This “Hated” Retail Stock Could be on the Verge of a Huge Comeback

Over time, the nation’s major department stores have always sought to provide consumers with a unique shopping experience. Sears Holdings (Nasdaq: SHLD) was known for a healthy mix of hardware and appliances along with the usual assortment of clothes, jewelry and shoes. Kohl’s (NYSE: KSS) was known for a solid merchandising touch in its clothing lines — at reasonable prices. Target (NYSE: TGT), for its part, sought to be the home of trendy designers, such as Isaac Mizrahi and others.

#-ad_banner-#Yet in the past half-decade, it’s become increasingly hard to tell these chains apart, as they’ve started to replicate each other’s look and feel inside stores. As a result, same-store sales and profit growth have cooled off, and only Macy’s (NYSE: M) can truly say that it has picked up market share with consumers. Investors have surely taken note: Shares of Macy’s are up roughly 20% during the past five years. That may not seem like much until you realize that Macy’s rivals have all seen their stocks move lower in that time frame.

Perhaps no retailer has suffered from the industry’s glut of me-too stores more than JC Penney (NYSE: JCP). The company’s board realized that this once-thriving retailer had lost its edge and needed a change. It did so this past autumn and hired former Apple (Nasdaq: AAPL) executive Ron Johnson to turn things around. His efforts thus far have been quite uninspiring, so investors are still saddled with a losing play: Shares of JC Penney are off a whopping 60% during the past five years, the worst performance of any major department store retailer.

Breaking the discount habit
JC Penney’s Johnson quickly tried to show that he was unlike most retail executives. He made a bold move that clearly hurt the company’s results in the near-term, yet it will likely end up helping in the long-term. He decided that the never-ending process of discounts and promotions had conditioned consumers to avoid paying full price. For this retailer, this means that earnings before interest, taxes, depreciation and amortization (EBITDA) margins had begun to steadily fall from around 11% in the middle of the past decade, to the 6% to 7% range in fiscal (January) 2010 and 2011 to just 3% in fiscal 2012. Johnson realized that the only way to rebuild margins was to get consumers to pay full price.

Of course, if the company’s stores are virtually identical to rival’s stores, then why would consumers want to shop at JC Penney’s? Here’s where the Apple angle comes into play. Johnson has been hinting for quite some time that JC Penney would emerge as a very different kind of retailer. And now we have a glimpse of what he’s been planning.

The Texas prototype
On Sept. 19, JC Penney walked analysts and the financial media through a heavily revamped store in Dallas, and it quickly became clear how JC Penney aims to be different. Note that Apple has had remarkable success in its retail efforts by creating a compelling environment for consumers to simply come in and hang out. Many consumers go to Apple’s stores with the mere intention of browsing and seeing the latest offerings. Yet many end up making a purchase anyway. The conversion rate — or Apple’s ability to turn foot traffic into retail sales — is among the highest in the business.

In a similar vein, Penney’s Dallas prototype aims to draw in more foot traffic, but without aggressive sales tactics. Instead, consumers are encouraged to browse and meander, and not explicitly seek out a purchase. It’s a counter-intuitive logic that just may work. To attract consumers, JC Penney employs a three-part retailing concept:

 Shops: Where consumers enter into unique store-within-a-store units that feel very different from the traditional big box department store experience.

Streets: Which are lined with coffee bars, juice bars and other places to stop along the way.

Squares: Where family members that don’t plan to shop (such as dads and kids) can hang out and engage in activities, such as games.

Tying these together is a heavy use of technology — from what customers can feel and use, to back-office administration efforts. That’s another page from the Apple playbook. Analysts at Citigroup say that a heavy use of technology “…will create a faster, more enjoyable shopping experience for the customer and will lower the overall operating costs of the store.”

Risks to Consider: JC Penney is launching this turnaround while consumers remain under duress. Major sales gains may be hard to achieve until the economy is on firmer footing. In addition, rival department store operators are paying attention and may look to mimic JC Penney’s moves if they are successful. Lastly, management has recently noted that same-store sales at most of its (yet-to-be-revamped) stores remains tepid, so near-term quarterly results are likely to be mediocre at best.

Action to Take –> Despite a well-received presentation of the new Dallas prototype, shares remain stuck in the mud. That’s because analysts have no reason yet to change their earnings models, and they see a stock that is fairly valued based on near-term operating metrics. Yet that’s precisely the backdrop you should look for when seeking out turnaround stocks.

Once a few of the new JC Penney stores have rolled out, the company has the potential to deliver improving same-store sales results. If that happens, then analysts start to extrapolate newfound momentum across the store base. So analysts may start to boost their outlook for Penney’s profits into mid-decade as the store upgrades really build a head of steam. That’s why you need to track this turnaround now, and not wait until sales trends are noticeably better.