In this article I will providing an update in my JC Penney (NYSE:JCP) long thesis. I previously wrote about how the stock had a lot of potential, mainly due the business operating leverage and overall excessive pessimism from media, analysts and investors.
I will be going through a number of factors that have surfaced since those articles, some of them were good and some bad, but I want to make the assessment of the stock valuation as realistic as possible and not to be biased either way.
Since I wrote about JC Penney the last time a number of events have happened, lets start with the good:
- The company raised its credit lines from $1.5B to $1.85B plus an accordion feature that enables it to raise another $400M. This adds significant liquidity to its operations.
- The bondholder group that was claiming an event of default against the company dropped its claim.
- Joe Fresh stores have opened nationwide, and early reports are that it is doing well.
- Pessimism around the company is now higher than ever. I consider that a good thing since the historical evidence is that risk premiums are higher than average when there is a lot of pessimism, as Buffett says "be greedy when others are fearful."
Now for the bad:
Comp store sales came in worse than expected in Q4 2012.
- The company ended the year short of its $1B cash target of balance sheet liquidity, and that number would be even lower if it weren't for the delaying of some payables. This further removes any credibility from management guidance.
- The CFO said that people shouldn't be using the new stores sales (annualized) to model the value of the firm. In one of my articles, I did exactly that. I was puzzled by that statement given that the only reason I produced that model was because Ron Johnson said someone should do that in the Q3 earnings presentation:
"What we have said is we think we will get higher productivity and what I think you should do if I were an investor, I would model JC Penney at $200 a square foot, $225, $250 and start to see the sensitivity to that sales productivity growth at 40 points margin relative to our historic profit at other peers. So we are not out there saying that we are going to be at this mall or in a specialty store; we would love to be there, but we are not trying to say that at all. We are just encouraged that putting eight shops into 700 JC Penney stores, having 13 weeks of evidence, that is more than twice as much square footage as Apple has in its retail stores, delivered $60 a square foot improvement. That is pretty exciting. It doesn't mean it is going to happen with the next shop, but if we are smart, we have learned a lot about how to pick shop partners, how to build shops, how to create shops that excite customers. And if we are good at it, we ought to be able to achieve productivity like that going forward. But long term, we will have to see where the productivity ends up".
So from being encouraged by these 8 shops, finding it pretty exciting and saying people should model JCP based on "that productivity growth," management went to being "uncomfortable" with disclosing their new store sales and saying people shouldn't model the value of the firm based on that. I believe the CFO is onto something with regards to the specific productivity growth number (I used 33%, in line with data); the final number probably won't be 33%. It could be higher or lower, but they shouldn't hype the numbers in one event and downplay them in another, which brings me to next issue.
- Management inconsistencies and mistakes. In addition to the above, there was the fair and square pricing issued that Ron Johnson was pretty sure about and that didn't end up too well. Now the company is reversing that. I explained these pricing issues in an article. The graph that I showed there is a pretty important part of my thesis. Their guidance also has been remarkably poor: management guided +$2 in non-GAAP EPS or 2012 and delivered -$3 - they were off by $5 per share. Management performance has been quite sub par so far, I expected more from Ron Johnson, and I'm not happy to see these big mistakes that he made.
- Two analysts downgraded the stock from Buy and cut their price targets significantly. Normally I don't pay attention to analysts, but this case its different because these two risked their reputations for a long-time "sticking their neck out" for the Ron Johnson method, which makes me think they must have strong reliable reasons for the downgrades. Brian Nagel had something to say that I had not considered before: "We expect the construction activities and lack of home-related inventory to weigh on top line trends and/or limit a sales recovery at JCP in the early part of 2013." I'm particularly concerned about the construction activity issue given that JCP will be transforming about 30% of its selling space this year. If the construction activities will be hurting sales then this could become a big issue. It is also concerning that the downgrade from Citigroup came after Deborah Weinswig met with management. Having reaffirmed the rating just a few days prior, clearly she saw negative things that she didn't before. Both these analysts think the first half of 2013 will be difficult.
- The CFO hinted that he is open to an equity offering in the Bank of America Consumer Retail Conference. He mentioned that after going through cash and the credit line, the next option is "permanent capital," something that wouldn't create legacy problems. The new credit line also makes it easier to raise equity capital. This can throw the valuation models out of the window because it all depends on the pricing of the stock offering and how much is raised, which no one can know in advance.
