Is Priceline’s Stock Valuation Out of Whack with Reality?

Rob Cox of Reuters Breakingviews was on CNBC this morning sharing his view that the stock of online travel company Priceline.com (PCLN) appears to be dramatically overvalued with a $30 billion equity valuation (even after today’s drop, it’s actually more like $35 billion). Rob concluded that Priceline probably should not be worth more than all of the airlines combined, plus a few hotel companies. While such a valuation may seem excessive to many, not just Rob, it fails to consider the most important thing that dictates company valuations; cash flow. In this area, Priceline is crushing airlines and hotel companies.

As an avid Priceline user, and someone who has made a lot of money on the stock in the past (it is no longer cheap enough for me to own), I think it is important to understand why Priceline is trading at a $35 billion valuation, and why investors are willing to pay such a price. While I do not think the stock is undervalued at current prices, I do not believe it is dramatically overvalued either, given the immense profitability of the company’s business model.

At first glance, Priceline’s $35 billion valuation, at a rather rich eight times trailing revenue, may seem excessive. However, the company is expected to grow revenue by nearly 30% this year, and earnings by 35%, giving the shares a P/E ratio of just 23 on 2012 profit projections. Relative to its growth rate, this valuation is not out of line.

The really impressive aspect of Priceline’s business is its margins. Priceline booked a 32% operating margin last year, versus just 4% for Southwest, probably the best-run domestic airline. With margins that are running 700% higher than the most efficient air carrier, perhaps it is easier to see how Priceline could be worth more than the entire airline industry.

Going one step further, I believe investors really love Priceline’s business because of the free cash flow it generates. Because Priceline operates a very scalable web site, very little in the way of capital expenditures are required to support more reservations and bids being placed by customers. Over the last three years, in fact, free cash flow at Priceline has grown from $500 million (2009) to $1.3 billion (2011). At 27 times free cash flow, Priceline stock is not cheap, but given its 35% earnings growth rate, it is not the overvalued bubble-type tech stock some might believe.

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

The Sears Holdings Dismantling Begins… Years Too Late

It is February 23rd and shares of Sears Holdings (SHLD) have already risen 100% this year, after a more than 20% jump today to nearly $64 per share. Such gains seem irrational, given how poorly the retailer’s business has been, but keep in mind that the stock opened 2011 about 10 points above where it currently trades, so you had to be quite nimble (and daring) to capitalize on the recent surge.

Today’s stock strength is due to the fact that the company seems finally ready to start splitting itself up, as it believes (probably correctly) that the sum of its parts are worth more than the whole. Sears will spin off its Hometown, Outlet, and Hardware stores (about 1,250 of the company’s 4,000 stores) via a rights offering to existing shareholders. This comes on the heals of the recently completed spin off of the Orchard Supply Hardware (OSH) division. Sears Holdings expects to reap $400-$500 million from the separation, which equates to about 7 times annual EBITDA of ~$75 million.

Splitting up the company is the right call, and should have been done many years ago when the retailer was far more profitable. Annual cash flow at SHLD peaked in 2006 above $3 billion and has collapsed, coming in at just $277 million in 2011. Interestingly, however, Sears has been spinning out its small and less desirable assets. Orchard Supply, now public, is a small cap stock, as will be the specialty store business later this year. The company’s crown jewels (Kenmore, Craftsman, Die Hard, Lands End) remain deeply hidden within the parent company, making it very hard for investors to figure out their intrinsic value.

In fact, Sears also announced today the sale of 11 stores for $270 million to a large mall operator (General Growth Properties). Selling just 11 of its full line Sears stores will bring in more than half as much cash as a complete spin off of their 1,250 unit specialty store business. It is a nice way of padding their balance sheet and alleviating concerns about a cash crunch and a possible bankruptcy (those rumors are completely baseless by the way), but it doesn’t really create all that much in the way of shareholder value.

