The big focus for J.C. Penney (JCP) right now, and its shareholders, is cash burn. We don't know the exact details yet because they have not filed the 10-Q for the second quarter. We'll know more then, but for now we can use their stated projections to make some predictions for the next six months.
The Next Six Months
In the recent quarterly press release the company said:
Cash and cash equivalents at the end of the second quarter of 2013 were $1.535 billion, an increase of $714 million from the end of the first quarter of 2013. The Company's total available liquidity is currently $1.85 billion. Total debt at the end of the quarter was $5.82 billion, including $850 million outstanding on the Company's revolving credit facility, the $2.25 billion senior secured term loan, $2.62 billion of outstanding unsecured debt, and $98 million in capital lease obligations and note payable.
What does this mean exactly? Cash is $1.535 billion and total available liquidity is $1.85 billion. That means they have $315 million available under the $1.85 billion AB credit facility. We also know that $850 million was outstanding under the AB credit facility. The total AB credit facility amount ($1.85 billion) - drawings ($850 million) - X = availability ($315 million). The plug, or $685 million, presumably is standby letters of credit. At the end of the first quarter, LCs were $469 million. Why the 46% increase in the LC balance? More on that later.
In any event, the company is projecting in excess of $1.5 billion of "total available liquidity" at the end of the year. What does this actually tell us? Does that mean they expect operating cash flow to be negative $350 million over the next six months?
First, working capital decreases at the very end of the year due to the holiday shopping season so that should benefit cash. By how much we don't know but the inventory balance decreased from $3.0 billion at the end of the second quarter of 2012 to $2.3 billion at the end of 2012, while accounts payable remained relatively flat. In 2011, inventory decreased from $3.6 billion to $2.9 billion.
Inventory right now is $3.2 billion. I don't think we'll see such a dramatic run down as in the last two years partly because management still feels as if inventory is too low and intends to continue to build inventory after the back to school season. I'd assume inventory drops to $2.9 billion (the year end 2011 balance) at the end of 2013 and accounts payable remain flat. That would represent a net working capital inflow of $300 million.
Of course it all depends on how well they do over the holiday season. But almost certainly there will be a cash inflow based on the current $3.2 billion inventory level, and that cash inflow should be considered together with the announced $350 million decrease in total liquidity over the next six months because at some point all retailers have to repurchase inventory.
Letters of Credit
Letters of credit are a wild card. They include standby and import letters of credit, the majority of which as of the first quarter supported workers' compensation and merchandise initiatives. Based on the total available liquidity of $1.85 billion at the end of the second quarter, the backed-out LC balance was $648 million. Merchandise accounts payable stayed flat during the quarter while LCs increased 46%. Some of this increase is likely the result of suppliers getting more nervous about the company.
It is likely that the company is projecting LCs to decrease by the end of the year as a result of seasonal inventory reductions and decreased nervousness about the company. Any decrease in the LC balance increases "available liquidity" and it is very likely that management is factoring in a $100-$200 million reduction in LCs in their year-end $1.5 billion "available liquidity" estimate. This of course is not sustainable liquidity (like cash) because the LC balance is seasonal and can jump quickly if suppliers get nervous.
Is Total Available Liquidity Really Available?
The company says the following about the AB credit facility in the first quarter 10-Q (italics added for emphasis):
Availability under the 2013 Credit Facility is limited to a borrowing base which allows us to borrow up to 85% of eligible accounts receivable, plus 90% of eligible credit card receivables, plus 85% of the liquidation value of our inventory, net of certain reserves. Letters of credit reduce the amount available to borrow by their face value. In the event that availability under the 2013 Credit Facility is at any time less than the greater of (1) $125 million or (2) 10% of the lesser of the total facility or the borrowing base then in effect, for a period of at least 30 days, the Company will be subject to a fixed charge coverage ratio covenant of 1.0 to 1.0 which is calculated as of the last day of the quarter and measured on a trailing four-quarter basis. As of the end of the first quarter, our fixed charge coverage ratio was below 1.0 to 1.0.
The 10-Q goes on to say that "as of the end of the first quarter of 2013, we had $526 million available for borrowing under the 2013 Credit Facility subject to limitations of the fixed charge coverage ratio."
In other words: "we had $526 million available for borrowing … but actually we really don't have $526 million available for borrowing."
Obviously they are miles away from having a fixed charge coverage ratio above 1.0 to 1.0. The full $1.85 billion under the AB credit facility is not actually available until the fixed charge coverage ratio increases above that threshold.
That raises an interesting question - in the recent earnings release was the company disclosing projections for "total available liquidity" at the end of the year that are based on the full availability of the credit facility when availability is subject to a fixed charge coverage ratio that they do not meet?
J.C. Penney is telling investors that current liquidity is $1.85 billion and is projecting liquidity at the end of the year of $1.5 billion. That doesn't sound so bad. But that ignores significant seasonal working capital inflows during the back half of the year that will eventually be reversed and likely assumes a material decrease in LC balances that are partly seasonal and may also be based on the assumption that supplier confidence in the company is restored. Further, total liquidity is not actually available liquidity because the company is not able to borrow the assumed amount under the AB credit facility because it does not meet the fixed charge coverage ratio.
All this points to a continuing significant underlying deterioration in the business based on (some would argue an overly-optimistic) management's own projections. The current structure will likely get the company through this holiday season but if the business does not materially improve, they will require additional financing in 2014.