To start, please allow me to apologize. In my previous article I made some grave mistakes. If there is one thing I have learned as a trader, you cannot fight the moonlight. Further, some of my subsequent points may rub my co-contributors the wrong way. I apologize in advance for pointing out some errors in your articles. However, in addition to my mea culpa, I would like to offer somewhat of an olive branch. Please return the favor and take my articles to the woodshed, because it will enable our unending search for The Truth.
This article should be the first in a three part series I plan to pound out in the next week or so. The second and third will be on my cash flow model and trading strategies, respectively.
Now for the task at hand. In this article I will be sharing my thoughts on common misconceptions pertaining to J.C. Penney (NYSE:JCP), questions on forward guidance, and unnoted inherent risk in JCP's capital structure. Within that framework I will be discussing the seemingly dilutive equity offering, timing of cash flows, accounting identities, D&A/CapEx/Gross Margin and interest rate expectations. If you remember, I am bullish on the company, and welcome any and all feedback.
Dilutive Equity Offering
What constitutes a dilutive equity offering? A simple example will illustrate what happens when you double the shares outstanding in a secondary offering.
As you can see, an equity sale which doubles the share count doesn't necessarily mean a 50% dilution. The same reasoning applies to J.C. Penney's most recent offering. This results from the relationship shown in the following table.
Many of you will now be thinking that a price to book ratio isn't the only way to value a company. You're right. It is, however, better at setting the value of a company which is losing money than some more popular metrics. A Price/Earnings ratio doesn't work if you're unprofitable. Further, if you are losing money and in a liquidity crisis, raising equity to stave off bankruptcy is a very good option.
Additionally, those of you who have bought in the last two months or so (below the equity offering price), may even be able to say the offering was accretive (obviously not pro-forma). This results from two things: without it - potential bankruptcy, with it - cash at (9.65/Your Average Cost)% above market. Obviously that isn't the whole story, value of any asset is = present value of all future cash flows and what not, but the above table's relationship holds. I hope this simplification can stymie some of the ubiquitous 38% dilution talk.
Timing of Cash Flows
Next, I would like to shift the discussion to the timing, or mistiming, of cash flows. In a recent article, an author who deserves our respect for putting his thoughts out there for us to harass, said something which we all misinterpret from time to time. In short, he wrote on JCP's recent cash infusion and subsequent loss. However, in saying that the $786mm raised at the end of September was mostly wiped out by the $489mm loss between August 1st and October 31st, he was both overstating and understating the loss and its relationship to the cash gained. The table below outlines the true flow of capital (once again - please excuse the simplification).
From this table, you can see that the author overstated the attributable loss in general, but by mentioning net loss instead of cash loss, understates the argument's potential.
A common malpractice when using quantitative arguments is to befuddle accounting identities. A simple accounting identity we all know is Assets - Liabilities = Shareholder Equity. There are many, but they are all the same in that 1 + 1 always equals 2. However, this relationship is often confused. Returning to the article discussed in the previous section (I promise, I'm not trying to gloat), we can see such alchemy at work. The author argues for looking at net working capital without inventory because inventory isn't current and it doesn't reflect current discounting practices. He then goes on to say that if Inventory were removed, JCP would then have negative working capital, is subsequently in a fire sale scenario, and headed to bankruptcy. Please allow me to take this one misconception at a time.
First, inventory is accounted for at the lesser of cost or market value, not sale price. Meaning that if the company had a negative gross margin and expected that to continue, you could mark down inventory. I understand that some inventory appears to be marketed below what we can presume it was acquired for, but because JCP has never had a negative gross quarterly margin, we can't mark inventory below cost.
Second, Current Assets are expected to be sold within a year, not immediately. If you would like to say the company will never sell anything again, that is one thing, but to confuse generally accepted accounting principles is another. Therefore, by taking inventory out of the net working capital calculation, one is effectively saying 1+1 does not equal 2.