The biggest problem Sears Holdings faces is that even with its crown jewels, the operating businesses are barely profitable (cash flow margins came in at less than 1% in 2011). Many of their stores are worth more to a strategic buyer like GGP ($24 million each) than they are on the public market inside SHLD. Before today’s stock jump the company had $5.5 billion of store inventory that was fully paid for. The equity value of the entire company was also $5.5 billion. Similarly, Lands End and Kenmore would both likely garner multi-billion dollar valuations as standalone companies, but aren’t inside SHLD. By spinning out the specialty business (32% of the store base and 27% of cash flow) for just $450 million, you can easily see that SHLD is worth more busted up than it is as a retailer.

Which brings us to the problem for investors with the stock now well north of $60 per share (a $9 billion enterprise value). As long as SHLD management is content doing smaller breakup transactions to pad the balance sheet, and not large ones to truly show Wall Street how much their brands and real estate could be worth on a standalone basis, it is hard to see how a pure play retailer with less than $300 million in annual EBITDA is worth $9 billion as an operating conglomerate. Management would argue that they will be able to improve profit margins by retooling the company’s retail strategy, but we are talking about Sears and Kmart here. That argument holds no water. Those stores are dying a slow death plain and simple.

The bottom line from my perspective is that with bankruptcy talk in the media and this stock at $30 (as was the case a few months ago) it is a very cheap stock. With only small moves being consummated to create value and those cash crunch rumors off the table, $64 per share is a tough sell for would-be buyers of the stock. The right number is probably somewhere in between as long as SHLD continues to focus most of its attention on improving the retail operations. If and when the focus becomes monetizing their various brands and real estate assets no matter what path that leads them on, then investors can start to get serious about the stock as an investment.

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

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

Ron Johnson’s First Target at J.C. Penney: Martha Stewart

News reports are coming out this morning that J.C. Penney (JCP) is set to buy a 17% stake in Martha Stewart Living Omnimedia (MSO) for $38.5 million. Not only is this Ron Johnson’s first big step as CEO, it also sheds light on his strategy with the retailer now that he has moved on from Apple to a different kind of retailing operation. There is no doubt that Johnson will be focusing on brands and how to get the best assortment of products in his stores to attract more traffic. He has always said that the reason Apple stores are successful is less about the design of the store and more about the actual products they offer.

Martha Stewart is the perfect candidate for JCP given her mass following. And the fact that her company doesn’t make a profit makes for a relatively cheap investment (less than $40 million is peanuts for a multi-billion dollar retailer). A stronger relationship with Martha Stewart should yield huge returns on this small monetary investment.

Ron Johnson’s track record building out the Apple store concept makes JCP an interesting stock to watch. Given the current price in the low 30’s and the fact that a revamp of the company’s stores is likely to take a lot of time as well as a lot of money, I would not expect financial results to accelerate quickly. This is likely more of a 2013-2014 story from an earnings and sales perspective (not 2012).

In fact, hints of increased corporate expenses as Johnson implements his plan could pressure earnings short term and cause a negative reaction on the company’s shares. At that point, investors might want to take a strong look at the stock if the price is right. In the mid to high 20’s I would be intrigued (the stock closed yesterday at around $33).

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

Numbers Behind Groupon’s Business Warrant Caution After First Day Pop

Daily deal leader Groupon (GRPN) is slated to go public today, selling 34.5 million shares at $20 each, which will raise $690 million in exchange for a 5.4% stake in the company. Combine a popular Internet start-up with a very low number of shares being offered (floating 5% of all shares is historically a very small IPO) and demand will far outstrip supply. We may not see a record setting first day pop, given the eleven-figure starting valuation, but the stage will be set for a solid jump at the open on Friday. And even without any first day gain, Groupon will be valued at about $12.75 billion.

As one of Groupon’s 16 million repeat customers, I was interested to dig into their IPO prospectus because I have already seen my use of Groupon decline meaningfully since I signed up to receive their daily deal emails last year. To me, Groupon has several headwinds facing their core business.

First, Groupon is dealing with many small business merchants who complain that they lose money when running a Groupon campaign. If businesses really see Groupons as a way to mint money immediately, they are mistaken about what role the deal campaign should play. A Groupon deal should be viewed as a marketing expense, not a profit center. A business should use Groupons to get prospective customers in the door. After that, just like any other marketing tool, it is the business’s job to treat them well and provide a good service, which should encourage repeat business. It will be those recurring customers that will grow your business long term and generate profits.

