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Company Name: J.C. Penney Company, Inc. (NYSE: JCP)


($ in millio ns, except per share data)

Target Price & Recommendation


Ticker Recommendation Catalyst Timeframe Current Share Price Price Target Upside/Downside $ $ JCP BUY Value 15.15 33.00 118%

Trading Stats
% of Current 52-Week High 52-Week Low $ $ 39.78 15.05 263% 99%

Enterprise Value & Valuation


Current Share Price Shares Outstanding Equity Value Cash Debt Min Int & Other Enterprise Value $ $ 15.15 219.4 3,324 (930) 2,982 5,376 EV / LTM EBITDA EV / FY2014E EBITDA EV / FY2015E EBITDA EV / LTM Sales EV / FY2014E Sales EV / FY2015E Sales $ NM $ (61.0) 49.8x $ 108.0 11.2x $ 478.0 NM $ (61) 0.4x $ 12,679 0.4x $ 13,133 Price / Book Value PEG Ratio Dividend Yield 0.9x NA 0.0%

No te: Estimates per Wall Street co nsensus.

Thesis Overview
J.C. Penney (JCP) shares have declined 60% in the past year, and 28% in the past five days. This has been fueled by a 25% decline in same-store-sales in 2012, and a once hopeful turnaround story led by Ron Johnson that has not panned out. Because of the stock price performance, critics are labeling Johnsons New JCP shop transformation as a failure, and some are even calling for a bankruptcy filing in the not-so distant future. However, if you analyze the early evidence of the increased sales efficiency new shop models are yielding to the company, you begin to see that Johnsons re-vamped JCP image may actually be working. Turnarounds always take longer than most expect, and media attention on this high-profile story is not helping the patience of many investors. At ~$15/share, the market is essentially implying that Johnsons plan has failed. However, as detailed in our analysis, JCP has time to get it right (in terms of liquidity) and only needs modest gains in productivity have this stock be worth a lot more than it is today.

Company Overview
J. C. Penney has been around since 1924, and operates 1,105 department stores in the U.S. and Puerto Rico. The company sells family apparel and footwear, accessories, fine and fashion jewelry, beauty products, and home furnishings. JCP also sells its products through its web site, www.jcp.com. A breakdown of the companys end customer base is as follows:

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Net Sales Mix: Women's Apparel Men's Apparel & Accessories Home Women's Accessories, incl Sephora Children's Apparel Family Footw ear Fine Jew elry Services & Other 2009 24% 19% 19% 11% 11% 7% 4% 5% 100% 2010 24% 20% 18% 12% 11% 7% 4% 4% 100% 2011 25% 20% 15% 12% 12% 7% 4% 5% 100%

Certain apparel brands that JCP sells include: Liz Claiborne, Joe Fresh (new), IZOD, Levis, Arizona Jeans, Nike, DC, and the JCP private label brand (about half of all product sold are private label). Certain home brands that JCP sells include: Martha Stewart, Jonathan Adler, Bodum, Keurig and Terance Conran. Certain accessories brands that JCP sells include: Sephora, Tourneau, Nicole Miller, and Monet.

JCP is attempting to transform itself from a coupon-based lower-income retailer, to more of a middle / upper-middle class retailer with a more transparent pricing model and a re-designed store footprint.

Evolution of the Old J.C. Penney into the New JCP


J.C. Penney was originally founded on the principles of fair prices with ongoing aggressive discounting and a coupon-heavy model. The companys model worked nicely, but JCPs stock peaked in the early/mid 1990s. From the mid 1990s to 2000, under the leadership of James Oesterreicher, JCP saw core retail EBIT drop about 80% as the fashion retailer: (1) acquired a drug store business in 1996, (2) did not continuously update its brands with modern styles, and (3) took on way too much debt. In 2001, Allen Questrom took over and he began divesting non-core businesses and began modernizing JCPs internal operations. A new CEO, Mike Ullman, took the lead in 2005, but not much happened with JCP. He attempted to expand small off-mall stores, but did not address the companys elevated cost structure. From 1990 to 2011, JCP stock has gone up and down, but it has essentially appreciated 0% in those 2 decades. During 2011, Bill Ackmans Pershing Square began acquiring a sizeable stake in J.C. Penney (currently owns ~18% of the company), and spearheaded the hiring of Ron Johnson to become JCPs CEO to help transform the struggling retailer (copy of Ackmans May 2012 JCP presentation can be found here). In June 2011, Johnson joined the company after decades of experience in the retail sector. For 15 years Johnson was the VP of Merchandising at Target (NYSE: TGT), helping the company transform into a chic discounter. Then, from 2000 to 2011, Johnson was Head of Retail at Apple (Nadaq: AAPL), where he built up Apples retail business from nothing into the fastest growing retail outfit ever. Johnson helped two major companies during key transformation phases, and Ackman saw the mans experience and vision within the retail sector, and recruited him heavily to lead JCP. Johnsons vision is to transform JCP from the Old J.C. Penney to the New JCP. In other words, Johnson wants to change JCPs image from a promotional department store with a disorganized setup,

