the red ink continues short term.

Still, as Bill Ackman of Pershing Square Capital Management pointed out shortly after JCP’s recent earnings miss, there is still a lot of potential here and we are really only in the first inning of the company’s plan. Specifically, he pointed to sales of $600 per square foot in JCP’s in-store Sephora boutiques. If Johnson can get exclusive merchandise in JCP and mimic the Sephora “store-within-a-store” concept, there is certainly upside here. Given that the stock was worth about this much before he was even hired, he would really have to screw up the entire brand and alienate his customers in order to destroy the stock permanently. As a result, JCP’s turnaround remains a very interesting story to watch.

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