JCPenney: A Transformation

This is a selection from my Q2 letter to the partners of Braewick Holdings. Braewick currently has a position in JCPenney (JCP).

We first purchased shares in JCPenney for $27½ in 2011. But as the difficult transformation has progressed, just as short-term optimism drove the price above $40, short-term worries have knocked the share price down below $22. This gave us the welcome opportunity to increase our ownership at bargain prices.

Worries stem from the inevitable bumpy road to fundamentally changing the business. The first quarter saw sales declines of 20%, and I wouldn’t be surprised if Q2 wasn’t pretty either. But despite what the market believes, the turnaround at JCP is on track.

The first step of the transformation is to decide who your customer base is, and in tandem, what products and services you want to sell them. JCP wants to sell brand-name, fashionable merchandise at affordable prices (similar to Ron Johnson’s previous employer, Target). The second step is to create a unique and outstanding experience within the stores to give customers something they can’t find anywhere else.

The problem with step one is that the desired customer base is different than the current customer base (although there is large overlap). Even with a crystal ball that told management the exact changes needed to attract the new customer base, the “customer replacement” wouldn’t occur on a 1-for-1 basis. It is inevitable that unwanted customers would leave quickly and new customers would take longer to attract.

Let’s take a (very) extreme example: say the management of RadioShack decides the business they’re in is going nowhere and will continually lose economic profit in the future. After some research, they decide the best business to be in is motorcycle repair for hardcore bikers. Imagine a parking lot full of Harleys and a store full of leather-wearing biker gangs. These two customer bases are very different, with little overlap. It would be difficult to engineer a “slow” transition. Now, even if they are correct about the potential of this new business, once they make the change sales will fall off a cliff. Old customers would hate it, and it would take some time for new customers to find out about it. I’m stretching the example a bit, but you get the point.

The following table compares retail statistics in 2011 for JCP and two competitors:

Rent is estimated based on proportion of stores owned vs. leased. The figures in this table make things look dismal for JCPenney… but therein lays the opportunity. Management has stated their intention to lower expenses by $900 million, or $8 a square foot. JCP and Kohl’s both have the same number of employees per same-sized store, so it seems possible to lower overhead by at least $5 a square foot without getting rid of associates and impacting customer experience. Reduced advertising is another possibility with the new pricing strategy.

But the biggest potential future gains come from sales increases. With the operating leverage inherent in the business, a 10% increase in 2011 sales translates into cash earnings over seven times the current amount.