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outdating inventory, and old-fashioned styles, to more of a specialty department store with a fresh image, more colors, modern styles and designs, and a chic mall within a mall format to encourage customers to stay in the stores longer. Specifically, Johnson is updating each of the (on average) 100 shops within every JCP mall (or store) to be much more of a pleasant, colorful, and modern experience. Some examples of the revamped shops within a JCP store look like this:

Each JCP store will have wide walkways (called streets), with a central square in the middle of each mall.

Intermixed in and around the shops will be snack, smoothie and coffee bars. Couches will be spread about the shops, and iPads will be available for consumers to use and help browse. Johnson is envisioning a re-vamped look to attract a newer and higher-income customer base. JCP successfully redesigned 8 shops within its stores during 2012. On average, this transformation yielded a 33% increase in sales per square foot productivity.

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Customers enjoyed the layout, variety, chicness and new styles that are all present in this new shop format Johnson has devised. Despite this newly devised strategy, same-store-sales for JCP declined 25% in 2012. A major mistake that Johnson made during the year was overhauling the traditional J.C. Penney promotions and coupons. He was convinced that the consumer would react well to having a consistent pricing strategy, where JCP would price its items at an affordable price with limited sales, promotions and coupons; essentially attempting to communicate to its customers that they can get great value at JCP every day. He saw a heavy customer backlash as a result, and capitulated that this pricing strategy was not working on the companys recent 4th quarter conference call. JCP is now returning to its regular coupon-emailing and its regular clearance strategy, however Johnson has communicated that he will not sell every day items at artificially marked-up prices like his predecessors had done. Another reason for JCPs same-store-sales decline was a result of shedding its large inventory load via massive clearance sales. As the company sold off older inventory in order to re-invigorate its clothing & accessories platform, it reduced inventory by 20% in just one year. Heavy sales and clearance programs helped reduce inventory load, which also impacted margins negatively, with total gross margin contracting 470 bps from 36.0% to 31.3% from 2011 to 2012. Johnson and team have done a good job identifying redundant costs to take out of JCPs fixed cost base. On a gross basis, management has identified $900 million of G&A to take out, $800 million of which was removed in 2012 alone. It was reported that after an internal assessment of employee efficiency, management discovered that Netflix consumed 20% of corporate internet bandwidth during work hours, and the average employee made 1,000 clicks on youtube each month. Needless to say, sizeable layoffs occurred in 2011 and 2012, and Johnson has communicated to the Street that right-sizing is a continuous process as JCP continues to tweak its strategy and offerings. JCP also reduced labor hours, simplified stocking and merchandise receiving, optimized supply chain deliveries, and reduced the number of cash registered (with help of supplying almost all floor employees with iPads one data point is as of the last week of February, 25% of all in-store purchased were made on employee iPads). As the company plans to support its transformation plans via cash on hand and internally-generated cash flow, it has increased its liquidity position by tapping credit markets early. Its ABL currently has

