Pershing Square's Bill Ackman Highlights J.C. Penney Thesis in Quarterly Letter

In Pershing Square Capital Management's quarterly letter to investors, fund manager Bill Ackman once again outlined his investment thesis for J.C. Penney JCP. As of Pershing Square's last 13-F filing, the firm held 39.1 million shares in the struggling retailer. According to Ackman, "the transformation of JCP is rapidly underway." Under new CEO Ron Johnson, who formerly was an executive at Apple AAPL, J.C. Penney has implemented a dramatically different pricing strategy. Under the new plan, promotional activity has been significantly reduced in favor of more straightforward pricing. Ackman argues that the company's heavy reliance on promotions - J.C. Penney held over 500 "sales" last year - has caused a deterioration in the quality of product merchandise in its stores as leading brands do not want to sell in such an environment. Ackman says that this strategy has resulted in "declining sales, reduced margins, and an inability to attract high quality, proprietary merchandise in the stores." According to the hedge fund manager, the strategy change at the company has allowed it to "attract a large number of new vendors and brands that were previously unwilling to sell in a JCP store." Furthermore, J.C. Penney will allow these new partners to sell their merchandise through in-store "boutiques," which Ackman says are "essentially small, medium, and large stores within a JCP store." This new "store within a store concept" will begin to be rolled out in August, and could provide a meaningful catalyst for the stock. For these brands, the ability to partner with J.C. Penney on this new concept will substantially lower their real-estate costs as the only other alternative is to pay much higher prices for mall locations. By partnering with JCP, they will also save on employee costs while gaining an overnight national presence. Ackman notes that J.C. Penney owns 49% of its real estate and leases the balance for around $4.00 per square foot. "This low cost real estate is an enormous competitive advantage when compared with specialty store rents which average approximately $40.00 per square foot in malls where JCP is located." Sephora's store-within-a-store concept at J.C. Penney is generating sales of more than $600 per square foot versus an average $150 per square foot for the rest of J.C. Penney stores. As the company expands this concept it should allow JCP to "greatly increase its overall sales per square foot and profitability." According to the letter, J.C. Penney will be unveiling 10 new store-within-store concepts starting in August. Making things even more interesting, Ackman tells his investors that Pershing Square, as a result of its large ownership stake in the business, is privy to important information about J.C. Penney that is not currently in the public marketplace. Ackman is apparently aware of the identity of the new store-within-a-store tenants, and is very confident in the ability of these brands to increase traffic within J.C. Penney stores. Furthermore, these new partnerships are expected to be rolled out at a pace of around two or three each month beginning in August, and this should create consumer buzz along with a catalyst for the stock price. Ackman's letter makes it pretty clear that his long-term vision for the company is a substantial restructuring of the J.C. Penney shopping experience--higher quality brands, along with a more straightforward pricing and marketing campaign, should generate a large new customer base. Ackman also argues that shoppers who have been confused, and maybe even disheartened by J.C. Penney's reduced promotions will return to the store once they better understand the business' new value and quality proposition. In the letter, Ackman also reveals that "one of the most respected private equity funds in the world" approached Pershing Square about a potential acquisition at a "substantial premium." Pershing Square rebuffed the overture, because "(they) believe in the long-term value creation opportunity" and the fund wasn't looking for a quick flip of the stock. As far as a timetable for the transition of the brand, Ackman said that he believes "the most challenging year of the turnaround will have been completed" by J.C. Penney's next fiscal year in February. While the entire strategy is expected to take four years, Ackman argues that investors should see substantial share price appreciation over the next year. "Sales should rise from the current low levels as the current JCP consumer comes to better understand the pricing strategy, and as new product is introduced with a new store presentation that attracts both new and traditional JCP customers," Ackman writes. In underscoring the value proposition embedded in the shares at current levels, he argues that the company is currently operating at merely a fraction of its potential and that on a risk/reward basis J.C. Penney is one of the best long-term profit opportunities in the market.