J.C. Penney Still Has Further To Fall - $7 Per Share Should Be A Ceiling, Not A Floor

Oct. 6.13 | About: J.C. Penney (JCP)

Here is a question for anyone looking at J.C. Penney (NYSE:JCP): Should J.C. Penney have a higher valuation now than right before Ron Johnson became CEO? If the answer is no, then J.C. Penney is still overvalued at its current price.

Although J.C. Penney's share price has reached its lowest levels since the 1980s and currently trades at only 0.14x sales, those figures do not tell the complete picture and we still believe it potentially has much further to fall. The reasons for this are:

1. While a price to sales of 0.14x sounds extremely cheap, that ignores the $2.7 billion in additional debt incurred over 2011. J.C. Penney had an EV/sales ratio of 0.47 the day before Ron Johnson became CEO and an average EV/sales ratio of 0.43 between its Q2 FY2011 earnings release and the start of Ron Johnson's tenure.

J.C. Penney's current EV/sales ratio is 0.50 based on the price of $7.86 per share. With trailing 12 month sales of $12.1 billion, a EV/sales ratio of 0.45 would equal $5.28 per share instead. That also assumes that J.C. Penney should be worth a similar EV/sales ratio as in 2011 despite lower margins, concerns about liquidity, no guarantee that it will be able to regain prior levels of profitability and it lacking the optimism that surrounded Ron Johnson's hiring.

2. If you are optimistic about J.C. Penney's future, you may think that it can get sales back up to $14-15 billion within a year or two, along with levels of profitability that are similar to 2011. It seems unlikely that it can do better than that since Myron Ullman was CEO in 2011 as well, and J.C. Penney was in much better shape then. Even in this optimistic scenario it is still likely going to burn cash for the next 4 to 5 quarters before it turns cash positive again. As a result, J.C. Penney will use up all of its recent capital raise, and may need to raise additional funds. Using the EV/sales ratio of 0.45 would give an enterprise value of $6.30 to $6.75 billion. That makes J.C. Penney's stock worth around $5.00 to $6.47 per share based on its projected net debt by that point in time.

3. If you are more pessimistic about J.C. Penney's future, then sales of $13 billion with a EV/sales ratio of 0.45 would equal an enterprise value of $5.85 billion. J.C. Penney would likely end up with net debt very close to $5.85 billion in that situation, leaving it at liquidation value of anywhere from $0 to $4 per share.

Historical Valuations

Here is a look at J.C. Penney's historical valuation on October 4th during the past several years. Despite its share price falling to $7.86 per share, J.C. Penney is still currently valued at a slightly higher EV/sales ratio than its historical level. This is due to the tremendous increase in debt, with net debt increasing from $1.1 billion in 2010 to $4.3 billion now.

 

Q2 FY2010

Q2 FY2011

Q2 FY2012

Q2 FY2013

Cash and Cash Equivalents ($ Million)

$2,003

$1,551

$888

$1,535

Debt ($ Million)

$3,099

$3,099

$3,151

$5,821

Net Debt ($ Million)

$1,096

$1,548

$2,263

$4,286

         

Share Price ($)

$27.57

$27.94

$23.77

$7.86

Shares Outstanding (Million)

236.4

213.3

218.8

220.4

Market Cap ($ Million)

$6,518

$5,960

$5,201

$1,732

         

Enterprise Value ($ Million)

$7,614

$7,508

$7,464

$6,018

Trailing 12 Month Revenue ($ Million)

$17,596

$17,741

$15,585

$12,109

EV/Sales

0.43

0.42

0.48

0.50

Click to enlarge

Having a higher EV/sales ratio now than in 2011 does not make much sense since J.C. Penney is losing tons of money now (net loss of $586 million in Q2 FY2013 and $934 million in 1H FY2013) compared to a slight profit of $78 million during 1H FY2011. As well, there are concerns about liquidity now and no guarantee that it will be able to even get back to 2011 levels of profitability.

Sales Trends

Sales appear to have stabilized but have a long way to go to recover to anywhere near the numbers that J.C. Penney did prior to Ron Johnson becoming CEO. Management has mentioned that there should be positive year over year numbers towards the end of Q3 FY2013, but it should be kept in mind that this comparison is against Q3 FY2012 numbers that were down over 30% from 2010. As demonstrated in the graph below, sales figures have bottomed out but there are no definite signs of a significant recovery yet.

Click to enlarge

Projecting Future Quarters

Here is an example of what would be considered a significant recovery scenario. Year over year sales growth increases to +4% in Q4 FY2013, +8% in Q1 FY2014, and +12% in Q2 FY2014. Gross margins also show signs of significant year over year improvement, reaching +4% in Q2 FY2014. SG&A expenses also decline slightly despite the increased sales.

