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J.C. Penney's (NYSE:JCP) turnaround is progressing slowly and it appears likely that Q4 results will fall toward the low range of analyst estimates. Bullish expectations for double-digit Q4 growth appear extremely unlikely. We have now updated our model to project a $316 million loss for Q4 (including $26 million in store closing charges), up from $266 million. As well, we have modeled out what a moderate growth (+5%) situation looks like for J.C. Penney over the next two years. This is an increase over the estimated +2% to +3% growth rate that we believe J.C. Penney is currently showing.

The Holiday Update

Although there have been multiple theories put forward as to the meaning of J.C. Penney's holiday update, we are going to go with both the simplest and most popular one - that J.C. Penney decided not to provide exact December numbers due to relatively weak December numbers. This remains consistent with J.C. Penney's statement that "it is pleased with its performance for the holiday period," as even a slightly negative December would result in overall positive comps for the holiday period (which consists of November and December). J.C. Penney could plausibly say that it is pleased with any level of positive holiday period comps.

In a note to vendors, Ullman noted that "the holiday season was certainly an interesting one, with a compressed calendar, winter snowstorms and challenging mall traffic." That is not the type of statement consistent with very positive December sales comps.

We are going with an estimate of flat comps for December. There is the possibility that a modest amount of December sales got pushed into mid-to-late January due to the extreme weather that occurred at the end of the December reporting period. Therefore we are going to go with +0% for December and +2.2% for January, with an estimated +0.5% combined comps for December/January.

Stacked Comps Vs. 2010

% Change

Q2 2012

-20.5%

Q3 2012

-27.3%

Q4 2012

-32.9%

Nov 2012

-36.3%

Dec 2012/Jan 2013

-31.0%

Q1 2013

-29.8%

Q2 2013

-30.0%

Q3 2013

-30.8%

Q4 2013

-30.4%

Nov 2013

-29.9%

Dec 2013

-31.0%

Jan 2014

-29.5%

When looking at stacked comps vs. 2010, it should be noted that J.C. Penney got stronger as 2010 went on (3% to 4% growth rate), so flat comps versus 2010 would likely translate into a real growth rate of 3% to 4%.

Q4 Revenue Estimate

We have updated our Q4 revenue estimate with the above projections for December 2013 and January 2014. This results in an estimate of $3.837 billion revenue for Q4 2013, representing 3.4% same-store growth over the quarter. As we have noted before, November's numbers were influenced by extremely easy comps (due to Hurricane Sandy and non-competitive Black Friday hours).

Month

($ Million)

Same-store Growth

November

$1,242

10.1%

Dec + Jan

$2,595

0.5%

Total Q4 2013

$3,837

3.4%

Q4 FY2013 Estimates

The reduced revenue estimate increases our net loss estimate to $290 million for Q4 2013 or $0.95 per share before the store closing charges. This is a $24 million increase from our prior Q4 net loss estimate. Gross margin percentage is maintained at 30% and SG&A and other items remain the same as detailed in our prior article. With the $26 million in store closing charges, net loss increases to $316 million or $1.04 per share.

(in $ Million)

Q4 FY2013

Net Sales

$3,837

COGS

$2,686

Gross Margin

$1,151

SG&A

$1,145

Total Pension

$34

Depreciation and Amortization

$165

Total Operating Expenses

$1,344

Net Interest Expense

$97

Net Loss

-$290

A Look At The Next Two Years

It is becoming increasingly likely that any potential turnaround with J.C. Penney is going to be slow. The weak holiday results of many other department stores shows that J.C. Penney is in a very tough and competitive market, and will need to slowly claw back market share point by point.

Here's a look at J.C. Penney's performance in a competitive marketplace where it slowly regains market share. The true rate of growth is estimated at +2.5% coming out of December and January. If J.C. Penney improves this rate of growth by approximately 1% each quarter up to a maximum of +5%, it will end up with $12.237 billion in revenue over the next four quarters (including Q4 2013). We are also assuming that gross margin improves by 3% in Q1 2014 (compared to Q4) and 1.5% per quarter thereafter. In addition to that, the effect of liquidation sales at closing stores has been included in Q1 2014 numbers.

SG&A assumes the restoration of $100 million in advertising spend (back to 2011 levels) as J.C. Penney tries to regain customers.

The result is that J.C. Penney will burn $939 million over the next four quarters in this scenario, bringing its liquidity down to around $825 million by Q3 2014, allowing for a slightly lower inventory level in Q3 2014 vs Q3. 2013.

