Solid Prospects for Appreciation Mean That This Is No Penney Stock

You can't ignore girth.

In turnaround investing, girth means leverage -- sales leverage, margin leverage, expense leverage, and so on. And with the leverage that size brings, slight incremental improvements in operations can translate into large earnings gains and a concomitant rise in stock value.

Sleeping Beauty? JC Penney could be coming back to life.

Everybody knows retailer J.C. Penney (JCP Quote - Cramer on JCP - Stock Picks) has, among other things, girth. But most investors have not yet realized that this giant is in the process of awakening from a long, torturous slumber.

Since I recommended J.C. Penney in a December column, it is up over 60%.

But we are not even close to realizing long-term full value, as my three-year target for JCP is $50, or about three times its current stock price.

Let's take a look at financial data for J.C. Penney to discover why it is on the cusp of a dramatic turnaround, and contrast it with fellow retailers Federated Department Stores (FD Quote - Cramer on FD - Stock Picks) and May Department Stores (MAY Quote - Cramer on MAY - Stock Picks).

Taking Stock of the Retailers
Retailer	Sales (in billions)	Market Cap (in billions)	Net Margin	Price to Sales Ratio
J.C. Penney(JCP Quote - Cramer on JCP - Stock Picks)	$31.60	$4.40	less than 1%	0.14
Federated Dept. Stores(FD Quote - Cramer on FD - Stock Picks)	18.40	9.10	3.40%	0.50
May Dept. Stores(MAY Quote - Cramer on MAY - Stock Picks)	14.50	11.80	5.70	0.82
Source: Company reports and TSC research.

Retail is a tough business, as illustrated above by the low- to mid-single-digit net margins of successful companies like Federated and May Department Stores. But therein is evidence of leverage in the stock of J.C. Penney -- management will generate large gains for Penney shareholders to the extent net margins can be lifted to levels like the 3.4% level of Federated. Such a level justifies a price to sales ratio of about 50% for Federated, which would translate to an eventual value of about $60 for JC Penney.

Can J.C. Penney ever attain profitability on a similar level as Federated? Of course it can. For the first eight years of the 90s, the company averaged 4.0% net profit margins. Major changes now being implemented at J.C. Penney are increasing the likelihood that Federated-type margins can be achieved in the next few years. The most important change at Penney is in the heart of the business, merchandising.

Merchandising Is Job One

For retailers, nothing is as important as merchandising. Presenting the right product at the right price for the right customer determines success or failure. But Penney has been laboring at a structural disadvantage in merchandising, making it difficult to meet the needs of its customers.

All major retailers centralize merchandising, with the startling exception of J.C. Penney -- until now. After a couple of years of work, led by COO Vanessa Castagna (formerly of Wal-Mart) and, as of last September, CEO Allan Questrom (formerly of Federated), the company will be rolling out centralized merchandising over the next several weeks.

For the last hundred years, Penney store managers had authority to select merchandise. But modern styles and products evolve at warp speed and quick reaction to change requires a centralized merchandising model.

Technology has made the competitive disadvantage even more pronounced over the last few years as other retailers could recognize and act on styles and trends immediately, not two or three months later. Now J.C. Penney can fully utilize its merchandising talent and compete on a level playing field with other retailers.

Other Assets

J.C. Penney owns the Eckerd drugstore chain. If new management can spur a return to reasonable net margins, Eckerd has the potential to be worth at least $8 billion or so in two or three years. Penney also owns a very valuable asset in its catalog/Internet business, a fast-growing business with a terrific future.

Unlike Internet-only companies, Penney did not need to engage a large buildout of infrastructure to handle its Internet business. Sales support and distribution capabilities were already in place at the catalog business. Another asset of considerable worth is the ownership of real estate at about 25% of Penney stores.

Risks

There are a lot of nonsensical arguments out there for not owning Penney, such as the move away from centralized mall shopping or the inroads of Target(TGT Quote - Cramer on TGT - Stock Picks), Kohl's (KSS Quote - Cramer on KSS - Stock Picks) and Wal-Mart into Penney's market. But neither contention is a major concern. Malls may not be in a vibrant growth phase, but they are not going away either. A valuation of Penney on par with other mall-based retailers like Federated or May would result in windfall gains for holders of Penney stock.

Other retailers are encroaching on J.C. Penney territory. But the size of the market, the so-called "middle market," is so vast that there is ample room for Penney to be reasonably profitable. The key variable for Penney that I'll be watching is same-store sales, particularly later this year. Expect disruption in the short term, with uneven operating results as centralized merchandising is rolled out.