After reporting dreadful Q3 results on Friday morning, J.C. Penney (NYSE:JCP) managed to limit its decline to less than 5%. Considering that the company missed analyst estimates by a country mile (posting a non-GAAP loss of 93 cents per share against analyst estimates for a 7 cents per share loss), this appeared to demonstrate relatively strong investor sentiment. However, the sell-off was merely delayed by a day; on Monday, J.C. Penney plunged 13%, setting a new 52-week low under $18. The stock continued to drop on Tuesday, exploring new 52-week lows before closing at $17.40. On Monday, the company was downgraded to sell by Credit Suisse, which also cut its price target for J.C. Penney to $15. While that was the only downgrade I saw, J.C. Penney also had its price target slashed at numerous brokerages, such as BMO Capital Markets, Bank of America Merrill Lynch and Piper Jaffray.
As The New York Times points out, an increasing number of analysts are moving from the view that J.C. Penney's transformation will be difficult to the thesis that it will fail outright. A primary point of contention is whether 2012 is a "reset" year for sales, with growth resuming in 2013. Michael Exstein of Credit Suisse and Charles Grom of Deutsche Bank (among others) suggest that sales will decline again in 2013. If this occurs, J.C. Penney is all but finished. The company is on pace to bring in roughly $13.5 billion of revenue this year. Assuming this declines modestly to $13 billion next year, J.C. Penney would generate gross margin of at most $5.2 billion: and that assumes that the company meets its 40% gross margin target, which it has not come close to this year. Yet J.C. Penney posted operating expenses of approximately $5.8 billion last year, excluding restructuring charges. I expect the company to exceed its $900 million annual savings target in 2013, but this will be offset to some extent by higher pension and depreciation expense, leading to operating expenses around $5 billion. After accounting for interest expense of roughly $200 million, J.C. Penney would be running at breakeven. For every 100 basis points of gross margin shortfall, the pre-tax loss would widen by $130 million.
In a scenario where sales are down again in 2013, J.C. Penney will not generate sufficient cash flow to fund the planned roll-out of 30 new shops. In spite of management's efforts to generate cash by reducing inventory, free cash flow will track very close to depreciation and amortization expense for the full year (roughly $550 million), and below D&A expense for the first three quarters. (Note that this keeps the very optimistic assumption of 40% gross margins). While J.C. Penney has not revealed a capital expenditures target for 2013, I am estimating that this will be $1 billion or higher. In other words, the vicious cycle I have described earlier would take place: poor cash flow would cause a slower "transformation," which in turn would depress future cash flows.
On the other hand, CEO Ron Johnson insists that J.C. Penney will indeed return to growth next year. The best evidence he has is the level of sales per square foot in the transformed shops: $269/square foot, or double the rate of the rest of the store. Management's argument is that J.C. Penney is really two companies today: a declining legacy "J.C. Penney" business, and a successful new "jcp" business. As the company moves from the current 89%/11% mix to a 60%/40% mix, the strong results of the shops will begin to have a noticeable impact on overall company results.
Given the number of strong brands that J.C. Penney has revealed, it is possible that 2013 will indeed be a turning point. The chain's home department could be revitalized by its partnership with Martha Stewart Living (NYSE:MSO), in spite of the selection being limited by the latter's exclusivity agreement with Macy's (NYSE:M) in some categories. The introduction of Disney (NYSE:DIS) stores could bring in lots of kids, as well as parents searching for presents. Apparel brands such as Joe Fresh (which is essentially exclusive to J.C. Penney in the U.S.) could catch on and bring lots of new shoppers in. Thus, it's possible that sales could stabilize and even show modest comp growth in 2013. If so, that would help margins (by moving more merchandise at regular prices rather than clearance prices) and set the stage for strong growth going forward.
Even if the baseline trends do not turn around in 2013, the stock could still turn around due to non-operating related catalysts. For instance, the company has recorded a net gain of roughly $400 million year to date from non-core real estate dispositions. J.C. Penney could look to sell off real estate more aggressively (including stores as well as non-core assets) and thus unlock additional value. Alternatively, hedge fund manager Bill Ackman, J.C. Penney's largest shareholder, could try to take the company private. As of Tuesday morning, Ackman continued to strongly defend Johnson's strategy, and he clearly believes that the company is undervalued in spite of its weak operating performance. While I wouldn't recommend buying J.C. Penney in the hope that a bigger fool (e.g. Ackman) will bail you out, the possibility of a buyout should still give pause to would-be shorts.
There is thus strong downside and upside risk in J.C. Penney shares at this point in time. This is why I think the stock is untouchable. There are plausible catalysts for a strong (>20%) move in either direction from here. I cannot see any reason to accept this level of risk, when there are much more clear cut long and short opportunities elsewhere in the market. If you are determined to invest in J.C. Penney, I would recommend using options to limit your risk; July $18 calls and $17 puts (both near the money) are each selling for roughly $3 as of Tuesday afternoon.
I missed out on some of the downside in J.C. Penney by closing my position last week in order to take some risk off the table (I thought the stock might make a brief bounce before resuming its descent). With the stock having reached my price target of $18, I plan to stay on the sidelines for the foreseeable future in light of the risks I have detailed above.