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$1.85 billion capacity, and maintenance covenants dont start to kick in until 90% of it is drawn. JCP currently has nothing drawn on its facility and has $930 million of cash on hand as of FY2013 end. The Bulls: JCP Strategy Review The Bulls have been warning since 2012 that this JCP turnaround will take time. Although at the beginning of 2012, Johnson had hinted that he was optimistic 2012 would see positive growth in the back half of the year, the company actually accelerated its same-store-sales decline in the back half of 2012 (as discussed above). Johnson, however, admitted certain faults and claims he has learned much from customer feedback and behavior (specifically revolving around pricing strategies). Bulls are optimistic about the improvement in sales efficiency of the re-designed shops completed in 2012. They put a lot of value upon Johnsons experience at Target and Apple. It helps that Ackman has put a lot of money behind this turnaround story, so he is motivated to make sure management is doing things correctly and the right people are at the helm. Turnarounds usually take longer than the Street expects, and if JCP can get margins and sales per square foot trends close to peers, then there is a tremendous amount of value in JCP stock. The Bears: JCP Strategy Review The Bears have been hanging their hats on I told you so. From FY2011 to FY2013, JCP revenue has dropped 27%, mainly due to following Johnsons strategy. Certain critics are appalled at the fact that Johnson is aggressively re-designing all of JCPs stores, and they claim that Johnson does not have enough data to analyze so soon that this new shop format is worth all the investment. The company will eventually have to tap the public markets to fund Johnsons capex plans, which will end up destroying equity value in JCP. There are also a few Bears saying that Johnson has never been CEO before, so he does not have a good grasp on the financial condition of his company. All these reasons are why there is a large group of JCP Bears out there, thus turning JCP into such a publicized and polarizing investment.

Model & Valuation


When we attempt to evaluate what type of value potential JCP has, especially at the $15/share level, we take a look at what management estimates it can earn over the long-haul, what results the company has achieved so far in its firm-wide testing and investment, and also what JCPs peers earn in terms of profitability and efficiency. On a gross basis in FY2012, JCP generated $154 gross sales per square foot. This compares to its peer set, which averaged $271 per square foot.

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FY2012 Peer Statistics: Gross Sales per Sq Ft Macy's $174 Kohl's $194 TJ Maxx $285 Nordstrom $431 Average $271
So urce: Co mpany filings. No te: Fiscal Year ends January 31 201 st, 2.

Gross SG&A as Margin % of Sales 40% 27% 38% 23% 27% 15% 39% 25% 36% 22%

EBITDAR Margin 14% 17% 17% 16% 16%

This inferior sales efficiency is due to the legacy JCP that was mismanaged as discussed in the above section of this JCP research report. On a net basis (only including its traditional department store format, which makes up ~2/3rds of the companys square footage), JCP generates on average $180 per square foot. What management saw during 2012, is that of the 8 shops that were re-designed with the New JCP look within JCP stores, on average revenue per square foot jumped 33% to $239. Although this is only one year of data, JCP has analyzed trends at shops such as Sephora, and over a 5-year period, Sephora saw net same store sales per square foot growing at 5% per annum, even through a recession (2007-2011), after a shop remodel. Thus we have some benchmark to sensitize sales efficiency as JCP continues to revamp its shop-base. Johnson has continued to identify 40%+ to be JCPs long-term gross margin. This is in the ballpark of where JCPs peers are (above), however this will not be achieved until the company sells off all its outdated inventory at a discount (like it aggressively did in 2012), and optimize its pricing strategy (like Johnson is trying to do currently). On the fixed cost front, JCP has identified $900 million in SG&A cuts to make, and has essentially implemented these measures almost entirely. Johnson is keen, however, on spending more on technology investment and new marketing plans. This ranges from iPads for employees, to a fresh TV marketing campaigns at events such as the Oscars. This resets SG&A to a base level of ~$4.3 billion, or 32% of sales. The company should have decent leverage in this new cost base as revenue grows, as evidenced by its competition that has SG&A averaging 22% of sales. Current levels of capex spend should continue over the next 3 years as JCP continues its shop transformation. JCP now has 10 shops transformed to the new JCP format as of FY2013 end, and will do 30 more shops per year over the next 3 years (on average ~100 shops within each JCP department store). Afterwards, capex should drop in the 2-3% of sales range which is in line with historical trends and competition. As we analyze where this puts JCP throughout its store transformation and beyond, we begin to get comfortable that there will not be a major liquidity event, at least in our base case.

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($ in millio ns)

FY End Jan 31: Square Footage Breakdow n (sq ft MM) Backroom / Office / Services Small Stores Transform ation Space Total Square Footage Growth in Sq Ftage # of Shops Transformed to JCP # Remaining of Old JCPenney Total # of Shops per Location Growth in Shop # JCP Square Footage Old JC Penney Square Footage Total Sq Ft (in MM) Revenue Productivity New JCP: New JCP Rev per SqFt - First Year Incremental New Square Footage "Mature" New Sqr Footage in Existence "2012 New "2013 New "2014 New "2015 New "2016 New "2012 New "2013 New "2014 New "2015 New "2016 New "2012 New "2013 New "2014 New "2015 New "2016 New SqFt" Lifetime Grow th SqFt" Lifetime Grow th SqFt" Lifetime Grow th SqFt" Lifetime Grow th SqFt" Lifetime Grow th SqFt" Rev SqFt" Rev SqFt" Rev SqFt" Rev SqFt" Rev SqFt" SqFt" SqFt" SqFt" SqFt" # # # # # per per per per per SqFt SqFt SqFt SqFt SqFt

