Shorting JC Penney (JCP)

It comes down to the quality of JCPenney’s management.  If you judge management based on its results to date (e.g. 21.7% drop in same-store sales), management has been shockingly bad.  Basically, the longs think that JCPenney is a turnaround story and the shorts think that JCPenney is one of the worst managed retailers.  The short trade may be a little crowded as 41.5% of the float is sold short.  In my opinion, stocks with short interest above 20% are usually seriously flawed and the shorts will be right in the majority of cases.  However, history has shown that life is unkind to short sellers and that short selling common stock is not a good way of making money.  There are books on this… Mr. Sauer worked at a long/short hedge fund that blew up and David Einhorn got burned shorting Allied Capital.

Some of the risks of short selling are specific to hedge funds (e.g. your broker leaking information about your positions so that you get squeezed, SEC investigations).  If you are a retail investor, you should watch out for margin calls, because your broker may/will happily liquidate your most illiquid positions first.  You have to stay liquid.  Don’t assume that XYZ stock won’t experience a short squeeze because “Volkswagen is a large cap” or because “China Medical defaulted on its bonds it is finished”.  If the short is really crowded, you may have to pay high interest on your borrow (e.g. sometimes this spikes to 90%+ like ATPG, Dotbomb 2.0 stocks, TSLA).  You may also be forced to buy-in your position at high prices.  Life is wonderful isn’t it?  So keep your position sizes small… really small.  And if you have tiny positions, you will realize that you will make basically nothing on each position.  So short selling common stock is hardly a worthwhile activity.  (Buying put options on the other hand can be very satisfying.  But puts are expensive for JCP so maybe that is not a good idea.)

You still want to short common stock?  Ok.  Let’s get back to JC Penney.

Good things about JCP

1. Ron Johnson (JCP’s current CEO) used to run the Apple store, which is one of the all-time greatest retailers.  When I go to the Eaton Centre mall here in Toronto Canada, the busiest businesses that I see are the Apple store, Sephora, and McDonald’s.  Sales per square foot for the Apple store is an astronomical $5,626/sqft (source), which is roughly 17 times better than the US average.

2. The Sephora in JC Penney concept will likely do well as Sephora is an extremely well managed retailer.  You can read what Sephora customers are saying at their message board.  If LVMH spun off Sephora I would be extremely interested in the stock.  *JC Penney’s joint venture with Sephora started long before Ron Johnson became CEO.

3. Expenses have been coming down.  This business insider article (*it may be a little biased) suggests that some of the cost cutting is from lowering wages… which is not quite the same as getting rid of inefficiencies.  Employees at all levels have been fired: at the home/head office, store managers, and older/experienced sales associates.  Some of the workforce has shifted to less experienced hires and to part-time employees (who do not receive benefits; those on 6-hour shifts do not get lunch breaks).  The layoffs may have had a negative effect on sales (due to less experienced staff and less staff on the floor), shrinkage (due to less staff; shrinkage has gone up), and employee morale.  It is unclear if the layoffs have increased or decreased profitability and what the long-term effects will be.

Bad things about JCP management

So far, the price integrity strategy hasn’t resonated with customers.  If you read JCP’s Facebook page, some are indifferent, some defend JC Penney, and some think that JC Penney no longer has good deals.  The reaction is mixed and skews towards the negative side.  There aren’t many people who are really excited about it.  Realizing that the “fair” pricing strategy is an obvious mistake, one might expect JC Penney to go back to what works.  (Like Coca Cola switching back to classic Coke.)  But JC Penney has only partially gone back as they did not reintroduce coupons.

Looking forward into the future, two main initiatives at JC Penney are:

1. Stores within a store concept.  (As their target is 100 stores within a JCPenney store, it’s like a mall within a mall.)  I’m not sure how this will turn out.  The Peridot Capital blog has an excellent post on JCPenney’s new stores within a store.  He likes their updated look.  “Still, the early response by customers has been poor.”  I think that the mall within a mall concept is entirely different from the Sephora inside JCP concept.  Sephora is probably the best retailer in its niche and it offers a selection of other companies’ brands that its customers want.  Most of the new store concepts are based on brands that may be second-tier at best (e.g. Izod) or unknown brands (e.g. Joe Fresh).  I am not sure how customers will respond to these lesser brands.  The other difference is that Sephora is a proven, top-tier retail model as standalone Sephoras are very successful.  With the mall with a mall concept, JCP is pretty much building 100 new retail concepts that have never been proven.  And JCP will roll out these new retail concepts without testing them on a small scale first.

