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Tuesday, August 27, 2013 - 08:30
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Tuesday, August 27, 2013 - 08:30

Should You Invest Alongside Soros In This Battered Retailer?

Tuesday, August 27, 2013 8:30 AM

There are two ways to invest in retail stocks. You can focus on strong and steady operators such as Costco (Nasdaq: COST) or Wal-Mart (NYSE: WMT) and hope to secure moderate upside. Or you can be bold and buy shares of truly struggling retailers that have fallen deeply out of favor.

That latter approach has been extremely profitable in 2013 for anyone with the guts to invest in GameStop (NYSE: GME) or Best Buy (NYSE: BBY). Just a few quarters ago, these companies looked to be in deep trouble as spending on video games and consumer electronics, respectively, increasingly was taking place at rivals. Those two retailers have found a way to lure back customers, and the payoff has been huge.

Major investors are now scouring the retail landscape in search of the next turnaround play, and mega-investor George Soros thinks he's found one. In this year's second quarter, he plunked down $3 million to buy shares of J.C. Penney (NYSE: JCP) at an average price of $16.83. Not only should a purchase of that size get your attention, but it's also notable that shares are now 20% lower. You've got a chance to ride herd with George Soros, at a solid discount.

But should you? This is certainly a company in trouble, with a great deal of risk. I've already been burned once, noting roughly a year ago that then-CEO Ron Johnson had crafted a creative new strategy to help differentiate the struggling retailer from the pack.

Johnson's strategy ultimately failed, and the board has brought back former CEO Mike Ullman to help stem the bleeding. In his previous tenure, Ullman wasn't held in high regard by investors, so the move to reinstate him was a bit curious. The board knew that Ullman would at least unwind some of his predecessor's most egregious moves.

Roughly three months ago, my colleague James Brumley helped frame the issue, identifying the necessary steps to help bring J.C. Penney back to relevance.

To be sure, Ullman has yet to stop the hemorrhaging. Fiscal second-quarter sales slid 12%, and gross margins dipped below 30%. That figure, which used to hover in the upper 30s, means the difference between solid net profits and massive net losses. Analysts expect the latter, calling for J.C. Penney to lose more than $5 a share in the current fiscal year and more than $2 a share in fiscal 2015.

Flickr/NHD-INFO
With J.C. Penney's shares down 20% since his $3 million purchase, you've got a chance to ride herd with George Soros, at a solid discount.

But behind the dismal numbers, clear improvements are underway. In recent months, J.C. Penney has begun to:

  • Whittle away at bloated inventories
  • Return the assortment of merchandise back to styles and fashions that formerly devoted customers used to embrace
  • Increase the sales emphasis on private label brands, which should eventually boost gross margins
  • Make an investment in previous staffing levels, which will hurt margins in the near term, but restore the shopping experience to levels that customers had come to expect

Though these moves not bear fruit in the current quarter, analysts now think J.C. Penney will eke out a small profit in the all-important fiscal fourth quarter (reversing a $745 million operating loss in the fiscal fourth quarter of 2013). And subsequent quarters are expected to show ever-smaller losses, when compared with the quarterly results being generated this year.

Such a trajectory is crucial if J.C. Penney is to regain relevance. The company recently established a new loan agreement that will ensure it has ample cash on hand through the holidays. Once better quarterly metrics are in place, management will have an even stronger hand in refinancing the current debt.

Of course at the end of the day, J.C. Penney needs to find the formula to return to positive free cash flow if balance sheet concerns are to truly recede. For a point of reference, a healthy J.C. Penney generated $791 million in positive free cash flow in fiscal 2010, and a whopping $906 million free cash flow loss in fiscal 2013.

The Soros Effect
In light of this retailer's challenges and opportunities, George Soros' massive recent investment in J.C. Penney is notable. He has presumably looked at the roadmap ahead, and concluded that new CEO Ullman can stabilize the ship. And stability may be just enough to justify Soros' interest. After all, J.C. Penney currently trades at a sharp discount to its peers.

Simply delivering acceptably boring results will close that valuation gap. Ullman doesn't need to be a hero. This stock would more than double if J.C. Penney is eventually seen in the same light as its peers. George Soros would be thrilled to see that gap close by half as much.

Risks to Consider: J.C. Penney alienated many shoppers with its myriad changes on the sales floor. It will be a challenge to win back those customers.

Action to Take --> Recent debt refinancings have given J.C. Penney breathing room, and as long as the company starts to show progress in stabilizing operations, then the retailer will be better positioned with lenders to take any other steps to improve the balance sheet. This isn't the kind of stock that you want to wait see become truly healthy in terms of quarterly results. By the time that happens, shares will have already moved up considerable off of their multi-year lows.

P.S. -- Soros has made a $3 million prediction that J.C. Penney will reverse its fortunes. At StreetAuthority, we're big on predictions -- and our previous predictions have given investors 89%... 92%... 293%... and even 310% gains in a year. To hear our latest, click here.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.