more about JCP

I’ve been thinking about Bill Ackman and JCP over the past few days, enough to have looked at the most recent financials for the company.  Why am I writing about this again?   You can usually a learn a lot from a situation where the wheels are starting to come off, and JCP’s 4Q12 financials give a good example of why the cash flow statement is an important document to study.

I haven’t (yet, at least, and I may never) done a real analysis and come up with an investment conclusion.  But I do have a reasonable hypothesis about what’s going on.  By way of its stores’ physical locations, JCP controls a lot of real estate, either through long-term lease or by owning it.  Given Mr. Ackman’s interest in real estate and his prior experience with Target, I imagine his plan has been to ultimately separate JCP into two parts, a real estate entity and a department store and thereby hopefully getting a much higher stock market valuation for each.  I’m sure he also saw some low-hanging operational fruit:  costs were too high, inventories were bloated, some non-essential assets could be sold.  Addressing these issues could raise a ton of cash.

In addition, the real estate value is connected in a strong way to the viability and profitability of JCP stores.  If the department store business is booming, the value of the real estate–in the sense of the ability to raise the rent–rises (and vice versa).  So a Ron Johnson-led makeover of JCP could have a big positive effect on both the value of the stores and the real estate on which they lie.

So much for the concept.  Where does JCP stand now?

Let’s take a look at the 4Q12 earnings report presentation:

recurring items

–during 2012, JCP cut SG&A (Sales, General & Administrative) expense by $603 million, even after  boosting marketing by $25 million and IT spending by $25 million.  That’s tremendous.

–at the same time, 2012’s same store sales comparisons fell by 25.2%.  Worse, comparisons deteriorated steadily as the year progressed, reaching -31.7% during 4Q12.  The number pf people going into JCP stores was off by 13% for the year, with, again, the low point of -17% happening during 4Q.  Conversion, meaning the percentage of people visiting the store who actually bought something, showed the same pattern:  -9% for the year, -10% for 4Q12.  To state the obvious, something went horribly wrong with department store operations.

–the cash flow statement (I’ve rearranged the order of the items JCP lists to give what I think is a more coherent story)…

Under GAAP (the accounting conventions used for financial reporting), JCP lost $985 million during 2012.

GAAP allows a company to reduce the reported loss by the extent it can shelter future profits from income tax (called deferred tax).  For JCP, this was $350 million.  Correcting for this, the pre-possible-future-tax-benefit loss was $1.335 billion.

Part of any company’s expenses are provisions for wear and tear on plant and equipment (the buildings, display counters and other fixtures).  This is called depreciation and isn’t cash out the door.  For JCP, this was $543 million.  Adding that back in gives a sense of whether the company took in money or had an outflow during the year.  In JCP’s case, the “cash flow” number is a loss of $792 million.

one-time items

JCP sold non-core assets during the year.  It wrote down others and took an employee benefit charge.  The gain on the sale and the charges pretty much offset one another, although the asset sales brought in $526 million in cash.

The company got rid of a lot of excess inventory, generating $575 million in cash in the process.  It also got better payment terms from suppliers that saved it, at least temporarily, from paying $140 million for merchandise.  Together, the two working capital actions generated $710 million in cash.  

The net of all this–and a couple of items I didn’t mention–is that operations pretty much broke even.

What’s important to note is that breakeven happened, in my view, only because the inventory and payables adjustments generated $710 million.  I doubt this can happen again in 2013.

investing/financing

JCP spent $810 million last year overhauling its stores and repaid $250 million in debt.  That’s an outflow of $1.060 billion.  It got $526 million in from asset sales.  There were a couple of other small items, leading to a net outflow of $$567 million from investing/financing.

the bottom line

For full-year 2012, JCP had a net outflow of cash of $577 million.  What jumps out at me, though, is that the figure is only this low because of asset sales and working capital adjustments totaling $1.236 billion.  Without them, the outflow is $1.8 billion+.

Of course, JCP would never have embarked on its aggressive store remake had it not figured the $1.236 billion would be available.  What it didn’t anticipate was the drain on cash from the collapse in sales.

where to from here?

