Buy Price -- $27 and $19; Sell Price $9.
The security had most of the hallmarks of a good investment. A legendary investor was buying the security, he was bringing in fresh management to take out the excess he had painstakingly identified by comparing the company in question with its peers. The company had a huge margin of safety through the real estate assets it owned over decades (which were recognized on the balance sheet at historical cost). The investor was bringing in a realty firm specialized in spinning off the real estate assets. The new management's strategy was as tantalizing as it was bold. The new retail store design was as original as the new Apple stores and it was designed by the same man. We made an investment in what we thought was a sound security.
How did it play out?
Approximately 24 months later, the legendary investor had resigned from the board and had sold the shares. The CEO was fired, the new strategy was in shambles, the company was raising capital in the markets and drawing on revolvers, the realty firm had sold the shares and left the board, the old CEO was bought back and we had lost 65% of the original investment.
The company in question was JC Penney and we had followed Bill Ackman into the common shares on terms almost similar to the ones made by him. Ackman had bought in Ron Johnson from Apple to run the company with a bold new strategy. Johnson made a $50M investment in the company's common shares that he could not sell for the next few years; his incentives were aligned with the shareholders. He also ringed in Vornado Realty to the board and they invested in the common shares as well. Along with these changes, a vision of 'Store within a Store' was announced, which was as innovative and as disruptive as the original Apple stores. All brands would have their own stores inside the JC Penney stores; a bold vision.
The original thesis of the investment had a lot of merit. It is the un-examined risks that came back to bite us later. We had forgotten the old adage that turnarounds rarely turn. The story was so compelling that we forgot to evaluate what would happen if the real estate could not be sold and if the new strategy did not work out. In short, we had not tried to kill the company.
The value of the real estate of JC Penney was worth quite a bit more than the market cap of the company indicated. However, as long as JCP was an operational company, it had next to no value. It had a lot of value in bankruptcy. While it was clear that the leftover for the common after all the employees and the bond holders had gorged their share of the carcass was probably more than the value of the common, to get access to that margin of safety, one had ensure years of operational losses and misery as the company convinced itself that it was better off in bankruptcy than in operations. What was the several $s over 27 worth 10 years down the line? A closer examination of our margin of safety would have revealed serious holes in our original thesis.
Furthermore, the store within a store concept required customers to change behavior (which is a red flag) and a cynic would have pointed out that it was like Wal-mart trying to act like Tiffanys. The typical customer for JC Penney lived on the discount coupons that the company regularly sent out to them and convincing themselves that they got a great bargain shopping at JC Penney. Convincing these customers on what might look like a great strategy for Apple should have been a red flag.
What happened over the next 24 months was what can be plainly explained as a butchery of execution. Overnight, the company abandoned the pricing policy that had been in place for decades and in doing so alienated most of the consumers. Without a pilot, they tried to roll out the store within a store concept nationally. Overlaying all this, the management was trying to convince customers that they had got it all wrong and the company was built for greater heights. The management kept building sand castles to the investors while the key operational metrics like SSS nose dived and consumers started leaving the stores in droves never to return back.
Not one thing went right with JCP in these 24 months. Ron Johnson was fired, the previous CEO was bought in, credit lines were drawn, Vornado threw in the towel, Bill Ackman left the board and the strategy was buried deep in the sand it was unearthed from.