2. A move to RFID.  RFID is like a wireless version of barcodes.  Items can be scanned by placing them near a RFID reader.  RFID theoretically offers some operational improvements since stores can check inventory levels without having to go through shelves manually.  They can help stores make sure that they have stock of every size and color.  However, Walmart has tried to move towards 100% RFID in the past and it did not work (though Walmart originally tried to implement it at the pallet level rather than the item level).  RFID has a checkered history in retail as it often hasn’t worked out that well in practice.

3. A move to self check-out… something else that Walmart has also experimented with.  I don’t think that self check-out will take over 100%.  One reason is that the check-out systems have some anti-theft/shrinkage countermeasures that make them unintuitive to use.  You have to put everything on the scale after you scan it.  Otherwise the process will fail.  Some people really hate it.  Right now what works is a mix of self check-out (one employee per four/six checkout machines) and traditional check-out.  Some retailers have ditched self check-out entirely after experimenting with it.  Theft/shrinkage (described here) and user frustration are issues.

Ron Johnson seems to be from another planet if he thinks that JCP can transition to 100% self check-out and RFID.  Both ideas have been tested in the past.  But it’s actually more than that.  Ron Johnson’s vision involves no promotions as some promotions (e.g. coupons, gift certificates) complicate the check-out process.  On top of that, he envisions a world where customers do not pay in cash.  From this interview transcript:

RON JOHNSON:  […]  We’re rolling out right now WiFi networks, really advanced WiFi to all stores.  We’ll have mobile checkout, you know, rolling out now and in the fall.  But we’re also doing something that no retailer has done completely, is we are going 100 percent RFID with ticketing this fall.

So February 1st next year, the entire Penney’s platform will be on RFID tickets.  Now most people use RFID for internal operations inventory management.  We’re going to jump right to the customer, and my goal in 2013, by the end of 2013 is to eliminate the cash route.  So you think of a physical store without a cash routing.

So basically his vision involves four things working together:  RFID, 100% self check-out, no promotions, and no cash payment.  His vision flies in the face of what customers want.  Many customers will fight you tooth and nail if you force self check-out on them as the systems (the process really frustrates and angers some people).  Customers respond to promotions.  And some of them want to pay in cash.  Now I doubt he will be so crazy as to actually force this upon JCPenney customers.  But he is crazy to think that this will work and clearly has not done his research.

Closing thoughts

What matters is the future and predicting the future can be a fickle business.  I think mistakes should be tolerated to a large degree (e.g. Steve Jobs should not have been fired from Apple for his mistakes).  What matters is the process.  What I don’t like about Ron Johnson’s process is that:

  1. He does not test ideas on a small scale first.  This causes mistakes to be unnecessarily damaging, as evidenced by JCPenney’s massive drop in same store sales.
  2. He hasn’t done his research on what the customer wants.  His self check-out vision is so bogus.
  3. He doesn’t try to undo his mistakes.  The promotional model was working better than the current model and he did not go back to what worked.
  4. He hasn’t done his research on his competitors.  Walmart’s foray into RFID and self check-out were not huge successes.  Why?  Ron Johnson should know the answer.  His interview with Fortune’s Jennifer Reingold mentioned previously suggests that he hasn’t done his research as he says he can’t comment for others.  He talks about not having conviction, but Walmart had conviction and was strong arming its suppliers to invest in RFID.  Walmart was a monumental part of the history of RFID.
  5. It’s better to steal good ideas than to be a visionary.  Sam Walton was always looking at competitor’s stores.  Even if that store was awful, he would still for good ideas to steal.  He did not come up with the idea of discounting, Sam’s Club, or Walmart greeters on his own.  Other retailers had already tested different concepts for him.  To be fair to Sam Walton, he did cut Walmart’s prices lower than its competitors rather than copying their prices.  He did have a vision about serving the customer.  But he did steal the vast majority’s of Walmart’s ideas and that is why he is a legendary retailer.