Jan-12 2012A 34 13 64 111 34 13 64 111

Jan-13 2013A 34 13 64 111

Jan-14 2014E 34 13 64 111 0.0% 40 60 100 0.0% 25.6 38.4 64.0

Jan-15 2015E 34 13 64 111 0.0% 70 30 100 0.0% 44.8 19.2 64.0

Jan-16 2016E 34 13 64 111 0.0% 100 0 100 0.0% 64.0 0.0 64.0

Jan-17 2017E 34 13 64 111 0.0% 100 0 100 0.0% 64.0 0.0 64.0

Jan-18 2018E 34 13 64 111 0.0% 100 0 100 0.0% 64.0 0.0 64.0

Jan-19 2019E 34 13 64 111 0.0% 100 0 100 0.0% 64.0 0.0 64.0

Jan-20 2020E 34 13 64 111 0.0% 100 0 100 0.0% 64.0 0.0 64.0

10 90 100

2 98 100

10 90 100

6.4 57.6 64.0

1.3 62.7 64.0

6.4 57.6 64.0

$239 1.3 5.1 1.3 5.0% 19.2 6.4 5.0% 5.0% 19.2 25.6 5.0% 5.0% 5.0% 19.2 44.8 5.0% 5.0% 5.0% 5.0% 0.0 64.0 5.0% 5.0% 5.0% 5.0% 5.0% $305 $291 $277 $263 $251 1.3 5.1 19.2 19.2 19.2 $390 $1,487 $5,312 $5,059 $4,818 $17,067 $267 0.0 64.0 2.0% 5.0% 5.0% 5.0% 5.0% $311 $305 $291 $277 $263 1.3 5.1 19.2 19.2 19.2 $398 $1,562 $5,578 $5,312 $5,059 $17,909 $280 0.0 64.0 2.0% 2.0% 5.0% 5.0% 5.0% $317 $311 $305 $291 $277 1.3 5.1 19.2 19.2 19.2 $406 $1,593 $5,857 $5,578 $5,312 $18,746 $293 0.0 64.0 2.0% 2.0% 2.0% 5.0% 5.0% $324 $317 $311 $305 $291 1.3 5.1 19.2 19.2 19.2 $414 $1,625 $5,974 $5,857 $5,578 $19,447 $304

$239

$251 $239

$263 $251 $239

$277 $263 $251 $239

$291 $277 $263 $251 $239 1.3 5.1 19.2 19.2 19.2 $372 $1,417 $5,059 $4,818 $2,294 $13,960 $254

1.3

1.3 5.1

1.3 5.1 19.2

1.3 5.1 19.2 19.2

"2012 New SqFt" - Total Revenue Generated "2013 New SqFt" - Total Revenue Generated "2014 New SqFt" - Total Revenue Generated "2015 New SqFt" - Total Revenue Generated "2016 New SqFt" - Total Revenue Generated Total Revenue from New JCP Concept ($ in MM) New JCP Weighted Avg Revenue per Sqr Foot Old JC Penney: Old JC Penney Rev per SqFt % Change in Productivity Old JC Penny Square Footage Remaining Legacy Revenue from Old JC Penney New JCP Weighted Avg Revenue per Sqr Foot Total Wtd Avg Revenue per Net Square Foot Small Store Format Small Store Rev per SqFt % Change in Productivity Revenue per Gross Square Foot

$153

$321 $612

$337 $1,285 $2,294

$354 $1,349 $4,818 $2,294 $8,816 $248

$933 $241

$3,917 $243

$180

$180

$180

$175 (3.0%) 38.4 $8,381 $175 $179

$169 (3.0%) 19.2 $4,878 $169 $203

$164 (3.0%) 0.0 $1,577 $164 $228

$159 (3.0%) 0.0 $0 $159 $251

$155 (3.0%) 0.0 $0 $155 $264

$150 (3.0%) 0.0 $0 $150 $278

$145 (3.0%) 0.0 $0 $145 $289

62.7 $11,290

57.6 $10,829 $180

$94

$91 (3.0%) $121

$89 (3.0%) $134

$86 (3.0%) $150

$83 (3.0%) $164

$81 (3.0%) $171

$78 (3.0%) $178

$76 (3.0%) $184

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($ in millio ns)