In February, JCP announced it has negotiated an increase in its bank credit line to $1.85 billion.  I read this as as much a psychological event as a financial one–to reinforce the idea that JCP has plenty of money to carry out its transformation.

In the 4Q12 earnings call transcript I read, I was struck by the fact that many analysts wished the company good luck after they asked questions.  I can’t remember ever having seen this before.  Putting on my fortune-teller’s hat, I think analysts believe JCP is on the right track but are not yet 100% convinced that this story will have a happy ending.

As far as cash goes, the company now has about $800 million on the balance sheet.  It says it has non-core assets worth several hundred million dollars that it can sell.  And it has it bank credit line.  Absent a repeat of the horrible operating performance of 2012, that should be enough.

On the other hand, Vornado Realty Trust, an ally of Pershing Square Capital, recently sold 40% of its holding in JCP–hardly an act that inspires confidence.

For me, at this point JCP is an interesting case study and nothing more.  I have no special edge here.  I have no idea whether sales will begin to rebound quickly–in which case JCP shares would skyrocket–or not. And I don’t need to have an opinion.   So I’ll just watch from the sidelines.

Bill Ackman’s investment philosophy?

A couple of weeks ago, I heard a conference call held by noted hedge fund manager Bill Ackman (Pershing Square Capital) and broadcast over Bloomberg radio.  I didn’t listen to the entire call, but two things I heard have been rolling around in my mind since then.

a fifty year investment horizon…

1.  Mr. Ackman said that what distinguished him from other investors was that he takes a longer view than most in analyzing his potential investments.   His time horizon?   …the coming 50 years.  

Virtually every investment manager seeking clients will say that two factors differentiate him from rivals:  that he does more meticulous research; and that he has a longer investment horizon, which makes him more resistant to the periodic panics that beset the stock market.  So in one sense, Ackman’s assertion is right out of Marketing 101.  In addition, it certainly sets him apart from the crowd.  And it’s possible that he sincerely believes what he’s saying–although I think that, if so, there’s a wide disconnect between what he thinks he does and how he actually makes money.

But does a fifty-year time horizon make any sense?

I don’t think so.

For one thing, all the available evidence shows that professional securities analysts can’t accurately forecast company financials even one year ahead, let alone fifty.

…when everything is in flux

For another, let’s consider what the world of fifty years ago was like:

–there was no Internet.  So, no Google, no Amazon

–there were no cellphones

–there were no video games (Nintendo was making decks of playing cards); there was also almost no color TVs to play them on

–there were no personal computers, and not that many corporate mainframes, either

–there were no microwaves, no copiers, no fax machines (people used manual typewriters, carbon paper and the post office.  They warmed stuff on the stove)

–there was no Civil Rights Act.  Women and minority group members could do little more than menial labor

–air travel was in its infancy and the interstates were still being built. People traveled by boat and train.

I could go on, but the point is that life fifty years ago was mind-bogglingly different from life today.  It’s almost impossible for us to imagine what it must have been like, even though we have all the historical data, as well as access to people who experienced it first-hand.  It’s also hard to find companies that have survived during the entire period, and even more difficult to locate within that small group ones that haven’t had to change radically to do so.

How much harder, then, to project fifty years into the future, where we will likely continue to see equally surprising twists and turns?

Mr. Ackman’s reply, apparently, is that he invests in real estate, and buildings and land can easily stay around for a half-century.  I guess the argument is that the practice of entering into long-term leases means that real estate only responds slowly to changes in economic circumstances.  Still, it seems to me that real estate remains subject to the same forces of flux that anything else in the economy is.  Cities or states may move in and out of favor (think:  Detroit, the Motor City in 1960 vs. now), as do neighborhoods and sections of cities as circumstances change.  Real estate still needs to be traded, depending on changing economic fortunes.

2.  Mr. Ackman also described the first time he entered the Apple Store on Fifth Avenue in Manhattan (no date given, but the store opened in mid-2006.  Even with its recent swoon, AAPL shares are up 6x since then).  He was deeply impressed and knew there must be an investment idea based on his experience.

Others might have bought AAPL stock.

Not Mr. Ackman, who knew it ‘s impossible to predicts  fifty-year timeline  for the company.  Instead, Ackman decided to hire away fellow Harvard MBA, Ron Johnson, the head of the Apple Store division, and put him in charge of turning around J C Penney, where Pershing Square and allies had a controlling ownership position.

