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A Great Investor Is About to Lose a Bunch of Money

By Frank Curzio, editor, Small Stock Specialist
Friday, November 23, 2012

Over the past year, billionaire investor Bill Ackman has taken a high-profile position in one of America's oldest, most well-known retailers... and it could cost his firm a lot of money.
As of the end of June, Ackman has more than $900 million invested in JC Penney (NYSE: JCP) stock. It's one of the most-followed, most-publicized investments made by a hedge-fund manager in 2012. And so far, it's been a disaster...
Ackman is a great investor with a great reputation. In 2010, he began buying shares of JC Penney. The famed retailer has struggled badly while competing against online retailers and other, more successful conventional retailers like Macy's and Kohl's. Ackman believed he could turn the JC Penney ship around.
The ship hasn't turned around yet. JC Penney shares are down 60% from their 2012 highs. JCP's selloff gained momentum after the company released abysmal quarterly results earlier this month. Shares have plummeted 35% in just the past month to hit a new 52-week low. This fall, one thing became clear: JC Penney is in big trouble...
I seldom write about stocks investors shouldn't own. But in recent weeks, my inbox has been flooded with e-mails from readers asking if JC Penney is a buy following its current, massive pullback.
I recommended JC Penney in my Small Stock Specialist newsletter in July. At the time, investor sentiment was terrible. Few people – including Wall Street firms – liked the stock, giving us the perfect opportunity to buy shares.  
JCP also had enough cash on its balance sheet to last at least two years. That would've been enough money to help the company push ahead with its plans to revamp the old business model... and modernize old stores.
Once people got a look at the "new" JC Penney, I knew the stock would pop. Two months later, we booked gains of 40%. We got out just in time... 
Today, JCP's fundamentals are deteriorating rapidly. The retailer only has $525 million in cash on its balance sheet. That's down 41% from last quarter. The company burned through $380 million in free cash flow over the past three months. That will amount to roughly a $1.3 billion burn rate for the year.
JCP was expected to generate over $500 million in free cash flow in the fourth quarter. But after another 20%-plus sales decline (Internet sales fell 37%), that's not going to happen. Keep in mind, the downtrend in sales is getting worse every quarter... not better.
In a recent interview on CNBC (which you can watch here), Ackman highlighted the productivity gains in stores transformed to the new model. But the company is bleeding too much cash to see this transition through to fruition. That explains the recent debt downgrades from rating firms Standard and Poor's and Moody's.
Short term, JCP is basically destroying its "old" brand, while placing all of its focus and growth initiatives in its "new" model. Only 10% of the stores have been converted to the new model. This ensures that JCP will have a terrible holiday season.
One-fourth of the company's sales this quarter came from items on clearance. In other words, the only reason sales were not worse was because customers bought discounted items... a strategy CEO Ron Johnson is against.
If the company continues to report 20%-plus sales declines, it will burn through its cash balance within six to nine months. That leaves two outcomes – both of which will result in shares taking a big hit from current levels...
1) The company will have to tap its $1.5 billion asset-backed lending facility... which is secured by merchandise inventory. Once it taps this, we'll see another round of debt downgrades.
2) JCP will have to cut back on spending. That means the company will have to slow growth of new stores, which will lead to fewer productivity gains.
Stay away from JCP until sales trends improve. You may miss a small move to the upside. But on the risk end, shares could collapse to the single digits if the retailer reports two more quarters of 20% sales declines.
Good investing, 
Frank Curzio

Further Reading:

Frank thinks you're better off following in the footsteps of another big-name investor: David Dreman. He's buying dirt-cheap, industry-leading stocks... and Frank believes these names could lead to "some huge winners on your hands a few years from now." Read more here: This Famous Contrarian Investor Is Buying Stocks Here.
And listen to Frank's S&A Investor Radio interview with Dreman for free by clicking here.

In The Daily Crux
Market Notes
Stocks and gold are running neck-and-neck in 2012... both are up 10% since the start of the year.
Natural gas touches its highest level in almost a year... despite record-high levels of supply.
Generic drugmaker Mylan breaks out... shares hit a new multiyear high.
Currency wars continue... Bank of Japan policies help push the yen to a seven-month low versus the U.S. dollar.
Market Watch
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Russia (TRF) 13.68 +1.1% -12.6%

Sector ETFs
Symbol Price
Construction (PKB) 15.81 +1.9% +36.3%
Financials (IYF) 57.01 +0.8% +21.6%
Health Care (IYH) 81.37 +0.8% +21.3%
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Consumer Svcs (IYC) 83.17 +0.6% +20.2%
Biotech (PBE) 22.19 +1.7% +16.4%
Retail (PMR) 24.59 +1.2% +16.0%
Real Estate (IYR) 61.89 +1.1% +16.3%
Water (PHO) 19.09 +1.0% +13.4%
Insurance (PIC) 16.65 +0.1% +13.0%
Big Tech (QQQQ) 62.30 +0.4% +10.1%
Telecom (IYZ) 22.91 +0.1% +13.3%
Industrials (IYJ) 68.59 +0.4% +11.0%
Defense (PPA) 19.53 +0.6% +10.2%
Software (PSJ) 25.98 +1.1% +4.2%
Basic Mat (IYM) 63.96 +0.4% -1.6%
Transportation (IYT) 86.80 -0.5% +0.8%
Utilities (XLU) 34.36 +0.9% +2.5%
Semis (PSI) 13.12 +0.6% -9.3%
Nanotech (PXN) 5.44 +0.2% -14.0%
Alt. Energy (PBW) 3.53 -0.3% -34.6%

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