Generally speaking, profit margins for small businesses are hardly ever high enough to make a 50% discounted transaction profitable to the business. If you offer $50.00 Groupons for $25.00 each and only keep $12.50 per voucher (Groupon keeps the other half), the odds are slim you will make a profit initially. Unless it only costs you no more than $12.50 to offer $50.00 in goods or services, you are going to lose money. Let’s say you lose $20.00 per Groupon in this case. The real question should be, is a new customer coming through your doors worth $20 to you? The only way to answer that is to look at other marketing options you have. Do they cost more or less than $20.00 per new customer generated? If the answer is more, then Groupon is a worthwhile way to market to prospective new customers.

Along the same lines, I think Groupon will struggle once they have exhausted most of their small business merchants in any given city. As the example above shows, Groupons themselves are not money makers, which makes it less likely that a small business is going to want to run multiple campaigns. As a result, when you run out of businesses, your deal quality declines and fewer Groupons are going to sell. Groupon is probably facing these issues today, as the business is three years old and many businesses have already used the service. It is my belief that new businesses should probably strongly consider running a Groupon campaign, given that the biggest obstacle for new businesses is lack of awareness. But honestly, there are not likely enough new businesses cropping up to support strong long-term growth of Groupon’s core daily deals business. As a result, merchant growth could very well hit a wall sooner rather than later.

Groupon’s IPO prospectus provided a lot of data that investors may want to use to try and value the company. For instance, as of September 30th, Groupon had 143 million email subscribers. How many of those have ever bought a Groupon? I was pretty surprised by this number actually… the answer is 30 million. Only 20% of the people getting these emails have ever bought one, and that is a cumulative figure for the last three years! Investors trying to place a value on Groupon’s subscribers may want to forget the 143 million number, as only 30 million are generating revenue for the company.

The numbers get worse. Of those 30 million people who have bought at least one Groupon (Groupon calls them “customers” as opposed to the 143 million “subscribers”), only 16 million are repeat customers. So only about 10% of the people who get the emails have bought 2 or more Groupons since the company launched. This is hardly a metric that screams “loyal customers that generate strong repeat business,” which is what investors would want to see.

Why is this important? I think a good way to try and value Groupon (if you even want to bother) is to place a dollar value on each paying customer. After all, Groupon is not unlike a subscription service like Netflix or Sirius XM Radio, aside from the obvious fact that a paying customer of the latter two businesses are more valuable because they generate guaranteed revenue each and every month. In fact, both Netflix and Sirius get about $11.50 per month on average from their paying customers. Interestingly, Groupon earns about $11.90 in revenue for each Groupon it sells, but they are not even close to selling every customer at least one Groupon per month on a recurring basis. As a result, it is correct to conclude that investors should value a Groupon customer far below that of a Netflix or Sirius customer.

Which brings us to the stock market’s valuation of Groupon versus Netflix or Sirius. Each of Netflix’s 23 million subscribers are worth about $200 based on current stock prices. Sirius XM, with 21 million subscribers, is valued at about $600 per subscriber (considerably more than Netflix because Sirius XM has higher profit margins). How much is the market paying for each Groupon customer at the $20.00 per share IPO price? Well, $12.75 billion divided by 30 million comes out to $425 each.

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.

***Update Fri 11/04/11 8:55am*** Groupon has increased the number of shares it will sell in today’s IPO to 40.25 million from 34.5 million. The figures in the above blog post have not been adjusted to account for this increased deal size.

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

Should Investors Revisit Sears Holdings Now That Eddie Lampert Appears To Be Shifting Strategies?

Longtime readers of this blog are familiar with my history with Sears Holdings (SHLD) and its predecessor, Kmart. A brief summary goes something like this.