In moving from the store visit to hiring Johnson, Ackman must have made several other judgments that connect the dots:

–that Steve Jobs, one of the biggest micro-managers of all time, had no role in the location, design or layout of the Apple Stores.  It was all, or mostly, Johnson

–that the the fabulous success of the Apple Stores was due to Johnson, not to the quality of the Apple merchandise or the company’s truly immense marketing budget, and

–that the skills needed to run a chain of specialty boutiques selling very upscale consumer electronics products are the same ones needed to run a mid- to down-market clothing-oriented department store.

How has this worked out so far?

…a string of mammoth same-store sales declines by JCP, a large net loss and a decision by insider Vornado Realty Trust to dump 40% of its shares.  JCP stock has lost over half its market value since Mr. Johnson took over, a period when the S&P is up almost 30%.

I’m sure Mr. Ackman would tell you that you can’t judge a 50-year plan based on a mere 2% of that time.  Still, for me the whole conversation had a certain through-the-looking-glass air about it.

spinoffs: sometimes toxic, sometimes hidden gold

The March 12th edition of the New York Times’ excellent Dealbook section has an article written by Buckeye professor Steven Davidoff, titled “In Spinoffs, a Chance to Jettison Liabilities.”  It’s well worth reading.

spinoffs

In it, Mr. Davidoff documents how in a spinoff ( which is when publicly listed companies separate out a chunk of themselves into a separate legal entity, whose shares they then distribute to existing shareholders) the parent companies sometimes have ulterior motives.  (…shocking!)

being left behind on an ice floe

Many times, such “spinoffs” are businesses the parent wants to sell but can’t find buyers for.  They often are loaded up with a disproportionately large amount of the company’s debt.  Sometimes the spinoff is even forced to take out new loans and turn the proceeds over to the parent before it’s launched.  Davidoff gives lots of examples.

One of my favorites is the case of Monsanto, which spun off its industrial chemicals and fiber operations as Solutia, to get rid of liabilities relating to its production of PCBs.  It later spun off its agricultural businesses as the “new” Monsanto, retaining its pharmaceutical businesses in the parent, which was renamed Pharmacia.  Spinoff Monsanto was forced to agree to compensate Pharmacia for any losses it might suffer from Solutia-related litigation.  Sort of like a belt and suspenders.

three points

–None of this spinoff-unfriendly activity takes place completely in secret.  Somewhere in the SEC filings all of the potential bad stuff is disclosed.  Don’t expect it to be to be highlighted in LARGE print and a bold typeface.

There is a quick and dirty way to help focus your attention, though.  See where the current CEO is going end up.  There’ll never be potentially toxic liabilities there.  Look at the other parts of the deal.

–Not all spinoffs are disasters waiting to happen.  There’s a legitimate case to be made against conglomerates.  If a company has, say, two unrelated businesses, one which generates tons of cash flow but has few growth prospects, and a second that has huge growth opportunities, it may make sense to separate the two.  Income investors will bid up the price of the first, growth investors the second.  The sum of the two parts can be worth much more than the original conglomerate.

Sometimes, too, a small growth business can be lost in a much larger entity and starved of capital.  Spinoff will allow it to flower.

Two things to look for:  in my experience, it’s a good sign if the spinoff is relatively small and doesn’t “fit” with the rest of  the firm (think:  Sara Lee and Coach).  Also, it’s a plus if the parent retains an interest in the spinoff.

–There’s a perverse, human nature aspect to the spinoff game.

A captain, dying to get his own ship–even if it is rapidly taking on water–may be unduly optimistic in talking about his new command.

On the other hand, if you’re a shrewd businessman, once you learn your division is going to be spun off–usually at least a year, maybe two, in advance–you know there’s no sense in shining up the business any more until it’s its own public entity.  Improving your business pre-spinoff only makes your post-spinoff job harder!!  Best just to go on vacation for a while.  The result:  a “good” spinoff can be shockingly good in the first few years.

noodle making returning to UK from China–what this means

noodles to Leeds

British Food company Symington’s, the inventor of pea flour and maker of Golden Wonder’s pot noodles, is returning its noodle manufacturing operations from Guangzhou to Leeds, according to the Financial Times.  The FT says the company cites equivalent/lower labor costs in the UK and better response times to customers’ requests as the main reasons.  (I’ve looked in vain on the Symington’s website for a press release.)