Q4 2013

Q1 2014

Q2 2014

Q3 2014

Total

Net Sales ($ Million)

$3,837

$2,747

$2,757

$2,896

$12,237

Same Store Comps

3.4%

4.6%

4.5%

5.0%

4.3%

Gross Margin ($ Million)

$1,151

$897

$951

$1,043

$4,042

Gross Margin %

30.0%

32.7%

34.5%

36.0%

33.0%

SG&A ($ Million)

$1,145

$1,020

$984

$1,024

$4,173

Capital Expenditures ($ Million)

$175

$75

$75

$75

$400

Net Interest Expense ($ Million)

$97

$97

$97

$97

$388

Cash Burn (Ex. Working Capital Changes) ($ Million)

-$286

-$295

-$205

-$153

-$939

Note: $20 million in cash charges related to the store closures have been assigned to Q4 2013.

Extending this scenario out by another year and assuming that J.C. Penney can maintain 5.0% growth in 2015 would give J.C. Penney revenues of $12.787 billion. J.C. Penney's Q4 2014 will be the first quarter in quite some time that it would not burn cash (independent of changes in working capital). However, it would continue to burn cash in the following three quarters, resulting in cash burn of $165 million between Q4 2014 and Q3 2015.

This is a much improved situation for J.C. Penney, but does require +5% growth and a return to 37+% gross margin. Under a continuation of +5% growth, J.C. Penney may finally have slightly positive free cash flow in 2016.

Q4 2014

Q1 2015

Q2 2015

Q3 2015

Total

Net Sales ($ Million)

$4,003

$2,834

$2,895

$3,055

$12,787

Same Store Comps

5.0%

5.0%

5.0%

5.0%

5.0%

Gross Margin ($ Million)

$1,441

$1,077

$1,100

$1,161

$4,779

Gross Margin %

36.0%

38.0%

38.0%

38.0%

37.4%

SG&A ($ Million)

$1,169

$1,004

$984

$1,024

$4,181

Capital Expenditures ($ Million)

$75

$100

$100

$100

$375

Net Interest Expense ($ Million)

$97

$97

$97

$97

$388

Cash Burn (Ex. Working Capital Changes) ($ Million)

$100

-$124

-$81

-$60

-$165

We have assumed an acceleration of growth from its current low levels as well as a relatively rapid return to normal gross margin levels and limited increases in capital expenditures in 2015. Despite this, J.C. Penney is quite likely to need additional capital based on cash burn of $1.1 billion over two years in this scenario.

Although there may be some debate about what gross margin, SG&A and capital expenditure numbers are appropriate to model, we would like to pose the following question:

Is J.C. Penney more likely to:

a) Attempt to regain market share by cutting expenses, not advertising more and attempting to restore margins to 2010 levels while competitors such as Macy's, Kohl's and Sears have had their margins decline by around 1% to 2% over that time?

or:

b) Attempt to regain market share by restoring advertising spend to 2011 levels and sacrificing a bit of gross margin to attempt to win back lost customers?

As the holiday quarter has shown so far, J.C. Penney is not going to magically achieve strong growth without working extremely hard for it. This is going to mean growth is going to come at the cost of higher advertising spend, heavier promotional activity and other actions that will impact J.C. Penney's bottom line. Even then, success and growth is not guaranteed, but such actions are necessary if J.C. Penney is to have even a chance at a comeback.

Conclusion

The apparently weak holiday results for J.C. Penney reinforces our view that the pace of J.C. Penney's recovery will be slow and that J.C. Penney's bottom line will continue to suffer as it tries to regain market share. The slow recovery pace means that J.C. Penney is very likely to need additional capital as it will burn $939 million (excluding working capital changes) by Q3 2014 and $1.1 billion by Q3 2015. This assumes that J.C. Penney can achieve growth of around 5%, restore gross margin over the next year and keep tight control over SG&A (except for advertising) and capital expenditures.

The additional cash burn means that at current share prices, J.C. Penney's enterprise value will be around $7 billion in 2015. This is over 10x estimated 2015 EBITDA, which appears steep given that +5% growth is a significant improvement over current levels and gross margin restoration is not guaranteed.

Source: Slow Pace Of J.C. Penney Turnaround Results In Potential Cash Burn Of Nearly $1 Billion Over Next Year