Third, negative working capital is not always a bad thing. If you were to go on Google Finance's stock screener right now and run a search for a company with greater than $1 billion in market cap, a P/E ratio greater than 6 (implying profitability), and a current ratio (CA/CL) of less than one (negative working capital), you would find over 1000 equities. This includes names from Sony (NYSE:SNE) to Walmart (NYSE:WMT).
It is a tougher idea to grasp than most, but many companies strive for negative working capital. It means they are operating extremely efficiently by selling and receiving payment for their product before they have to pay for it. Depending on trade terms, this quasi debt can be free, or cheap if funded through short term borrowings. This does not necessitate a fire sale.
Fourth, a fire sale doesn't equal bankruptcy if the company has the cash to back the losses. Case in point - JCP. Many have recently noted the steep discounts JCP has been offering to clear out old merchandise. I would hazard to say that $2 jeans are fairly close to a fire sale. Why didn't JCP file as a result? The equity offering gave it the capital cushion to execute its strategy and attempt a turnaround.
Depreciation, Amortization, and Capital Expenditures
What first intrigued me about the J.C. Penney story was the vast amount of capital invested in the Ross Johnson era. If many of the stores had been refurbished, then there may not need to be much spent on them in the immediate future. This drives future D&A up and CapEx down, subsequently increasing free cash flow. I was somewhat flawed in this approach by failing to account for the retooling Ullman invariably undertook to bring JCP's business model back, but the effect on fiscal 2014 cash flow may be spot on. Some may have noticed the relatively high CapEx in the most recent quarter during the depth of the turnaround. However, now that all that money has been spent, those assets will now be depreciated. With $600mm in D&A expenses, in addition to $1.25B+ in year-end NOL's, JCP can expect to have tax shielded operating cash flow for the foreseeable future in the event EBIT is positive. In many of your minds this is a big if, but it is an undeniable benefit to have those types of assets.
As for this very well written bear piece, I'm not positive why they decided to include Capital Expenditures = 229% of management's expectations, and D&A of less than fiscal year 2012. Given their already bearish sentiment on revenue and operating margins, I'm wondering if it would be strategic to be investing more capital. Meaning, if a company is hemorrhaging cash - CapEx is usually the first to go - unless there is some light at the end of the tunnel. Given their conclusion of an imminent bankruptcy, that light would not be there.
This is where I turn more skeptical. Take a look at this chart from Zerohedge.
* by Profit margin they mean gross.
Management is calling for 30% in gross margin in the fourth quarter. However, given the current trend of decreasing gross margins, and a seasonal trend in lower than average gross margins, I can see it being easier for JCP to miss in this metric this quarter than beat. However, as you will have noticed the steep discounting the last few months, JCP was still able to pull out 29.5%. That is fairly noteworthy, given the steep discounting, so I am very curious to see some further guidance.
Interest Rate Risk
As I begin the last subsection, I am further skeptical of JCP's susceptibility to fluctuations in LIBOR. The squawking heads on CNBC have been forewarning of rising interest rates for some time now. Goldman (NYSE:GS) just issued a new "Top Trade" for upcoming years. In short, if interest rates rise, JCP may have trouble funding interest payments. As of the end of October, JCP had $2.25 billion of debt with a rate of LIBOR + 5%, and $650mm with L + 6%, both with a 1% LIBOR floor. That means a minimum of 6.24% APR on $2.9B with a potentially large upside. With LIBOR levels closer to the last major market peak, JCP could face an extra $90mm a year in interest expense. Now my cash flow models show JCP able to support it without any serious turn around in revenue, but you may want to test the sensitivity of your models to a drastic interest rate increase.
What to Expect Next
I mentioned in the beginning that this is the first of a three part series on J.C. Penney. In the next article, which you can expect sometime at the end of this week, I will outline my cash flow models complete with sensitivity analyses. In the last article, which I hope to deliver at the beginning of next week, I will be utilizing my Bloomberg Terminal access to pull trading statistics and prices on securities related to JCP. With these variables I will outline various different trading strategies to best capture some of that holy alpha grail. This may range from the capital structure arbitrage utilized by one of the best JCP commenters Fliper2058, to classic long-term buy and hold. Best of luck Alpha Seekers.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.