This says something about China.  

But it’s not new news.  Alerted by Hong Kong-based distributor Li and Fung and by David Pilling of the FT, I wrote  in late 2010 about the shift of labor-intensive manufacturing, like t-shirt making, away from China to places like Bangladesh and Vietnam.  As I commented back then, this wasn’t particularly new news in 2010, either.

China has run out of cheap labor on its eastern seaboard, a signal that at least this region of the country has to shift to higher value-added manufacturing.  The textbook solution for a nation facing this issue is to allow its exchange rate to rise, while holding local currency wages steady.  China, however, hasn’t followed the schoolbooks.  It has kept its exchange rate relatively stable, while aggressively encouraging local currency wages to rise.  Although this also gets the job done of forcing the most labor-intensive and low value-added businesses to go elsewhere, it runs the risk of creating a lot of inflation.  We’ll see how things turn out.  But, personally, I’m not betting against Beijing on this one.

What’s more interesting, to my mind, is what this says about the UK

Yes, the home country has won back the noodle makers.

There certainly are transportation time and cost savings.

Symington’s will doubtless use “Made in the UK” to its marketing advantage.  And there are probably political points being scored as well.

Nevertheless, this isn’t wresting high-tech business from Google, or Samsung or Amazon.  It isn’t bio-tech.  It isn’t competition for LVMH.  It’s labor-intensive work that would otherwise have ended up in a developing country further down the food chain than China.

“Reshoring” of this type is a two-edged sword.  On the one hand, it’s an illusion-shattering phenomenon for dreamers who recall the days when Britain held a privileged place as the manufacturing hub for a far-flung colonial empire–including Bangladesh.  On the other hand, it’s a place to start.  And with sterling gradually depreciating, UK labor will be in increasing demand.

as an investor…

…this may not be great news for UK manufacturing.  Nor is it a reason to be interested in this sector, because profits are likely to be slim.  But even a low-end manufacturing revival means more jobs.  That suggests that mid- to low-end entries in consumer-oriented areas like lodging, specialty retail and supermarkets may have better prospects than is currently factored into their share prices.

types of stock indexes

Indexes can be categorized in several different ways, including:

reach, or coverage

geographical

There are broad market indexes like the S&P 500, which cover all the important sectors and contain all the key large-capitalization stocks within a geographical region.  In this case it’s the US.  There are similar indexes for all the other major–and most minor–stock markets of the world.

There are also indexes that cover larger geographical regions, like North America, the Americas, Europe, the EU, Greater China, Asia, the Pacific…

There are also indexes like EAFE (Europe, Australasia and the Far East), which covers the world ex the US and Canada.  It’s purpose is to provide a benchmark for foreign stock portfolios held by US or Canadian investors.  There are similar indexes for the World ex Japan, World ex UK…

sectoral

There are also indexes that focus on specific sectors or industries, sometimes divided into local and foreign, depending on the portfolio being measured.

size

There are also indexes that focus only on mid-cap or small-cap stocks, like the S&P 400 (mid-cap) or S&P 600 (small-cap).  With these, the definition of what counts as mid-cap and what’s small-cap may vary from index provider to provider.

investing style

Personally, I find these more problematic, but there are also indexes that claim to contain only value stocks and others that contain only growth stocks.  The sectoral composition of such indexes can deviate wildly from each other, as well as from a larger, style-neutral index.

how the index is calculated

Virtually all today’s stock market indexes are capitalization-weighted.  That is, the effect of the price change of any given stock in the index is based on the total market value of all that company’s outstanding shares.  Stocks where this value is large have more influence on the index movement than whose where the value is small.

Example:

Let’s say the index contains three stocks, whose value totals 100.

Stock A has a market value of 70

Stock B has a market value of 20

Stock C has a market value of 10

On a given day, A rises by 1%, B by 2%, C by 3%.

