I argued in a prior article that J.C. Penney (NYSE:JCP) appears to be undervalued based on a variety of financial metrics. However, the gap between the stock price and the company's intrinsic value is likely explained, at least in part, by the fact that investors fear another round of dilution (remember that JCP diluted their stockholders by approximately 38% in late September 2013). How credible is this further dilution fear? In order to answer this question, we'll need to construct operating and cash flow models for JCP for FY 2014.

## Base Assumptions

I start with management's guidance for Q4 of FY 2013, which was delivered when JCP announced Q3 2013 earnings results and which was recently reaffirmed by the company:

The Company's current outlook for the fourth quarter of 2013 is as follows:

- Comparable store sales and gross margin are expected to improve sequentially and year over year;
- SG&A expenses are expected to be below last year's levels;
- Depreciation and amortization is expected to be approximately $165 million;
- Interest expense is expected to be in line with third quarter ($100 million);
- Capital expenditures are expected to be approximately $175 million in the fourth quarter including accrued and unpaid expenditures and approximately $300 million for fiscal 2014;
- Inventory is expected to be approximately $2.85 billion at year end;
- Total available liquidity is expected to be in excess of $2 billion at year end.

Also note that, based on current analysts' estimates, Q4 revenues are expected to come in at ~$4B and FY 2013 revenues will be ~$12B. For purposes of this article, I will assume that these are accurate predictions. I also assume that SG&A for FY 2013 will end up at ~$4275MM (or actual 1st 9 months of 2013 SG&A of $3100MM plus an estimated $1175MM for Q4 2013) and that the quarterly run rate for depreciation and amortization (D&A) for FY 2014 will be in line with Q4 2013's expected $165MM of D&A. Since the "pension," "real estate and other, net" and "restructuring" lines in the P&L are not predictable by me, I will leave each of these at zero for purposes of this article. I will also assume that JCP's tax rate will be 35%.

Furthermore, I will need to refine management's guidance that available liquidity is expected to be "in excess of" $2B at the end of Q4. Although "in excess of" is quite vague, I'll be conservative and assume it means an amount equal to only 5% of $2B, or $100MM (so that total available liquidity at the end of Q4 2013 will be ~$2.1B).

## Base, Bull and Bear Operating Results Scenarios for Fiscal 2014

Next, I'll make some further assumptions about FY 2014 operating results, using a base, bull and bear scenario, as follows:

**Base Case** - Revenues up 5% from FY 2013, Gross Margin 33% and SG&A up 3% from FY 2013

**Bull Case** - Revenues up 8% from FY 2013, Gross Margin 35% and SG&A up 3% from FY 2013

**Bear Case** - Revenues flat with FY 2013, Gross Margin 31% and SG&A up 3% from FY 2013

Using the above assumptions, I obtain the following expected operating results for FY 2014:

## Base, Bull and Bear EBITDA and Free Cash Flow Scenarios for Fiscal 2014

Using the above expected base, bull and bear operating results scenarios, I arrive at the following EBITDA and free cash flow, or FCF, numbers (using the additional assumptions that, first, cash taxes will have a positive $23MM effect on FCF for FY 2014 and, second, working capital changes will have a positive $326MM effect on FCF for FY 2014, each of which are based on the Goldman Sachs report on JCP from September 24, 2013; interestingly Goldman, in Exhibit 5 in their report, actually has the company at $136MM of EBITDA for FY 2014, which is close to our bull case EBITDA number):

## Base, Bull and Bear Total Available Liquidity Scenarios for Fiscal 2014

Therefore, going back to the starting point of $2.1B in total available liquidity at the end of Q4 2013, I come up with the following base, bull and bear scenarios for total available liquidity at the end of FY 2014 (for simplicity, I will assume the size of JCP's revolving credit agreement stays at $1.85B and will ignore for now any potential additional changes, positive or negative, in revolver availability that could result from a change during FY 2014 in JCP's financial covenant calculations, such as its fixed charge coverage ratio):