FY End Jan 31: Financials New JCP Revenue Old JC Penney Revenue Small Store Format Total Revenue Growth % yoy Gross Profit Gross Margin Margin Expansion Base SG&A New SG&A - Tech Investment, Marketing Total SG&A % of Sales Pension Exp D&A Other Total Other Opex % of Sales EBIT Margin % EBITDA Margin % Less: Cash Interest Cash Taxes Non-Cash Pension Exp Stock Comp Capex Change in W.C. Other FCF Total Cash Pile ABL TLs, Bonds, etc Total Debt Net Debt / EBITDA $1,850 Max Borrowing

Jan-12 2012A

Jan-13 2013A $933 $10,829 $1,223 $12,985

Jan-14 2014E $3,917 $8,381 $1,186 $13,484 3.8% $4,315 32.0%

Jan-15 2015E $8,816 $4,878 $1,151 $14,844 10.1% $5,121 34.5% 2.5% $4,326 $111 $4,437 29.9% $200 $594 $0 $794 5.3% ($110) $484 3.3%

Jan-16 2016E $13,960 $1,577 $1,116 $16,654 12.2% $6,162 37.0% 2.5% $4,456 $115 $4,570 27.4% $200 $666 $0 $866 5.2% $725 4.4% $1,391 8.4%

Jan-17 2017E $17,067 $0 $1,083 $18,150 9.0% $7,169 39.5% 2.5% $4,589 $118 $4,707 25.9% $200 $635 $0 $835 4.6% $1,627 9.0% $2,262 12.5%

Jan-18 2018E $17,909 $0 $1,050 $18,959 4.5% $7,679 40.5% 1.0% $4,727 $122 $4,849 25.6% $200 $664 $0 $864 4.6% $1,966 10.4% $2,630 13.9%

Jan-19 2019E $18,746 $0 $1,019 $19,764 4.2% $8,005 40.5% 0.0% $4,869 $125 $4,994 25.3% $200 $593 $0 $793 4.0% $2,218 11.2% $2,810 14.2%

Jan-20 2020E $19,447 $0 $988 $20,436 3.4% $8,276 40.5% 0.0% $5,015 $129 $5,144 25.2% $200 $613 $0 $813 4.0% $2,319 11.3% $2,932 14.3%

$4,066 31.3%

$4,506 34.7% $353 $543 $0 $896 6.9% ($1,336) ($793)

$4,200 $108 $4,308 31.9% $200 $539 $0 $739 5.5% ($733) ($193)

7.5% 35.0%

($268) $0 $120 $50 ($800) ($98) $0 ($1,190) $930 $0 $2,982 $2,982 $1,190 $2,982 $4,172 -16.8x

($338) $0 $120 $51 ($800) ($218) $0 ($700) $890 $1,850 $2,982 $4,832 8.1x

($362) ($127) $120 $52 ($800) ($302) $0 ($28) $862 $1,850 $2,982 $4,832 2.9x

($326) ($455) $120 $53 ($500) ($192) $0 $961 $862 $889 $2,982 $3,871 1.3x

($257) ($598) $120 $54 ($500) ($118) $0 $1,331 $1,305 $0 $2,982 $2,982 0.6x

($224) ($698) $120 $55 ($500) ($188) $0 $1,376 $2,238 $0 $2,982 $2,982 0.3x

($224) ($733) $120 $56 ($500) ($157) $0 $1,495 $2,357 $0 $2,982 $2,982 0.2x

Broadly speaking, JCP falls into a liquidity trap by 2015 if it cannot get gross margin back up to the 35% threshold. This also assumes the New JCP revenue per square foot metric of $239 stays flat throughout the lifespan of the new shops, which results in gross sales per square foot to be $25 below Macys (the lowest of the peer group). If you think downside of JCP is to generate EBITDAR margins of 5-7% (~1,000 bps below peers), then liquidity is definitely a concern. If you believe Johnson can get revenue per square foot and EBITDAR margins, above these depressed levels (which we believe), then the liquidity concern should not be a primary risk. JCP Price Target As we think about what the appropriate share price is for JCP, we run a DCF using the same base case assumptions as discussed above. We use 6x as an exit EBITDA multiple, which is a one turn discount to its department store peers, as the company is clearly lagging its peers in terms of sales efficiency and

