Thursday, August 30, 2012

Ackman on J.C. Penney

Here's an excerpt from William Ackman's latest quarterly investor letter on JCPenney. (If anyone finds the full letter, please do send along a copy)
J.C. Penney Company, Inc. (JCP)
In our last quarterly letter, I wrote in detail about our investment in JCP. Very little has changed since that letter other than a continued decline in the share price, which from its high of $43 in early February has cost us more than nine percentage points of gross return this year. The stock price has declined largely due to lower than expected sales in the first quarter, the elimination of the dividend, and a senior executive departure. The fact that the company has yet to build credibility with the investment community has contributed to the stock price decline. This will take time and will largely be driven by better results.
I have complete confidence in Ron Johnson and the new management team he has assembled to execute a total transformation of this iconic U.S. retailer. Ron has been at the job for eight months and has made remarkable progress in many of the requirements for the turnaround. The execution has not, however, been flawless. In particular, the company has had a somewhat confusing pricing message and has struggled to communicate the new business model and every-day value available in the store.
The company has stated that it expects some progress on sales in the second half of the year, an assumption that we believe is realistic in light of the opening of 10 new shops – branded stores within the store – for the back-to school-season in August along with approximately 50% new product in the stores. These new product offerings and improved presentation when combined with better designed advertising and marketing should drive increased traffic and sales. 
The JCP bears’ principal argument rests on additional dramatic declines in sales contributing to balance sheet deterioration at the company. In fact, JCP’s balance sheet is equipped to handle even a large decline in sales for several reasons. Unlike most other retailers for which rent is an enormous fixed cost, JCP’s real estate cost is very low because it owns 50% of its stores and leases the balance at low single-digit rents. The company also benefits from long-term, low-cost debt with limited expirations over the next several years, more than $800 million of cash at the last quarterly report, $1.5 billion of undrawn revolver capacity, and more than $600 million of non-core assets that it can sell. 
Retailing is a cash-flow seasonal business. Certain bearish investors have annualized the first quarter’s negative cash flow in modeling the company’s future cash flows. As with other retailers, most of JCP’s cash generation will occur in the fourth quarter of the year. At its last analyst presentation, the company estimated that it will generate approximately one billion of operating cash flow in 2012 which will be sufficient to fund its $800 million in capital expenditures for new shop development and other needs. Even if the company’s estimates prove optimistic, JCP’s significant liquidity and financial resources should enable it to weather all but the most catastrophic storms.
The company has executed successfully on $900 million of annual cost savings that will drop to the bottom line beginning over the next several quarters. Starting next year, the company’s quarterly sales will be compared with the first quarter’s 18.9% decline, and will benefit by the launch of several new branded shops each month and further improvements to the pricing message and strategy. In light of the large reduction in operating costs, even a modest increase in sales in 2013 should generate large cash flows and profits for shareholders. We look forward to the continued transformation.