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Valuing JC Penney After President Michael Francis' Departure


Thoughts from a JC Penney investor.

MINYANVILLE ORIGINAL In my previous two comments on JC Penney (JCP), I have repeated that getting the public to go for an EDLP (everyday low pricing) strategy would be a tough sell. In my last comment, I stated that it looks as though the consumer is even more price sensitive than I would have thought.

I also am very sure that the consumer turned out to be more price sensitive than both CEO Ron Johnson and the company's president Michael Francis expected, as lost sales from JC Penney did not stay in the department store realm but went mostly to discounters. In the intervening two weeks while looking at recent results from Kohl's (KSS), I have become even more negative on JC Penney's ability to make EDLP work in this environment.

Still, I was as surprised by the resignation as anyone else.

Both Johnson and Francis had to have known that there would be some major missteps, unless Johnson had contracted a very severe case of hubris from his success at building Apple's (AAPL) profitable retail store business. No retailer I know of had made a change directly from couponing to EDLP since the recession hit in 2008. Moreover, no change to EDLP has been easy.

So one major mistake early on should seemingly not be the reason to jettison Francis, especially when communication of the strategy to the consumer can be tricky. Indeed, Johnson had to have signed off on how the new strategy would be communicated to the consumer. I do think that the consumer communication could have been better by being more straightforward -- but then again, I did not see the focus groups from the other side of a one-way mirror either, assuming the company did some homework on how to implement EDLP and sell it to consumers.

While most observers seem to think that Johnson told Francis to go, I believe that it might have been the case that Francis changed his mind on the EDLP strategy after seeing the first results in the last quarter, and wanted to go back to couponing. Then it might be reasonable to assume that Johnson told him to go because he was not a believer in the strategic vision.

At this point, what happened here may not matter too much. I think that the question for the stock is how long JC Penney will stay with its EDLP efforts and what sales and earnings will be when Johnson, or a new CEO brought in to replace Johnson, changes back to a couponing strategy.

Calling the future base level of sales and earnings is tough because, as the last quarter showed, the customers left for lower priced retailers, not other department stores, and will be hard to win back. Assuming they can be persuaded to return, the next question is whether it will take one, two, or more quarters.

With the caveat that valuation is very tough under these conditions, I would first assume that a 7% risk premium is appropriate, down from 8% (thus going back to the old risk premium and assuming a return to standard couponing). But that only is applicable when Johnson finally throws in the towel on EDLP.

The lowest sell-side earnings per share ("EPS") estimates for this year and next are $.80 and $1.44 respectively. JC Penney earned $1.67 in 2010. Plugging in $.80 and $1.44 and using a 4% growth rate for EPS, which seems reasonable for an average department store in a slow economic recovery, results in a $14 price. [Editor's note: The author is assuming a 3.8% risk free rate, which is 2.8% for the 30-year treasury plus 1% for the current extreme Fed ease.]

In an optimistic case, and assuming that turnaround actions work, using an 8% above average growth rate for EPS on a $1.44 base results in a share price of $18.

The present $22 price implies a 12% growth from that base -- or possibly more realistically, an 8% growth rate from a 2013 calendar EPS in the $1.70-$1.80 range. I am not comfortable with that.
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