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margin (at least at the moment).
($ in millio ns, except per share data)

Stock Price % of 3/4/13 52-high Dept Stores Macy's Kohl's TJ Maxx Nordstrom

Market Cap

Enterprise Value

EV / EBITDA 2013E 2014E

Price / EPS 2013E 2014E

EBITDA '13E Margin Leverage

Price / Book

Div Yield

$41.54 $46.39 $45.20 $53.82

98.5% 84.0% 96.9% 92.1%

$16,420 $10,670 $32,962 $10,769

$22,096 $15,888 $35,580 $15,062 Average Median

5.8x 5.7x 9.2x 8.1x 7.2x 6.9x

5.5x 5.6x 8.3x 7.5x 6.7x 6.5x

10.8x 10.1x 16.0x 14.0x 12.7x 12.4x

9.5x 8.9x 14.2x 12.7x 11.3x 11.1x

13.5% 14.2% 14.2% 14.4% 14.1% 14.2%

1.8x 1.7x 0.2x 1.7x 1.3x 1.7x

3.0x 1.7x 9.5x 5.7x 5.0x 4.3x

2.0% 2.8% 1.1% 2.1% 2.0% 2.1%

Malls Simon Property Group $161.46 General Grow th Properties $19.91 Taubman Centers $76.94

98.3% 93.7% 93.1%

$50,644 $18,703 $4,874

$80,050 $35,852 $8,072 Average Median

21.5x 19.5x 17.4x 19.5x 19.5x

20.0x 18.6x 15.7x 18.1x 18.6x

45.6x 79.6x 46.1x 57.1x 46.1x

40.6x 52.4x 40.7x 44.6x 40.7x

73.3% 71.0% 59.8% 68.1% 71.0%

6.2x 8.8x 6.4x 7.1x 6.4x

8.6x 2.5x NM 5.5x 5.5x

2.9% 2.5% 2.4% 2.6% 2.5%

We view a 12% as appropriate, as this turnaround story is clearly an above-average risk strategy, and JCPs current debt levels are high relatively to EBITDA. We are unsure what the companys NOL position is as of year-end, so to be conservative we assume JCP pays cash taxes as soon as it gets back to profitability, which most likely will not be the case as the company is going through a period of numerous years with negative net income.
($ in millio ns)

FY End Jan 31: DCF EBIT Taxes D&A Capex Change in W.C. Free Cash Flow WACC Term Mult 12% 6.0x

Jan-12 2012A

Jan-13 2013A ($1,336) $0 $543 ($810) $683 ($920)

Jan-14 2014E ($733) $0 $539 ($800) ($98) ($1,091)

Jan-15 2015E ($110) $0 $594 ($800) ($218) ($534)

Jan-16 2016E $725 ($254) $666 ($800) ($302) $36

Jan-17 2017E $1,627 ($569) $635 ($500) ($192) $1,000

Jan-18 2018E $1,966 ($688) $664 ($500) ($118) $1,324

Jan-19 2019E $2,218 ($776) $593 ($500) ($188) $1,346

Jan-20 2020E $2,319 ($812) $613 ($500) ($157) $1,464

35%

Sum of Discounted Cash Flow s PV of Terminal Value Im plied Enterprise Value Cash Debt Other Equity Value Share Out Im plied JCP Share Price Upside/Downside to Current

$1,357 $7,959 $9,316 $930 ($2,982) $0 $7,264 219.40 $33.11 118.5%

These base case assumptions yield a $33 stock price for JCP. As a sanity check (view model to confirm), we see that by FY2020 JCP is generated $184 of gross revenue per square foot, which is at a slight premium to what Macys generates today, yet is still well below what the average of the peer group generates ($271). JCP also creeps up to close to a 16% margin in terms of EBITDAR, which is in line with the rest of the department store space. As we analyze our downside in JCP shares, we assume that the new shop format only grows per annum at 2-3% (as opposed to 5%). The old store format continues to decline on a sale efficiency basis. Also, we assume JCP struggles to get gross margin higher, and only reaches 38% of sales by FY2018, staying at

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these depressed levels in perpetuity. We do not assume any SG&A cuts or any pare back in capex spend either. These assumptions yield us a $12 stock price on the enterprise. One thing to keep in mind when thinking about other value levers applicable to JCP, is the companys real estate holdings. Management has been divesting some interests in mall locations throughout 2012, and Ken Hannah (JCPs CFO) states that there is a couple hundred million more (dollars) of real estate interests to sell for cash. JCP also owns a good amount of its own buildings and properties, equating to ~$4.9 billion (gross) in book value. Unfortunately, there is not a lot of clarity as to what specific properties JCP owns, but there is a strong possibility that the market value of the companys PP&E assets could be significantly higher than current book value. We have not included any of this in our stock price target. (For reference, other analysts estimate JCPs real estate holdings have a replacement cost of $11 billion.)

