JC Penney's (JCP) fundamental position is worse -- and the challenges facing it more dire -- than many investors thought.

A year ago, the struggling retailer hired Ron Johnson, the former head of Apple's (AAPL) retail stores, as its CEO. In addition to his credits at Apple, which included the creation of the stores' open layouts, Johnson had been at Target (TGT) and played a role in the makeover of its stores, which included high-profile, highly publicized designer partnerships.

On the day Johnson was named Penney's CEO, the stock climbed just over $5 to $35.37 a share. At the end of January this year, JC Penney announced it was shifting to an "everyday low pricing" (EDLP) model, eliminating discounts for in-season merchandise, which would be marked down from the start, similar to the way Target operated. The announcement coincided with the start of the company's fiscal year. By mid-February, the stock had climbed to a high of $43.18.

I could not understand the stock price run-up to the $40s. There were obviously huge problems in educating customers about the new pricing system. Many retail analysts shared my skepticism. I figured the euphoria would fade in time and the stock would come back to a level that represented a possible buying opportunity.

In mid-May, when the company announced its first-quarter results, it was obvious that it was in an even weaker position than most investors, including me, believed. Same-store sales were down nearly 19% in the quarter. Gross margin shrank to 37.5% from 40.5% the previous year, and the company announced it was canceling its dividend of 20 cents a share.

When the results were announced, the stock fell 20% to $26.75, the largest drop on the Nasdaq since July 1980 and the largest drop recorded by the S&P 500.

The first-quarter GAAP earnings per share was a loss of 75 cents. Two-thirds of the loss was attributed to restructuring and management transition charges and the remaining one-third to a change in non-cash qualified pension expense

Store traffic was down 10%. Worse, customers were spending less per trip, and some were not making any purchases at all.

Selling, general, and administrative (or SG&A) dollars were down 9% since last year. Sounds bad -- and is bad -- but changes like these in pricing strategy are few and far between, so there is little precedent regarding what to expect. 

What caught the market by surprise was the elimination of the dividend. That might better have been done earlier when the new pricing strategy was announced. And the company did burn about $600 million in cash this quarter.

In all, management has a hard road to travel to make the new strategy work, even though management reaffirmed its $2.16 adjusted EPS outlook for this year and asserted a $5 EPS by 2015. Executives believe they will be able to cut inventories from 17 weeks to 13 weeks, which would free up $500 million. They also said that they were speeding up the realization of expense savings generally. 

At this point I do not think there are many who still believe the $5 EPS number for 2015. That figure was based on reaching $300 in sales per square foot (historically JC Penney has been in the $135 to $150 area), or the 13% EBIT (or earnings before net interest and tax) margin. Only one store, Nordstrom (JWN), ever achieved such a high EBIT for one year among department store companies in recent memory.

While there still is a chance that JC Penney will be a buy at some point in the next year or two, the expectation will be more soberly based. 

But none of that, I think, is the really bad news. 

Here's where it gets worse
This is where I'm going to drop the proverbial dime. I have see something very ugly.

One sharp sell-sider did an analysis showing that JC Penney's past quarter's sales loss in apparel, accessories and footwear went almost entirely to Wal-Mart (WMT) (35%), Target (30%), Sears (SHLD) (25%) and Costco (COST) (10%).

If the losses had gone predominantly to Kohl's (KSS), Macy's (M) and other department stores, with Sears following those, the losses might have been still considered sector-wide and thus easier to win back. The expectation is that if a Sears bankruptcy happened in the next few years, that would be a plus for Penney.

What the analysis showed was that Penney's customers skipped a normal "step" in the trade-down process. It proved that Penney's customers were not only price-sensitive but so economically pressured that they wouldn't or couldn't switch to another department store but would immediately make the bigger trade-down to discount stores.

This was not a development I, or probably Penney's management, believed would be the case during the attempt to change the company's pricing structure. 

Given the across-the-board consumer retrenchment that is still going on, I believe lost sales to discount stores will tend to be a "one-way ratchet" similar to the situation in consumer packaged goods where buyers who trade down from name brands to private labels seldom reverse themselves.

Valuation-wise, I had assigned JC Penney a 7% risk discount for a long time. The 7% risk discount applied to JC Penney’s $25 price and an adjusted EPS of $2.16 for this year and (a very shaky) $2.50 EPS for next year would imply a 1.5% infinite EPS growth rate. 

But given the elimination of the dividend in the first quarter, the fact that almost all of the near-term earnings growth will come from expense savings and, for me, the likelihood of very high market share losses to come in the pricing transition, an 8% risk discount is more appropriate.

Applying an 8% risk discount to these earnings and a $25 price implies a 4% five-year EPS growth rate, something an average department store is likely to achieve.  Therefore JC Penney stock is, at best, efficiently valued at $25. The stock closed Monday down nearly 5% to $24.

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