Hedge fund manager Eddie Lampert loaded up on the debt of Kmart for pennies on the dollar as it fell into bankruptcy (nobody else wanted to come anywhere near the stuff). When the struggling retailer emerged post-restructuring, Lampert owned a majority stake and began cutting costs and reduced the company’s focus on competing with Wal-Mart on price (a losing proposition). The changes worked. Kmart was making money again and the stock soared from $15 to $100 before anyone really knew what had happened. Lampert merged Kmart with Sears in 2005 and investors cheered the move, imagining the magic he could work with strong brands and valuable real estate. Investors assumed he would close money-losing stores, sell off real estate to other retailers, ink deals to sell proprietary products (Kenmore appliances and Craftsman tools) in other chains, and use the cash flow to buyback stock and make acquisitions to diversify the company away from Kmart and Sears, which were clearly dying a slow death. Sears Holdings stock hit a high of $195 in 2007, for a gain of 1,200% in just four years.

Then something strange happened. Those grand ideas never materialized. People close to Lampert were convinced that was the route he would take, based on his experience and philosophy, but he never came out and said it himself. Investors had resorted to blind faith. While Lampert has closed some stores and sold off some real estate, the total store count has actually risen from 3,800 to over 4,000. Lampert cut costs and bought back stock (shares outstanding have fallen from 165 million to 107 million) but he has spent most of his time trying to turn around the retail operations. Couple that flawed strategy with an economy that went bust (the Sears deal closed in the heat of the housing bubble) and profits at Sears Holdings have plummeted. Despite the 35% reduction in shares outstanding, earnings per share dropped like a rock from $9 in 2006 to $1 in 2010. Like many others, upon realizing faith alone was not enough, I sold the last of my Sears stock in 2008 after it had dropped back down to the $100 area. Sure I had a huge profit from the early Kmart days, but the potential for Sears Holdings was just too great to be squandered.

So why rehash the past when readers could get all of that information just be reading all of the posts I penned back then about Sears Holdings? Because it appears Lampert might finally be getting his act together and not putting all of his eggs in the “make Kmart and Sears popular again” basket. It started last year with some subtle moves like splitting up the company into smaller divisions (including one for brands and one for real estate). Then the company reached a deal to sell Craftsman products in Ace Hardware stores (a much better idea than just putting them in Kmart stores). None of these moves were big but maybe they indicated a larger shift in strategy.

This year we have seen further movement in that direction. Sears has announced plans to spin off its Orchard Supply hardware store business into a separate public company. Craftsman tools can now be found in Costco stores and indications are that Kenmore appliances might be next. Diehard batteries are now going to be sold in 129 Meijer stores across the country. Floorspace is now available for other retailers to lease within most of the company’s existing 4,000 Kmart and Sears locations. In Greensboro, North Carolina, for instance, there is a Whole Foods Market store located inside of a Sears. For the first time since the Kmart/Sears merged closed in early 2005 we are seeing signs that Sears Holdings might finally be focused on extracting value from the company’s assets in ways other than trying to turn back the retail industry’s clock several decades. As a result, it makes sense to keep close eyes on the company’s stock once again.

Caution should be advised here, however. Annual revenue at Sears Holdings, while down from $54 billion in 2005, is still formidable at about $43 billion. Selling a few screwdrivers here and leasing some floor space there won’t have a huge impact on their financial results. However, one can certainly see the potential if these efforts prove successful and are adopted in widespread form across not only the company’s 4,000 stores, but within other retailers’ four walls as well. It is too early to predict a turnaround, but the stock price is not factoring in much of this strategy shift, if indeed it is real and sustainable. After dropping from $195 in 2007 to $100 in 2008, Sears Holdings stock has been cut in half again over the last 18 months and now fetches just $55 per share. If we see these moves start to bear fruit on the income statement, the bull market for the stock just may well resume after a five-year hiatus.

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

Amazon: The One Overvalued Stock I Wouldn’t Mind Owning

“I know you are a value investor, but if you were forced to own one growth stock with a hugely un-Peridot-like valuation, what would it be?”