Risks & Mitigants


Risk #1: Macys legal dispute over JCP selling Martha Stewart home brands in stores. Mitigant #1: Martha Stewart is literally taking the stand today in a trial revolving around JCP signing a deal with Martha Stewart Living (MSL) to sell MSL home products in its stores. Macys, however, is claiming that most of MSL products are under exclusive contract with Macys only. Thus, JCP should not be allowed to sell much of its MSL products in its stores. (Case details here.) The trial is scheduled to end in April, and its anyones best guess how the judge will rule (I am not a lawyer, unfortunately). What gives us comfort is Home products is only 15% of JCPs sales, and MSL is just one and very many brands JCP offers in its stores. Yes, there will be a hiccup in sales and Johnson will be forced to sign up new distribution deals, but most likely this will be a short-term roadblock as MSL is not a key component to JCPs rebound. JCP shares, however, have fallen ~18% in the past 2 days because of the heavy media attention on this trial. We think an 18% destruction in equity value is too severe, even for an event such as this. Risk #2: Some people are claiming that Ron Johnson is already rich and has no real incentive to give all his energy to re-build JCP. Mitigant #2: The man is rich, no arguing that (rumored to have earned $400 milion while working at Apple). However, there are many rich CEOs out there who have the innate fire in their bellies to face a challenge and overcome obstaclesThats just who they are. Plus, Johnson still has his legacy to preserve, and if he fails at JCP, then most likely this is how the media will remember him by. Johnson has personally invested in JCP warrants and is heavily incentive based. Warrant terms are as follows: Warrants purchased for $50 million 7.3 million shares Strike price $29.92 Maturity is 7.5 years, and warrants may not be hedged for sold for 6 years Risk #3: Liquidity issues and potential for bankruptcy filing.

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Mitigant #3: We detailed in the above Model section of this report what you need to believe to get JCP in a liquidity crunch. We feel as though there is no structural reason why JCP should earn gross margins in the 35% range for the next 3-4 years (which would put them in a liquidity crunch). Sure, to some extent department retailing is a relatively commoditized industry. But that also goes the other way in that JCP should not be pushed to earn sub-market margins after it has re-invested in its footprint and its product offerings. The companys liquidity position should be solid generating anything in the upper30% gross margin range.

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Financial Overview
($ in millio ns)

Jan-10 2010

Jan-11 2011

Jan-12 2012 $154 33 11 0 (543) ($499) 1,102 111.2

Jan-13 2013 $117

Apr-12 1Q13

Jul-12 2Q13

Oct-12 3Q13

Jan-13 4Q13

Metrics Sales per Gross Square Foot $149 $153 Components of Sales Increase/(Decrease): SSS, incl Internet (1,085) 406 Sales of new stores 342 77 Sales of closed stores (34) 0 Sales decline thru catalog print media and outlet (280) (153) stores Total Increase/(Decrease) ($930) $203 # of Dept Stores Gross Selling Space (sqr ft in MM) P&L Sum m ary Total Revenue Growth % yoy SSS Growth % yoy Traffic Growth COGS % of Sales Gross Profit Margin % SG&A Pension D&A Real estate & other Restructuring SG&A & Other % of Sales EBIT D&A Adjustments Stock Comp Adj EBITDA Margin % Adj EPS Growth % yoy Avg Dil Shrs Out LTM EBITDA Margin % LTM Adj EPS 1,108 111.7 1,106 111.6

NA 1,105 111.2

(732) (5) 0 (54) ($791) 1,103

(832) 0 0 (52) ($884) 1,101

(1,027) 8 0 (40) ($1,059) 1,105

NA NA

$17,556 (5.0%) (6.3%)

$17,759 1.2% 2.5%

$17,260 (2.8%) 0.2%

$12,985 (24.8%) (25.2%)

$3,152 (20.1%) (18.9%) (10.0%) $1,966 62.4% $1,186 37.6% 1,160 58 125 (7) 76 $1,412 44.8% (226) 125 69 0 ($32) (1.0%) $

