Why J.C. Penney should go privateOctober 9, 2013: 1:23 PM ET
J.C. Penney needs to seriously rethink its business model and it needs the space to execute on a new strategy. That cannot happen in the frenetic public markets.
By Sanjay Sanghoee
FORTUNE -- Shares of embattled retailer J.C. Penney surged this week on news that its cash levels at year-end will be better than expected. That is certainly good news for a company that has had nothing but problems lately. After JCP announced an equity offering to raise $1 billion a few weeks ago, its shares tumbled and Goldman Sachs, its sole underwriter for the new offering, issued a report recommending that investors short the stock. All this after the recent Bill Ackman debacle, in which the hedge fund investor dumped his entire stake in the retailer for a $500 million loss.
However, despite the good news about liquidity and despite the company reporting a smaller decline in September same-store sales, investors should be wary. Cash on hand and less bleeding is not the same thing as operating performance and nor is it a strategy for the future. The company is still facing desperate times, and its best bet may be to go private.
The rationale for going private is easy to encapsulate. J.C. Penney's failed turnaround of its brand, its meager online sales (8% of total), its high fixed cost structure, and its inability to articulate a compelling value proposition for customers all require a serious rethink of its business model, and the space to execute on a new strategy. That cannot happen in the frenetic public markets, which are driven by quarterly earnings, impatient shareholders, higher regulatory burden, and debilitating media scrutiny. Increasingly, too, activist shareholders are disrupting business, threatening takeovers, and forcing buybacks -- JCP's own experience with Ackman is a good example and so is Carl Icahn's latest gambit of demanding a $150 million buyback from Apple.
Public markets are a great source of capital, but that capital comes at a heavy price for most companies. The day-to-day pressures of pleasing stock analysts and short-term investors can stifle innovation and prevent management from being able to pursue a larger game plan. A private structure will give JCP (JCP) the room it needs to modernize its business in a gradual and thoughtful manner.
As former CEO Ron Johnson's failed attempt to change the retailer's image illustrates, JCP's problems are not merely cosmetic but systemic. For one thing, the company needs a management change. Like his predecessor, Mike Ullman has been unable to fix problems despite having the support of the Board and even Ackman (until recently). In addition, since the early 1990s, shoppers have increasingly moved away from department stores toward specialty retailers who can offer both value and quality. Discount stores such as Target (TGT) command the market for basics, while stores like H&M rule the day with customers looking for cheap but hip clothes. Even within its category, JCP faces fierce competition from department store competitors like Macy's (M) and Kohl's (KSS), and online giants like Amazon (AMZN).
In light of all this, JCP needs to direct its resources more efficiently, which includes shutting down some of its stores, identifying a profitable niche in the market and specializing its product line to cater to it, and refocusing its marketing to promote online sales and to target younger and slightly more affluent demographics (nearly half of its current customers skew older than 55 and/or expect very deep discounts). These are major shifts that will require careful study, time to execute, short-term expenditures (to satisfy current leases, hire new personnel, revamp marketing campaigns etc.), and most importantly, will not yield the immediate benefits that public markets demand.
If JCP went private, it would not be alone. Recent converts to private status include Blackberry, BMC, and Dell, all of which are confronting serious challenges to their business model, slumping market share, and pressure from Wall Street. These firms all need to be able to innovate and pursue longer-term strategies, and possibly reverse some of the decisions they made as public enterprises. Of course, private companies confront their own challenges, including the possibility of large shareholders forcing them to pursue the wrong strategies without anyone to challenge their power, but that is simply par for the course. The key is to have room to navigate and change course when necessary, and that type of flexibility is nearly impossible when a management team is tied to quarterly results, not to mention exposed to market volatility.
As for performance, private companies are mostly at par with their public counterparts in terms of sales growth, but where they seem to excel is in higher profit margins. According to Sageworks, a financial analysis firm, profit margins for private companies have been growing for the past few years and on average are 50% higher than before the recession. This may be due to more conscious cost control, flexibility in changing direction and product mix, and greater sense of ownership by management, but whatever the reasons, the fact remains that private company performance is on the upswing, which is yet another argument in favor of JCP going private.
Finally, excluding this week's one-time uptick, JCP has generally been trading at both 52-week and 5-year lows. For comparison, both Macy's and Kohl's are down but still trading close to their 52-week and 5-year highs. While some analysts continue to be optimistic that the retailer will be able to turn a corner in 2014, the reality for JCP looks pretty grim, and the stock price reflects it. If a buyer were to emerge with a smart strategy to turn the company around, it may be able to buy it on the cheap given the constant barrage of negativity surrounding JCP.
Of course, turning around J.C. Penney's fortunes is not a small task, and the result would be far from guaranteed, so the real question is, Does anyone have the stomach and desire to take the company private and fix it? We will see but it is certainly an idea worth considering. With all due apologies to Ackman, of course.
Sanjay Sanghoee is a political and business commentator. He has worked at investment banks Lazard Freres and Dresdner Kleinwort Wasserstein. He is the author of two thriller novels, including Killing Wall Street.