J.C. Penney (JCP) is a great business school case study. Activist hedge funds, management change, board intrigue, marketing disasters, retail macro and micro issues, distressed debt intrigue...
While most of the analysts on SA and elsewhere are bears, I think many have given a good faith effort to understand a very complex situation. As a bull, I disagree with the herd. That doesn't mean I am right. But when everyone is on one side of the ship, maybe the bears should at least stop screaming and listen.
A retail investor friend of mine said about JCP, the numbers are actually easy as everyone is playing off a few simple variables: Gross margins, sales, SG&A and net debt. These variables interconnect with inventory and working capital and of course debt and debt covenants, but those are the key metrics and everyone knows them. His basic point is that we can all see where JCP is right now: sales of about $12 billion, gross margins of about 30%, run rate SG&A of about $4 billion (maybe $4.1 billion with a bit of Christmas bump, but Q3 run rate is $4 billion so we know it can be run at that level) and net debt of about $3.5-4.0 billion (depending on what time of year it is). The trick is to project where JCP is going. If these numbers - especially the gross margin number don't improve over the next 12 months, JCP will most likely need to raise debt, equity or both as it will burn about $1 billion and maybe more and liquidity will drop below $750 million to $1 billion level that is perceived to be needed to run the company. Yes, liquidity will drop even lower into the Christmas season, but if JCP is on track to be at $1 billion in liquidity at year end, they will most likely be able to skate through without dilution. If things don't change, JCP may decide to file for Chapter 11 to convert the unsecured bonds to equity and run a smaller and far less leveraged company.
I have spent a lot of my career as and in the company of distressed debt analysts and what I would say as a gross generalization is that they are very good at looking at trailing 12 month EBITDA and a company's capital structure and telling you that they are covered at 2-4x EBITDA through whatever tranche of debt they happen to own. They are also very good at exploiting leverage in a capital structure to squash junior securities. What they are less good at is looking at looking at a living breathing business and seeing what management can do to make things better. They tend to lack imagination about what a business can be, which is fine since their upside is capped. The old saying is that in debt investing you only have to be right, in equity investing, someone else has to think you are right. They are spreadsheet and document analysts, not business operators. Many tend to fail when they actually try to run a company where they have taken the keys.
JCP is the perfect example of the strengths and myopia of distressed debt analysts. If after a historic drop in sales under a visionary but misguided activist and CEO, 2013 is the new normal then JCP will file for bankruptcy or severely dilute the common shareholders or both (dilute first, file second). If there is even a modest recovery to historical and industry norms then the bears will be very wrong.
From recent numbers and company reports, sales and margins seem to have stabilized at current levels. As for SG&A, we also know that recent store closures will take about $65 million off this number so it is possible to be lower than $4 billion, which is what I am projecting. If sales decline further, the company has told me and other analysts that there is more room to cut in SG&A. This statement makes sense, JCP was once a $19 billion in sales company and had the SG&A to grow sales from there. JCP needs far less SG&A to run a company almost half that size, which is common sense. Fixed costs can become unfixed as companies shrink. Hidden assets like corporate jets and hundreds of acres around their corporate headquarters also get monetized (see last week's press release). The gross margins are 700-1100 basis points lower than JCP used to earn and from what competitors currently earn as you can see in the comp. sheet from my article: what if JCP could just be average?. To assume that 30% is the new JCP normal is to assume that Ron Johnson will come back this year and order more upside down Christmas trees and Michael Graves items that their core customer doesn't want. It also assumes that there can be no margin improvement from bringing back higher margin private label that we know sells to their core customer. That coupons won't drive traffic like it used to, that none of Ron Johnson's remodeling worked... the list goes on.
If the home stores with 11 million square feet of selling space, which were closed for the first half of last year, generate only $50 a square foot in sales (the company average is around $100), that is over half a billion in revenue on $12 billion in sales. The results could be much better. How many customers were lost because they couldn't buy home merchandise for 6 months or just didn't like the new high-end merchandise? 1000 basis points of gross margin improvement, which is back to what JCP used to do and what the best department stores generate would be $1.2 billion in incremental cash flow.
If sales remain around the $12 billion level and SG&A is just under $4 billion and gross margins are mid 30s, JCP will generate about $400 million in EBITDA and burn about $300 million next year. With over $2 billion in liquidity, JCP could do something like this for 2-4 years and not have to raise incremental liquidity. JCP has about $1 billion of debt capacity in the form of second lien bank debt and their existing accordion loan, which could provide an additional 3 years of sales and EBITDA at these levels without equity dilution. Even Imperial, Uber bear on JCP, outlined the case of the extra $1 billion of debt with no common raised.
Distressed debt funds have a vested interest in trying to make JCP file. There is a fee frenzy to feed themselves and their advisers. Many of these funds can't actually by mandate invest in JCP unless it actually is distressed or some form of real restructuring. They can use the courts to steal equity value from the common and unsecured as happened in Visteon and countless other cases.
I don't believe that Ullman came back and Steve Sadove became Chairman to take the company into Chapter 11. I don't believe Ullman bought $1 million in stock to just paint the tape. The turnaround may be just too big, but the evidence of stabilization, combined with the time $800 million of fresh equity just bought and what I see as a lot of time even if numbers are not that great this year makes me think that JCP at $5 is a very cheap option on my bull case where JCP makes $1.5-2.0 billion in EBITDA and the stock rockets to $20-40 a share. The buy and sell side loved Ackman and Ron Johnson in the 20s and 30s and they all hate JCP now...
Additional disclosure: positions can and do change at any time without warning or notice.