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As a financial analyst at one point early in my career, I was getting ready to dust off my analyst hat, roll up my sleeves and dig into the financials of J.C. Penney (JCP). Before I began my deep dive, it occurred to me that JCP is widely covered, one could even say blanketed, by analysts. So I checked and there are no fewer than 24 analysts covering the name.

Instead of analyzing the financial numbers in the quarterly and annual reports and developing assumptions for financial projections, my due diligence took a different turn. I decided to utilize the analyst numbers to evaluate the financial condition of JCP and establish my thesis based on that analysis. One approach would be to just take the mean estimates of all the analysts as provided below:

First Call Mean Estimates

Fiscal Year Ending: Jan - Last Changed: 02/07/14
YR EndingQ1 AprQ2 JulQ3 OctQ4 Jan
2018N/AN/AN/AN/A
2017N/AN/AN/AN/A
2016-0.73-0.55-0.330.43
2015-1.15-1.03-0.88-0.22
2014-1.31A-1.17A-1.85A-0.81
2013-0.43A-0.50A-0.93A-1.95A
20120.28A0.07A-0.16A0.74A
20110.25A0.06A0.19A1.09A
20100.11A0.00A0.11A0.84A
20090.54A0.52A0.55A0.94A
20081.04A0.78A1.03A1.93A
20070.90A0.75A1.26A2.00A
20060.63A0.46A0.94A1.71A

Based on the above, JCP doesn't turn the corner to profitability until the fourth quarter of 2016. There's a lot of bleeding still to come. So assuming the numbers represent a reasonable estimate, it doesn't take much effort to determine the number of shares outstanding of a little more than 304.5 million times the estimated quarterly losses to calculate an accumulated cash flow deficit of over $1.7 billion before projected profitability is reached.

With a tangible book value of a little over $2.6 billion that leaves less than $1 billion in book value before JCP turns the corner. What's more concerning is the effect on liquidity and working capital. Currently at $2 billion, it would be nearly wiped out. No working capital, no inventory, and no inventory no sales. End of story.

Again, assuming the mean estimate is a good proxy for expected performance, without further action by management to shore up the finances, it looks like JCP is a $3 per share company at best from a book value perspective ($900 million book value in 2016 divided by 304.5 million shares outstanding).

It's obviously not reasonable to assume that management will just sit idle and watch as JCP shuts the doors. There will most likely need to be a cash injection either in the form of additional dilutive capital or additional debt.

Highly Leveraged

Clearly as a shareholder, additional debt if the company could support it would be preferable, particularly in today's ultra low interest rate environment. Unfortunately, JCP has already leveraged itself to the point where any additional leverage would be detrimental to its chance of survival. In May, 2013 JCP issued $2.25 billion in long term debt for working capital purposes to go along with their $1.85 billion asset based revolving line of credit. The company has a total liability to tangible net worth ratio of almost 3.5x and a debt to equity ratio of over 2x. So, covering the $1.7 billion liquidity hole with additional debt is unlikely.

Dilution Will Come

With little capacity for additional debt it looks like the bridge to profitability will need to be built on the backs of shareholders. The question is can JCP withstand dilution and still provide a reasonable return to investors? Assuming the current stock price of $6, the size of a capital raise would result in 100% dilution. Shares would balloon to 610 million and the stock price would tumble to $3 a share. On the very positive side, JCP would have an additional $1.7 billion in their coffers.

Value Is A Product Of Price

Obviously, JCP doesn't need to raise $1.7 billion day one. As they continue to make progress and move closer to profitability, the stock price should appreciate in proportion to their success in meeting analyst expectations, which would minimize dilution substantially. Using the current share price and assuming 610 million shares outstanding would require a 50% reduction in the earnings per share figures used in the First Call Mean Estimates table above. Looking at historical EPS before the wheels completely came off of JCP and taking into consideration the additional share count, 2009 would provide a price per share of $4.17 with a 10% PE and 2007 would provide a price per share of $18.06. Using a different price point will either increase or decrease investment potential.

Managing Dilution

In many ways, JCP is similar to developmental stage biopharma, an investment space I am very familiar with and have been successful including as part of my diversified portfolio. With developmental stage biopharma the key is to generate sufficient capital by selling shares until the science travels the long road to commercialization. The market is continually evaluating the potential and progression of the science and the need of the company to raise capital to continue the progression. Market value is determined somewhere within that struggle between value creation and value destruction. Companies in this space have become very skilled at driving up value in order to dilute shareholders with the least impact. In other words, price matters.

Catalysts

JCP will need to take advantage of catalysts in order to manage dilution. An obvious catalyst is earnings announcements that exceed expectations. However, JCP will have other opportunities such as providing the market with sales comps that exceed expectations or restructuring their extensive real estate holdings. Management's ability to utilize catalysts to minimize dilution and maximize shareholder value will be key.

Conclusion

I have found in general that analysts are usually late to the party and late to leave meaning that they are often slow to adjust downward when a company's performance is deteriorating and slow to adjust upwards as they recover. That said, using that conservative benchmark provides a reasonable basis for an analysis of JCP. At today's stock price, using EPS from the recent past and assuming a very conservative dilution scenario, JCP has a 3 year price range of $4.17 to $18.06 and a mid range of $11.11, representing close to a 100% improvement in stock price.

There are many variables at play when considering a company that is trying to restructure itself and regain profitability. JCP is not the company it was historically both from a balance sheet perspective and a performance perspective. The cost of operating has increased due to additional debt. Foot traffic into the store has declined substantially and JCP has lost a large portion of its loyal customer base. Recovery will take time but with the right decisions by management and achieving analyst expectations, investors should be rewarded for the risk.

With a company at this stage of recovery, volatility should be expected. Just in the last week the stock price has bounced 20% off the bottom. Keeping with my developmental stage biopharma comparison, investors should actively manage their position. A buy and hold strategy is not the best approach. Maintaining a core position while buying the dips and selling the pops will maximize returns and minimize risk. If JCP exceeds analyst expectations and manages dilution effectively, the upside could be substantial. Comparing actual results to mean estimates will guide the way forward.

Source: J.C. Penney: Ability To Manage Dilution Will Drive Value