I recently was posed this question and I have to say, even though it does go against my overall philosophy when it comes to investing, it is an interesting inquiry to ponder. I would actually say Amazon (AMZN) is the one overvalued stock I would not mind owning. Now, long time readers of this blog will recall I have long warned against Amazon shares. The valuation has always baffled me and raised red flags, but for years such caution was wrong, as the stock has done extraordinarily well. So why today, at $213 per share, 50 times trailing EBITDA, and 86 times 2011 earnings would I pick Amazon as an overvalued stock that might make sense owning? Well, it doesn’t hurt that they have defied my expectations for years, and I don’t think I am the only one.

I never really thought Amazon was going to be anything more than a great online retailer of other people’s goods. And while their position in that space will only strengthen as more and more people become comfortable buying online and allocate a higher percentage of their purchases from storefronts to the web, offering low prices keeps their margins minuscule. In fact, Amazon’s operating margins in 2010 were 4.1% compared with 6.1% for Wal-Mart and 7.8% for Target. It turns out that Amazon’s retail model is not more profitable than bricks and mortar stores, probably because they still need to maintain huge warehouses across the country (fewer bricks, yes, but bricks nonetheless), which is costly, and they have to offer rock bottom prices and free shipping to entice people to buy more online. Amazon has certainly perfected this strategy, but high margin it isn’t.

The part of the story I missed, frankly, was how strong they could be in new markets that they essentially help build from scratch. The Kindle e-reader was Amazon’s first real big venture outside of just trying to beat bricks and mortar stores at their own game. They successfully created a new market and more importantly, one that has the potential to be higher margin than traditional book printing (digital books). Sure, today they don’t make much money on each e-book sold, or the Kindle device itself for that matter (publishers are still setting prices for the most part and keep most of the revenue) but Amazon has the potential to eliminate the middleman in the years ahead. They could become the publisher and help millions of regular authors publish electronically. This is not unlike what Netflix is trying to do by funding their own original tv series now that they have millions of subscribers.

Next up for Amazon is an entrance into the tablet market sometime in the fall. With such a huge library of streaming music, movies, and television shows, there is nothing stopping Amazon from being a heavyweight in digital music and streaming video. Frankly, Amazon can offer a lot more to consumers with a web-enabled Kindle or Amazon-branded tablet versus the Barnes and Noble Nook or yet another me-too Android tablet like the Motorola Xoom or Samsung Galaxy Tab.

Other than Apple, Amazon appears to be the only consumer electronics player that could offer its customers differentiated products. The margins on commoditized Android tablets will head towards zero as everyone cuts prices to the bone to try and grab market share. Amazon seems well positioned to offer more with their products. As a result, they could easily be a formidable competitor to Apple in the tablet and e-reader markets. I’m not saying they pass Apple, but they certainly can pass Samsung, Motorola, HP, and whomever else to be the clear number two player, and I feel good about that prediction even before they have launched many of the products they have in the pipeline.

So what about the stock? Why could it go higher even at its current valuation? Look, at its current market value of $96 billion, I can’t possibly make a valuation case for Amazon stock based on cash flow and earnings in the near-term. However, if you simply look at their addressable market opportunity over the next 5-10 years and compare their market value with other leading technology and retail companies, you begin to see how a bullish argument could be made longer term. Apple is worth $330B. Google $170B. Wal-Mart $185B. Facebook could fetch $100B after its IPO. If Amazon continues to innovate like they have what would stop them from being worth $125B, $150B, or even $200B in five years?

I know I have completely changed my negative tune on Amazon as a stock investment (and don’t get me wrong, as a value investor I am not going to go out and buy it), but since I was asked the question, if I had to own one seemingly grossly overvalued stock, that would be the one I would pick. Given what they have done in the last five years, coupled with what they are planning and compared with the values of other companies they compete with, $96B seems a lot more reasonable if you ignore the fact that such a figure is 50 times trailing cash flow, or 86 times this year’s profits.

Thoughts?

 

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

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

Sears, Urban Outfitters Smart to Consider Rival Bids for J. Crew

According to reports out of Bloomberg today, J. Crew Group (JCG), the upscale clothing retailer run by former Gap CEO Mickey Drexler, could receive competing buyout offers from the likes of Sears Holdings (SHLD) or Urban Outfitters (URBN). J. Crew has already agreed to a private equity buyout for $43.50 per share in cash, but the deal included a “go-shop” provision,which allows the company to solicit higher bids until January 15th. This Bloomberg report signals that other parties are indeed interested to some degree.

