Wednesday, December 8, 2010

Examining Pershing's Activist Investment in J.C. Penney

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Following recent pressure by activist investor Pershing Square, Fortune Brands (Ticker: FO) confirmed this morning their plan to carve up the company into three separate operating businesses. The market's reaction has been positive.  As a result, Pershing has so far generated an unrealized return of over $300 million on their investment in the company in just a few short months. (Read the WSJ article for further details)

With this phenomenal investment return in mind, we decided to take a deeper look at Pershing's other major activist investment in J.C. Penney Company (Ticker: JCP) to better understand the activist's strategy and potential for share value improvement.

Since October 8, 2010, when Pershing Square and Vornado Reality Trust first disclosed their respective 16.5% and 9.9% beneficial ownership of JCPenney ("JCP"), there has been some speculation about how vulnerable the retailer might be to an activist campaign.  

Certainly, JCP is feeling the pressure, as evidenced by the fact that the company almost immediately employed a poison pill with a 10% trigger, in addition to hiring Goldman Sachs, Barclays Capital, and Skadden, Arps, Slate, Meagher & Flom LLP for financial and legal counsel.

Upon reviewing the company further, we found several areas of dormant value we believe Pershing Square will proactively pursue in an attempt to help "unlock" the company's true potential.  These include (i) realizing the full value attached to the company's real estate assets, (ii) reforming select corporate governance provisions such as director/executive compensation and low insider ownership, and (iii) addressing several operational inefficiencies that appear even more pronounced when comparing the company's recent results with other major department store chains.

Below is a quick look at each of these along with some thoughts about where Pershing Square might focus their efforts if an activist campaign escalates further.  

Extracted from Pershing Square's Q3 investment newsletter dated November 17, 2010

"We were attracted to JCP because of its inexpensive valuation, strong brand name and assets, and well-deserved reputation for overseas sourcing, high quality systems, and large in-house brands. We purchased our holding at an average price of $25.28 per share, an enterprise valuation of 4.1x 2010 EBITDA (adjusted for excess cash and other saleable non-core assets), a low multiple of what we believe to be trough or near-trough pre-tax earnings. At yesterday’s [November 16, 2010] closing share price of $30.80, JCP’s valuation has increased to 5.1 times EBITDA, a valuation that we continue to find attractive."


JCP may be vulnerable to a request to either lease out its real estate holdings or spin off the assets into a REIT operated by Vornado, which (unlike JCP's management) has significant ~28 years experience in the field.

According to the most recent 10-K statement, JCP (a company with a current market value around $8.0 Billion) owned $308 million worth of land and $4.3 billion in buildings. At January 30, 2010, JCP operated 1,108 department stores throughout the continental United States, Alaska, Puerto Rico, of which 416 were owned, including 119 stores located on ground leases.

Despite the attractive real estate, JCP appears to be struggling to effectively manage the optimal value associated with these asset. Todd Sullivan, a General Partner for value investor Rand Strategic Partners, argues that "JCP doesn't need to own its real estate. It makes them no money".

Oppositely, JCP has seemingly done well investing into REITs. While the retailer does not disclose which REITs it is investing in, as of January 30, 2010, the fair value of their investments in REITs was $178 million, experiencing a net unrealized gain of $63 million in 2009.


Implementation of anti-takeover provisions without shareholder approval
JCP recently enacted a poison pill with a 10% trigger without the approval of shareholders. The Shareholder Rights Plan expires on October 14, 2011. The retailer's stock price fell 3% upon the news when it first implemented the defense.

Low insider and board of director ownership
Additionally, as Todd Sullivan points out, "Abysmal. As a group".
According to the 2009 proxy statement, the company's directors at the time held a total of 1,176,095 shares, equaling less than 0.5% of the company's total shares outstanding.  Sullivan further commented, "I have not seen that during 2009 or 2010 management made ANY open market purchases of stock." 

Director and executive compensation
Despite their lack of substantial ownership, directors receive an annual stock grant that has a market value of ~$120,000.

The activists may also take issue with the amount of compensation paid to top executives.  From 2007 through 2009 JCP paid their top four executives (Ullman, Cavanaugh, Theilmann and Hicks) close to $70 million during a period when shareholder value eroded by about $6 billion.  Below is a breakdown of JCP's top executives' compensation for the past three years, extracted from its 2009 Proxy Statement:

The activists may also highlight JCP's generous golden parachute plans for their top executives. CEO Myron Ullman's plan, for example, is set at 2.99 times his target bonus and annual salary. In the event that Ullman's job is terminated without a change in control, he would receive ~$12 million if he resigns or retires. However, in the event that there  is a change in control, Ullman receives ~$20.3 million if he resigns or retires.


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JCP has been facing stiff competition against Kohl's, Macy's, Sears, and other top department chain stores. Arguably, the company's most significant vulnerability to an activist attack is the fact that, from a competitive standpoint, the company has struggled to perform.

Much of the company's loss in share value is, understandably, attributable to the recession, which depressed consumer spending, especially amongst JCP's market. With a consumer market of limited discretionary income JCP - more so than other department stores, slashed prices in an effort to maintain (and hopefully gain) consumers.

In order to determine why Pershing Square and Vornado found the retailer "undervalued" from a comparable market value perspective, we examined the company's change in stock price over the past three years compared to that of its competitors immediately preceding the activists' announcement on August 17, 2010. As illustrated below, just before the activist intervention, JCP had lost in excess of half of its value over three years, reducing total shareholder value by approximately $6 billion during the period. 

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The company has also struggled in terms of earnings and margins. On November 12, 2010, the company released disappointing third quarter results. Net sales rose a dismal 0.2% from last year's 3Q results, which totaled $4.19 billion in 2010--below analyst expectations of $4.25 billion. Shares fell 3% on the news. Net income was up 63% from last year at $44 million in 3Q.

The retailer was able to fuel sales growth by discounting its products. However, by doing so, JCP cut into profits. Gross margins were down 3.6% from last year at $1.6 billion, or 39% as a percentage of sales, in 3Q. Profit margins were further limited by JCP's lack of layoffs relative to its competitors during the recession--a point which Pershing Square has notably mentioned in the past.

Pershing Square further commented in their 3Q10 letter to investors:

"[T]here is significant potential for operational improvements at JCP which has underperformed its competitors including Kohl's and other retailers. Trailing earnings are at cyclically depressed levels; margins have been squeezed and sales productivity is low, with sales per square foot now at 2002 levels. 2010 adjusted EBITDA is approximately 30% below its 2007 peak and EBIT margins have deteriorated by about 45%".


As the economy further improves and consumer spending recovers, JCP seems to be in a good position to recover much of its lost wealth even without activist intervention. Attractive new brands, like Liz Claiborne and Sephora, have already aided sales growth--and likely will continue to do so. However, it is likely the activists' involvement will help unlock even more value associated with real estate, corporate governance, and operational improvements.

Going Forward:  Important Dates to Keep in Mind:
Expected date of 2011 Annual Meeting: Mid-May 2011
Deadline to Nominate Director Candidates: Mid-February 2011

Posted by David Schatz

Stock Images extracted from Google Finance with comments added by the author.