Given all these factors, one might ask, why not sell the stock? As much as there are all these negatives I believe the stock can still pop due a number of other reasons:
- Even though the fundamentals have worsened, the market reaction has been extremely negative and so have the media, analysts and pretty much everybody with a pulse. This, combined with the high short interest, creates a situation which in my experience offers significant positive risk premiums for longs. When I began writing about JCP last year, the stock had just came off the earnings release and declined all the way down to $16. Then it proceeded to squeeze all the way up to $23. I believe something similar could be in the cards, although this time is further from a nobrainer compared to previous times, so my position size is smaller. I have been a short seller for a long-time and I can assure you it's extremely difficult to make money shorting when you have a stock that is down a lot, short interest is high, analysts hate it, the media hates it and implied volatility is high. If shorting is not the side to be on, then I want to be long unless I have a very good reason not to.
- New stores coming out offer asymmetric payoff for longs. If Joe Fresh is not so great perhaps the stock drops $2 or $3 (the decline is cushioned by short covering). If it is great, the stock is likely to fly back to $20s+ and trigger a squeeze. As I previously said this stock is like an option that is being mispriced due excessive pessimism; the shorts seem not to be aware of the significant skew that is in their return distribution.
- Comps are easier to beat this year.
- The risk of the offering is likely to be more of late 2013 or 2014 story.
JCP Liquidity Analysis and the Risk of an Equity Offering
Let's address liquidity in a practical way. For the entire year of fiscal 2012, the company had a negative operating cash flow of $10M. Backing out the merchant accounts payable (since it simply delayed the payment for a few weeks), you get to a negative operating cash flow of $150M per year. It did get a cash flow benefit from the inventory drawdown that was going on, and thus received an inflow of $575M from inventory liquidation.
The inventory drawdown is supposed to be over now, and this could mean some of that cash benefit would go away. Some people are speculating this means the company could run into cash trouble, I believe that point is irrelevant for the following reason: There is a credit line tied to the inventory. This means that from a cash perspective it can get the same benefit of decreasing the inventory to zero by drawing the credit line to its full capacity without even having to conduct one sale.
If you subtract the $575M from the $150M you get an organic cashburn of $725M from operations. But this assumes the clearance sales from inventories will disappear 100%, which is too conservative given that some clients will buy something else. Let's decrease that to $650M to be more realistic. Adding the expected $850M in capex, you get $1.5B in yearly cash burn (there are no debt maturities of meaningful size till 2015). This figure is probably overstated given that the company hasn't fully realized the $900M in savings, and that shows up in a lower operating cash flow (it is at a little less than $700M). Adjusting for that we would get to something like $1.32B in yearly cashburn. How does all of this compare to the liquidity available?
The CFO showed in the earnings presentation that the combination of cash on the balance sheet + credit line + accordion equals $3.10B in liquidity. This number backs out the delay in payments that it made in Q4, so to not double count that change (which is already adjusted in my cash burn figure), I would add that back in. So there would be $3.23B in liquidity. But there are also "several hundred million dollars" on non-core assets that can be sold according to the CFO. Since the company sold more than $500M worth of assets in 2012, I have no reason to doubt that statement. Adding $400M to that liquidity number we get to about $3.6B in "potential" liquidity.
How does the cash burn compare to the potential liquidity? $3.6/$1.32 = 2.72 years of liquidity left (2.4 years without the additional operating cost savings). This is a theoretical number, because it doesn't take into account issues with covenants, suppliers, partners, etc. (though the credit line doesn't have covenants until it's 90% drawn). But the main point is that for 2013, the liquidity of JC Penney is completely taken care off, even if sales deteriorate, and it is likely to be ok for a most of 2014 as well. It can also slow down investments since their capex is almost entirely discretionary. This makes me think that an equity offering is unlikely for 2013.
JC Penney fundamentals have worsened. But I believe the pessimism has increased even more, which makes me think the stock is still a buy even if for just a trade. The risk in the stock from a fundamental perspective is high for the first half of 2013 due to some of the operating issues I mentioned in this article, but I also know that nobody has ever gotten rich shorting a stock with a huge implied volatility (a proxy for fear) and high short interest that analysts and the media hates, which makes me think the long side is side to be on. My position size is not big due the uncertainties, but I'm prepared to significantly increase my stake if the comps in Q1 or Q2 start to look better.
Additional disclosure: This article does not constitute investment advice