$3,022 (22.6%) (21.7%) (12.0%) $2,018 66.8% $1,004 33.2% 1,050 58 128 (208) 159 $1,187 39.3% (183) 128 (49) 0 ($104) (3.4%)

$2,927 (26.6%) (26.1%) (12.0%) $1,975 67.5% $952 32.5% 1,087 51 133 (197) 34 $1,108 37.9% (156) 133 (163) 0 ($186) (6.4%)

$3,884 (28.4%) (31.7%)

$10,646 60.6% $6,910 39.4% 5,410 337 495 5 0 $6,247 35.6% 663 495 5 0 $1,163 6.6% $ 1.14 (57.4%) 233 $1,163 6.6% $ 1.14

$10,799 60.8% $6,960 39.2% 5,358 255 511 (28) 32 $6,128 34.5% 832 511 4 0 $1,347 7.6% $ 1.65 45.2% 238 $1,347 7.6% $ 1.65

$11,042 64.0% $6,218 36.0% 5,109 121 518 21 451 $6,220 36.0% (2) 518 472 0 $988 5.7% $ 0.73 (56.0%) 217 $988 5.7% $ 0.73

$8,919 68.7% $4,066 31.3% 4,506 353 543 (324) 298 $5,376 41.4% (1,310) 543 (26) 0 ($793) (6.1%) $ (4.63) NM 219 ($793) (6.1%) $ (4.63)

$2,960 76.2% $924 23.8% 1,209 186 157 88 29 $1,669 43.0% (745) 157 117 0 ($471) (12.1%) (2.03) NM 220

(0.63) $ NM 218

(0.86) $ NM 219

(1.11) $ NM 219

$671 $341 ($61) ($793) 4.1% 2.2% (0.4%) (6.1%) $ (0.19) $ (1.17) $ (2.39) $ (4.63)

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($ in millio ns)

Jan-10 2010 1,163 (264) (130) 391 (600) 0 $560 3.2% $1,573 ($587) $183 $0

Jan-11 2011 1,347 (258) (50) (303) (499) 0 $237 1.3% $592 ($485) $189 $0

Jan-12 2012 988 (227) (91) 141 (634) 0 $177 1.0% $820 ($870) $178 $900

Jan-13 2013 (793) NA NA 683 (810) 0 ($920) (7.1%) ($12) ($291) $86 $0

Apr-12 1Q13 (32) (90) (4) (612) (107) 0 ($845) (26.8%) ($577) ($116) $43 $0

Jul-12 2Q13 (104) (23) 55 218 (132) 0 $14 0.5% ($32) $116 $43 $0

Oct-12 3Q13 (186) (92) 134 99 (341) 0 ($386) (13.2%) ($48) ($62) $0 $0

Jan-13 4Q13 (471) NA NA 978 (230) 0 $277 7.1% $645 ($229) $0 $0

Sum m ary Cash Flow EBITDA Cash Interest Cash Taxes Change in WC Capital Expenditures Other Free Cash Flow as % Sales Cash Flow from Ops Cash Flow from Inv Dividends Paid Share Repurchases Balance Sheet Data Cash & Equivalents Inventories PP&E Merchandise A/P Debt Book Equity Inventory Days on Hand Payable Days on Hand Credit Stats EBITDA / Cash Int Expense Total Debt / EBITDA Net Debt / EBITDA Capex as % of Sales

$3,011 $3,024 $5,357 $1,226 $3,392 $4,778 104 42

$2,622 $3,213 $5,231 $1,133 $3,099 $5,460 109 38

$1,507 $2,916 $5,176 $1,022 $3,102 $4,010 96 34

$930 $2,341 $5,353 $1,162 $2,982 $3,171 96 48

$839 $3,084 $5,126 $984 $3,102 $3,936

$888 $2,993 $5,153 $1,015 $3,151 $3,671

$525 $3,362 $5,493 $1,408 $2,965 $3,502

$930 $2,341 $5,353 $1,162 $2,982 $3,171

4.4x 2.9x 0.3x 3.4%

5.2x 2.3x 0.4x 2.8%

4.4x 3.1x 1.6x 3.7%

-3.8x -2.6x 6.2%

3.0x 4.6x 3.4x 3.4%

1.5x 9.2x 6.6x 4.4%

-0.3x -48.6x -40.0x 11.7%

-3.9x -3.8x -2.6x 5.9%

Disclosure: I am long JCP.