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There's a Sale on Penney's Shares


Don't look now, but one of the year's hottest stocks is J.C. Penney (JCP), up 165%. I had trouble believing that, too, and a trip the other day to one of its department stores failed to explain it. Few cars were parked outside. Inside, I saw even fewer shoppers for Penney's lackluster mix of goods, many of them marked down, and such services as a portrait studio and wig salon. All that stood out was a kid's $14.99 T-shirt, sure to start a fight: It was printed with the words "Home Skooled" and the silhouette of a trailer.

So what has lifted Penney's shares above $29 (chart)? In a word, drugs--specifically, those sold at Penney's other retail chain, Eckerd drug stores. Acquired in 1997, Eckerd now makes up 42%, or $13.2 billion, of the company's total revenue and all of its sales growth. The trouble has been the drug chain's profits. They dwindled in 1998 and 1999 and disappeared in 2000 as Eckerd saw a $76 million operating loss.

With no growth at Penney stores and no profits at Eckerd, a sell-off in the shares may seem inevitable. But if you ask me, Penney's stock, which topped $78 three years ago, has room to run. There are risks, naturally, especially if the consumer economy recedes and shoppers snap their wallets shut. Just the same, make a few assumptions and crunch the numbers, and Penney's shares look cheap.

OVERDUE REFORMS. Assumption No. 1 is that Penney's new CEO, Allen Questrom, can pull off one more turnaround. From 1990 to 1997, Questrom led giant Federated Department Stores out of bankruptcy to prosperity. Next, he helped jump-start Barneys New York after its own bankruptcy. Since joining Penney last fall, Questrom quickly bolstered its balance sheet by cutting inventories and selling receivables and an insurance-sales unit. Penney last year generated $600 million in free cash flow and expects free cash flow to continue for the next few years.

Now, Questrom is targeting operations. His new management teams are making such overdue reforms as centralizing merchandise purchasing and cutting prices at Eckerd. That helped Eckerd swing up from a first-quarter 2000 operating loss of $30 million to a $56 million profit in 2001's first quarter. Eckerd aims to increase sales by at least 8% and realize a minimum 4% operating margin. The department stores hope to expand margins from last year's sub-2% level to at least 6%, while raising sales by 2% a year.

Eckerd rivals Walgreen (WAG) and CVS (CVS) enjoy fatter margins near 6%, while Penney's competitors get about 10%. To meet his more modest goals, Questrom has given the chains lots of time, three to five years. So assume that Penney and Eckerd don't reach them next year. Let's say department-store sales don't grow at all, while Eckerd's grow half as fast as hoped, by 4%. And suppose margins widen only half as far as expected. How much then would Penney figure to make in 2002?

Do the math, and the department stores' earnings before interest, taxes, depreciation, and amortization come to $1.1 billion. Eckerd's EBITDA pencils out to $575 million. At conservative multiples of future EBITDA (four for department stores, nine for drug stores), Penney would be worth $9.6 billion. Today, even after this year's leap in Penney's shares to $29, the stock market values the company at only $7.6 billion.

Penney insists its only plan for Eckerd now is to fix it. But a healthy Eckerd could be worth plenty as a separate company (table). Penney estimates that in three years Eckerd by itself may command $10 billion. Questrom one day could sell Eckerd to fund the vast makeover Penney stores need so badly. I'm betting that, with over a million shares of stock plus options on 3.5 million more, Questrom will ensure value will out. By Robert Barker


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