In addition, based on the foregoing calculations of available liquidity at the end of Q4 2014, and further assuming that Q4 will include a positive $533MM swing in free cash flow versus the end of Q3 2014, including a positive $542MM from working capital changes in Q4 (each as per p. 5 of the Goldman report), I expect that JCP should end Q3 of FY 2014 (typically the low point in the year for liquidity) with the following total available liquidity:

## Sensitivity Analysis

Since the Goldman report does not reveal how they arrived at their figures of positive cash flow of $326MM from working capital changes for FY 2014, I've included a sensitivity analysis below illustrating how total available liquidity as of the end of Q3 2014 would change under different working capital scenarios:

## Possibility of Further Dilution

This brings us to the key question: Given the foregoing calculations, will JCP be forced to raise additional equity in FY 2014?

I begin with the assumption that JCP needs an absolute minimum of $500MM in cash in order to operate its business (see here: "[The Goldman analyst] calculated that JC Penny's minimum threshold for cash is around $500 million"). This is especially true in Q3 of each fiscal year, when the company builds inventory for the upcoming holiday season. I also note that, had JCP not issued 84MM shares during Q3 2013 (bringing $786MM into the company's coffers), it would have ended Q3 with ~$924MM of available liquidity ($1.71B minus $786MM). JCP was likely forced by nervous vendors to raise cash in Q3, so we'll make another assumption that JCP's vendors will not tolerate anything less than $1B in total available liquidity at any time; otherwise, they may start a "run on the retailer." Thus, to be safe, we'll assume that the absolute minimum amount of total available liquidity (MTAL) during FY 2014 that JCP will need to maintain will be $1B (or 100% higher than Goldman's minimum cash number) and that a targeted amount of total available liquidity for the company would be at least $1.25B (TTAL).

Based on the above calculations, it appears that even at the low point for cash and available liquidity during FY 2014 (i.e., the end of Q3), JCP should be above the MTAL in the base case and the bull case, and above the TTAL in the bull case (but not the base case). It would be well under both the MTAL and the TTAL in the bear case.

## Contingency Plans

However, the company still retains the certain levers to raise additional cash [up to $1.215B at a minimum] before resorting to further dilution of the common. According to p. 6 of the Goldman report, JCP could still:

- Sell fringe land (est. value: $100MM)
- Sell tire, battery, and automotive locations (est. value $115-135MM)
- Sell mall partnership interests (est. value $100-150MM)
- Tap debt markets for $500mn of incremental second lien bank loan or bonds (est. value $500MM); and
- Monetize portion of its below-market leases (up to $400MM).

Assuming for now that we ignore the option for JCP to do a second lien financing in the amount of $500MM (since JCP has enough debt already and this option would likely cause a negative repricing of JCP's existing debt), JCP would have remaining potential liquidity-raising options equal to a minimum of $715MM. Obviously, it would be preferable for JCP to keep as many as possible of these arrows in its quiver for a rainy day, but it's always nice to have a viable backup plan available in case things turn out worse than expected.

## Liquidity Scenarios with Additional Levers Pulled

Set forth below are the liquidity scenarios for end of FY 2014 and Q3 2014, respectively, assuming JCP were to pull the available liquidity levers noted above (excluding the second lien option), thus adding an additional $715MM to the balance sheet:

Thus we see that JCP in this hypothetical situation ends up above both the MTAL and the TTAL in each scenario, almost surely averting another forced equity raise during FY 2014.

## Conclusion

Based upon the assumptions and projections set forth above, I conclude that, excluding any asset sales, JCP will likely be free cash flow negative during FY 2014 in each of the base, bull and bear scenarios. JCP should be able to avoid further dilution during FY 2014 under the bull scenario (which appears to be closest to Goldman's projections). In the base scenario, liquidity may get tight towards the end of Q3 2014; however, this could be remedied by JCP exercising one or more of the additional liquidity-raising options noted above. In the bear scenario, JCP would likely need to raise additional cash during 2014 through one or more of the following: an equity raise, a second-lien debt issuance, additional cash flow from working capital management actions, further SG&A cost cutting or asset sales.

**Additional disclosure:** I am long JCP's unsecured bonds.

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