The change in the index is calculated as follows:

(.7 x .01) + (.2 x .02)  + (.1 x .03)  =  .007 +.004 + .003  =  .014

The index rises by 1.4% that day.  The greatest influence on the index performance is stock A because it’s much larger than the other two.

A variation on capitalization weighting is free float weighting.  It may be that in a given country, the government or a powerful family owns a large chunk of one or more large-cap stocks.  The part that’s so held is never traded.  It’s said not to be part of the pubic “float.”  Where this is the case, indexes often weight the stock using only the float, not the full market capitalization.

variations

equal weighting

The Value Line index is an example.  In an equal weighted index, all constituent stocks count the same.  In the example above, an equal-weighted index would be up by 2%.

Versus a capitalization-weighted index, an equal weighted one gives much greater emphasis to smaller stocks.

the Dow and Nikkei Dow

These indexes are wacky.  They use the per share stock price as a weighting factor.  In other words, a $100 stock counts for 10x what a $10 stock does, no matter what the total size of either company is.  To my mind, this is sort of like saying a nickel is worth more than a dime because the coin is larger.

“fundamental” weighting

At one time in the recent past, some investment managers claimed they were offering an index product in which stocks were selected as index constituents either because they had a strong record of high and increasing dividend payments, or because they combined strong earnings growth with modest stock market valuations.

To my mind, this is a marketing ploy.  These are active management offerings, not index funds/ETFs.  The active manager has decided to rely exclusively on mechanical rules that embody his investment judgment.  Many value managers do much the same thing.

As far as I can see, the investment managers I’ve heard making index claims for their products have stopped doing so–with or without the prompting of regulators I don’t know.

stock indexes and indexing

what stock indexes do

Stock indexes have two main functions:

1.  They provide information about how stocks in general are doing.  Part of this is that it’s nice to know, sort of like the weather. But that’s not all.  The broad stock market has an important role in macroeconomic forecasting.  In the US, the stock market is historically the most reliable leading indicator of economic activity.  Even in today’s world where half the market’s profits come from abroad, changes in stock market direction tend to accurately foretell changes in economic growth that occur around six months later.

2.  Indexes serve as measuring tools to assess the performance of professional money managers.  Three factors have made the role of benchmark increasingly important:

–the widespread rise, post-WWII, of pension plans for workers,

–The Employee Retirement Income Security Act (ERISA).  This Federal legislation, passed in 1974, set down strict standards for corporate stewardship of employee pension plans, and

–rising affluence, which has transformed stock market investing from the exclusive province of coupon-clipping bluebloods into an arena where middle-class Americans can, and do, participate.

academic research on active management

Most of the finance taught in universities is pure nonsense, in my view.  The real world is much more complex than professors realize.  Nevertheless, academics do do good empirical research studies.  One of their most devastating findings is that the typical professional, or “active” investment manager in the US routinely underperforms his benchmark index.  Almost no one outperforms after deducting the fees he charges for his services.   Ouch!  (As it turns out, my portfolios generally outperformed, but I usually ran portfolios that had large exposure to foreign markets–which are another story).

Once ERISA forced pension funds to pay attention, they quickly learned this lesson.

Hence the rise of index funds, which track very closely the performance of benchmark indexes like the S&P 500 and have extremely low costs.  That’s “low” in the sense of better performance than an active manager, at far less than 10% of the costs.

lots of index providers

Standard and Poors has a whole slew.  So does the Financial Times.  Pension consultant Frank Russell has a bunch, too.  And MSCI.

Why so many?  

–They’re profitable.  They’re also relatively easy to set up.  All you need is the money to hire a few quants and a giant computer.

–The first guy in collects the most assets.  Therefore, unless he really messes up, he should have the lowest costs.  And as a result of that, he should get the majority of new inflows.  So it’s much, much better to have an index fund product a little in advance of any demand.  Being late to the party is devastating.

they’re all a little bit different

The FT index for large-cap US stocks has somewhat different constituents from S&P’s;  both are different from Russell’s.  That’s to make it more expensive for large institutional clients, who may pay only a few basis points per year in fees, to switch among index fund providers.  So they can’t play one provider off against the others and bargain for lower fees.

More tomorrow.