 

 

 

Q3 FY2012

Q4 FY2012

Q1 FY2013

Q2 FY2013

Q3 FY2013

Q4 FY2013

Q1 FY2014

Q2 FY2014

Net Sales ($ Million)

$2,927

$3,884

$2,635

$2,663

$2,900

$4,025

$2,850

$2,975

Gross Margin ($ Million)

$952

$924

$812

$787

$899

$1,006

$941

$1,012

Gross Margin (%)

33%

24%

31%

30%

31%

25%

33%

34%

                 

Change in Net Sales Vs. Prior Year (%)

-27%

-28%

-16%

-12%

-1%

4%

8%

12%

Change in Net Sales Vs. FY 2010 (%)

-30%

-32%

-33%

-32%

-31%

-29%

-27%

-24%

                 

SG&A ($ Million)

$1,087

$1,209

$1,078

$1,026

$1,050

$1,150

$1,050

$1,000

Click to enlarge

If things go quite well as in this scenario, J.C. Penney will still likely burn an additional $1.3 billion in cash over the next four quarters. This includes the above $393 million of SG&A expense in excess over gross margin, $136 million in pension expense, $400 million in interest expense and $375 million in capital expenditures. The $810 million gained from its recent share offering will offset part of the cash decline, but cash will still decline by another $494 million. Based on trailing 12 month sales of $12.75 billion and a EV/sales ratio of 0.45, J.C. Penney should be worth around $3.15 per share in this significant recovery scenario. Using 12 month sales of $14 billion (a 16% increase over current levels) would increase J.C. Penney's value to $5 per share.

 

 

 

Q2 FY2010

Q2 FY2011

Q2 FY2012

Q2 FY2013

Q2 FY2014

Cash and Cash Equivalents ($ Million)

$2,003

$1,551

$888

$1,535

$1,041

Debt ($ Million)

$3,099

$3,099

$3,151

$5,821

$5,821

Net Debt ($ Million)

$1,096

$1,548

$2,263

$4,286

$4,780

           

Share Price ($)

$27.57

$27.94

$23.77

$7.86

$3.15

Shares Outstanding (Million)

236.4

213.3

218.8

220.4

304.4

Market Cap ($ Million)

$6,518

$5,960

$5,201

$1,732

$959

           

Enterprise Value ($ Million)

$7,614

$7,508

$7,464

$6,018

$5,739

Trailing 12 Month Revenue ($ Million)

$17,596

$17,741

$15,585

$12,109

$12,750

EV/Sales

0.43

0.42

0.48

0.50

0.45

Click to enlarge

If you were very bullish, you could project J.C. Penney's sales to reach $15 billion per year, which is nearly 25% above current levels. Valuing J.C. Penney at a EV/sales ratio of 0.45 and $15 billion per year in sales would make J.C. Penney worth $6.47 per share.

Another take on things would be to use EV/EBITDA to come up with a valuation. Assuming $15 billion in sales, the historical level of 37% gross margin and SG&A expense of $4.4 billion, and an EV/EBITDA multiple of 6.0x, the target price per share would be $6.96.

Sales ($ Million)

$15,000

Gross Margin (%)

37%

Gross Margin ($ Million)

$5,550

SG&A ($ Million)

$4,400

EBITDA

$1,150

EV/EBITDA Multiple

6

Enterprise Value ($ Million)

$6,900

Net Debt ($ Million)

$4,780

Market Capitalization ($ Million)

$2,120

Shares Outstanding (Million)

304.4

Price per Share

$6.96

Click to enlarge

Liquidation Scenario

As for what happens in a more pessimistic scenario, $13 billion in annual revenues will result in negative cash flow of over $400 million even with a 37% gross margin. J.C. Penney would possibly need to restructure in that scenario. Citigroup mentioned a liquidation scenario where J.C. Penney would be worth around $1 per share. Citigroup's scenario is based on current cash levels though. If we project cash levels forward one year based on our numbers above, it would change the expected net liquidation value from $324 million to negative $170 million. That includes real estate value of $2.7 billion. Essentially the longer J.C. Penney continues to operate at this point, the less it would be worth in a liquidation scenario.

Cushman & Wakefield valued J.C. Penney's real estate at $4.1 billion. Using this higher value would change J.C. Penney's net liquidation value to $1.2 billion or $3.94 per share.

Conclusion

Based on historical valuations, J.C. Penney is still overvalued despite its recent precipitous fall. Its current valuation is still above its historical EV/sales ratio from before Ron Johnson's tenure started in 2011, while its current position is more precarious and less profitable than 2010 and 2011 as well.

J.C. Penney's business appears to have stabilized, but there are many challenges remaining for it to make a significant rebound and return towards profitability. Even if it does get back close to those pre-Ron Johnson profitability levels, it should be worth no more than $7 per share, which should only happen after it shows it can get to $15 billion in annual revenue with 37% gross margin and no more than $4.4 billion in SG&A. The ceiling for J.C. Penney should essentially be $7 per share right now.

In a significant recovery scenario where it is showing progress in rebuilding the business and gets to +12% year over year sales by Q2 FY2014, and then to $14 billion per year in sales, J.C. Penney may be more fairly valued at no more than $5 per share. If there isn't a significant recovery, then J.C. Penney likely is worth no more than $4 per share as it deals with a huge debt load.

To argue that J.C. Penney is worth even its current price of $7.86 per share would necessitate the belief that J.C. Penney deserves a higher EV/sales valuation multiple now than before Ron Johnson became CEO, despite all the damage that has been done to the company over the past couple years. The current price of $7.86 per share also already prices in a recovery to over $15 billion in annual revenue and historical gross margin levels without any additional SG&A expense.

Disclosure: I am short JCP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.