I have been following the situation closely because J. Crew is a current holding in a portfolio I manage for Peridot Capital on Wealthfront. Normally with the stock of an acquisition target trading less than 1% below the agreed upon buyout price I would have long sold the stock, but the price J. Crew accepted made me hold on with hopes of another offer. JCG agreed to sell out for less than 7.5 times trailing cash flow, which may be in line with their peer group, but JCG is not just an average run-of-the-mill retailer. The company’s upscale apparel, coupled with the merchandising abilities of CEO Drexler, make the company a very hot commodity in retail. The original purchase price of $43.50 seemed low to me, given that one would expect a buyout to fetch a premium price for such a wonderful asset within the retailing arena.

As a result, the Bloomberg report that other retailers are poking around and weighing offers should not be overly surprising, but the two parties mentioned are very interesting. Sears, you may recall, was taken over by Eddie Lampert in a move widely expected to result in him diversifying away from their legacy Sears and Kmart stores. Investors (myself included) were excited about the potential for Lampert to siphon off cash flow from Sears’ retail stores and expand into other areas with better growth prospects, but became disgusted and bailed on the stock after he did very little to move away from those two chains. Other than a bid for Restoration Hardware several years ago, Sears has squandered an opportunity so far but perhaps their interest in delving into J. Crew’s books signals a much needed shift in strategy. Not only would J. Crew give Sears a new upscale brand with much more growth potential, but the company’s lower end J. Crew factory outlet line could sell quite well in Sears and Kmart stores, which would boost J. Crew’s reach almost immediately.

Interest from Urban Outfitters is also interesting because it would fit in with the company’s Anthropologie stores as an upscale brand with a middle age target consumer. Rather than building new brands from scratch, which is what Urban has chosen to do in the past, buying an established company like J. Crew (and getting Mickey Drexler) would really mesh well with the company’s image and overall direction in the industry.

While there are no assurances that a rival bid will actually emerge in the next 10 days or so, this story is certainly one to watch. Not only could a company easily justify a purchase price 10-20% above the $43.50 that J. Crew has already accepted, but in the case of the specific companies rumored to be sniffing around, the strategic fits are quite obvious, which cannot always be said in the world of M&A.

Full Disclosure: Long shares of J. Crew and Urban Outfitters with no position in Sears at the time of writing, but positions may change at any time.

Biglari Exchange Offer Signals Inflated Stock Price of Warren Buffet Follower

Biglari Holdings (BH), in the company’s first major move since changing its corporate name from Steak ‘n Shake (read my last post about Biglari and Steak ‘n Shake), has chosen an uncommon method for completing its next public market transaction. Rather than use the company’s cash to acquire a minority stake in Advance Auto Parts (AAP), Biglari has offered to exchange shares of his own stock for shares in AAP at a ratio of 0.1179. Such a move is rare, but more importantly, it signals to investors that Biglari feels that his stock is at least fully valued and at most overvalued. Otherwise, he would have preferred to use cash rather than stock to invest in AAP. Smart capital allocators such as Biglari only have a reason to dilute their ownership stake if they are using prime currency. In this case, BH shares at nearly $400 each were certainly on the expensive side, at nearly two times book value.

Unfortunately, the market has reacted appropriately to this move by shedding nearly 10% from Biglari Holdings’ market value. Trading down into the mid 350’s, the exchange offer to Advance Auto Parts shareholders went from being an attractive option (originally representing a premium of about $1 per share) to being very unattractive (about a $3 per share discount). The markets in general are quite smart and they appear to have sniffed out Biglari’s intention of swapping an expensive stock for a cheaper one.

Why he did not opt to make this offer privately to one or a handful of existing AAP shareholders is baffling. By going public with the offer, he essentially ensured that his stock would get hit hard and reduce any interest in his exchange offer. Of course, the more Biglari makes headlines the more investors might start to read up on him and decide to invest in his company. That exposure could result in a fairly quick rebound in the stock price of Biglari Holdings, prompting more offers like this one.

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