Ron Johnson’s problem is that reality is conflicting with his vision.  His vision of a technological self check-out future will work better without coupons.  The reality is that coupons work.  But here’s the crazy thing.  Ron Johnson is going to stick with his vision.  He is going to build that mall within a mall.  This might take until 2015, depending on capital availability at JCPenney.  Until then you can expect many stores to be in a state of continual renovation.  If Johnson isn’t fired before then, then his vision will materialize in 2015.  And then we’ll see if his vision works or not.  Of course he could have just tested the damn thing on a small scale like every other retailer out there.  You don’t have to bet the entire company on a grand experiment that has so far been a massive failure.  But Ron Johnson has conviction… just read his Fortune interview: “Most people try things, but they really don’t execute courage, you know.  I’m just one, I’ve learned in my life that when I’ve fallen short it’s when you don’t let your imagination win.”

I don’t mean to be extreme but JCPenney looks like one of the worst managed retailers out there.

Links/References

RFID:  Did Wal-Mart love RFID to death?

Presentation by Bill Ackman (owns 18% of JCP)

Presentation (bullish) by Whitney Tilson

VIC writeup (bullish)

Goldman Sachs Global Retail Conference Transcript – “So, the question is, what type of research and testing did we do in determining the strategy, and what is our demographic profile, is that right? Okay. So, from a testing standpoint, the change to move away from the promotional model and go to an everyday price, there wasn’t a lot of testing. That was cold turkey, a decision to move away from the promotional model.”

Allen Questrom interview – Allen Questrom was JCP CEO from 2000 to 2004.  He has various criticisms of the way JCPenney is currently run.

Business Insider article (with great photos) of JCPenney’s new shops – There aren’t that many customers in the photos.

Sam Walton: Made in America – The Walmart founder’s autobiography.  I recommend it.

*Disclosure: I am short.

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3 thoughts on “Shorting JC Penney (JCP)

  1. Interesting commentary/thoughts.

    You and I seem to have opposing views on 3 of my largest holdings EGD, YNG and JCP! One of us is going to end up rich and the other poor.

    Just my two cents but I don’t understand the vitriol toward Ron Johnson. The man was a sensation at Target and then at Apple. He speaks with a passion and vigour which I find quite inspiring (not necessarily grounds for an investment!). Things like the free haircuts initiative will hopefully foster long term brand loyalty from a generation of customers.
    He clearly has the courage of his convictions with his option positions leveraging his net worth to the long term success of the turnaround too.

    The “normalisation” versus peers argument on metrics like sales per sq foot, advertising spend, overhead costs etc is convincing enough to make it a decent long from today’s prices.

    • Thanks for the comment. 😀

      Regarding the free haircuts, you can read the comments on JCP’s Facebook page. Some/many are grateful, some are unhappy with the upselling, and some stylists are a little peeved at overly demanding moms. I’m not sure it builds price integrity due to the upselling. Right now traffic is down in stores. Morale is low among all the rank and file (stylists and sales associates) because people are getting fired, wages are being cut, and they have to work harder. What makes it worse is that they see competent people getting fired. That being said… there are mass layoffs all the time in successful turnarounds. If you have layoffs, low morale is unsurprising. (There are also people who enjoy working at JCP.)

      2- I have my doubts about the normalization argument. In the long run, what often ends up happening is that a small minority of stocks make up almost all of the investment return. And among the losers, a portion of those companies will become corpses or shadows of what they once were. Capitalism is very vicious like that.

      At JCPenney, I see it as a longshot bet on Ron Johnson’s vision. There is a small chance that he will really succeed. But empiricism would suggest that he is failing and will likely continue to fail because he is repeating his mistakes (still no coupons).
      JCPenney will not have a normalized level of capex. Their plan is to transform JCP into a mall within a mall with 100 stores. I don’t think that mall within a mall will have any peers. It will not be a traditional retailer.
      Ron Johnson is going all-in on his vision. It is more likely that he will significantly outperform his competitors, or do far worse. The middle ground doesn’t seem likely to me.

  2. Pingback: Coach: Victor Luis could be the next Ron Johnson | Glenn Chan's Random Notes on Investing

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