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A few weeks ago I published an article focusing on the liquidity issues facing J.C. Penney (NYSE:JCP). My thesis was that the emphasis of many analyses on sales growth was misplaced because there is no plausible rate of sales growth that renders JCP able to meet its liquidity needs in the near future.

This article, which is in large part a response to a number of recently published "bull" models of JCP, discusses what degree of SG&A reduction and gross margin increase would be required for JCP to become profitable.

I show, below, that there is no plausible combination of performance numbers that would give JCP positive EBITDA or FCFF by 2016.

The Model and Its Results

To perform this analysis, I prepared a model for JCP that allowed me to test the effect if different levels of comparable store sales growth, declines in SG&A, and increases in gross margins. The model is designed to reflect a "best case" management performance in which JCP is able to improve its operating efficiency and reduce working capital each year. The model treated adjustments to SG&A and gross margins as "magic wand" changes -- it asked what would happen if one were to magically cause SG&A to drop and/or gross margins to rise by various amounts.

(I would have liked to present the result graphically, but the web is not yet capable of displaying a 4-dimensional chart.)

I tested rates of sustained comparable store sales growth from -2% to +6% yoy; adjustments in SG&A from +10% to -10%; and gross margins from 28% to 36%.

The model's output showed that even if JCP achieves instantaneous comps of +6%, if its SG&A maintains its current trajectory after instantly dropping by 10%, and gross margins instantly shift to 36%, then JCP still will not generate positive cash flows by 2016.

As for EBITDA, the model showed that JCP would product positive EBITDA by 2015 if it sustains comps of +6%, immediately reduces SG&A by 10%, and maintains 36% gross margins. For 2016, JCP achieves positive EBITDA if it maintains comps of +6%, with a 5% SG&A reduction and gross margins of 36%.

Before placing those results into context, it is important to place them into perspective: The model showed that JCP could not achieve positive FCFF under any of the assumptions tested. That is more important to equity holders than EBITDA because JCP has looming debt maturities. If it cannot generate cash then it will have to borrow to sustain its operations (which it would have great difficulty doing), or make a dilutive offering (which would also be difficult).

Put another way, as long as FCFF stays negative, changing EBITDA affects only whether JCP can restructure or must liquidate -- it doesn't spare the company from bankruptcy.

The next section of this article considers what rates of sales growth, SG&A reduction, and gross margin increase are actually realistic.

The Assumptions in Context

Sales. The assumption that JCP could achieve sustained yoy sales growth of 6%, or even 4%, has no plausible basis in reality.

The following chart illustrates where JCP has been, and where it is now:

(click to enlarge)

As the chart shows, even before 2012 JCP showed consistently negative net sales growth. There was one exception, as the economy peaked in 2006 an 2007. Otherwise the trend was unquestionably downward.

Sales did not recover in 2013. The rate of reduction declined, so that sales dropped 9.6% yoy rather than 24.8% yoy as in 2012, but sales continued to drop. (Its true that I'm mixing up aggregate sales with comps here, but the difference is immaterial to the analysis.)

For JCP to achieve positive EBITDA, as above, it would have to go from last year's -9.6% sales change to positive 6%, and sustain that rate of growth for years. There is, as the chart shows, no basis in JCP's historical performance, under current CEO Ullman or otherwise, to suggest that such performance is even remotely realistic.

Gross Margin. The assumption that JCP could jump from its current 29% gross margins to 36% overnight, or in the short-term, has no plausible basis in reality.

The following chart of gross margin performs the same function as the chart of net sales above:

(click to enlarge)Again, note that when Ullman ran the company before 2012, gross margin was consistently and steadily declining. It was not stable, and it was not going up.

SG&A. The assumption that JCP could reduce SG&A by an additional 10% while simultaneously increasing sales, has no plausible basis in reality.

The following chart shows SG&A as a percentage of net sales, and how that metric changed over time:

(click to enlarge)

There are a few things to note about this chart. The first is that JCP's SG&A closely tracks its net sales.

There are reasons for this. One of them is that SG&A includes rent and salaries so it tracks the size of JCP's selling operation, including seasonal workers.

Another is that JCP reports credit card income as a reduction in SG&A rather than as revenue. As a result, JCP's financial statements understate its SG&A and overstate comparable store sales growth relative to JCP's competitors. (The credit card income is comparatively stable because of the structure of JCP's deal with the credit card vendor.) JCP has been reporting this way for years. JCP doesn't report the credit card number separately, so there's no way to adjust and compensate. Sneaky, sneaky JCP...

Back to the chart -- as it shows, much of the 18% yoy decline in JCP's SG&A is probably attributable to the decline in sales. This means that if JCP needs to *increase* sales to achieve positive EBITDA, it will have a great deal of difficulty doing that while lowering SG&A.

It also shows that during Ullman's pre-2012 tenure, SG&A consistently rose as a percentage of net sales. (2004 appears as an exception likely because of accounting effects related to the sale of a drug store chain JCP had owned.) In other words the company got less efficient over time, not more efficient.

Conclusion

Putting together numbers that would render JCP profitable is easy, as long as we agree to use magical thinking. Once we stop waving magic wands and take a realistic view of the company, its history, its managers' prior performance, and so forth -- we see a very different, but much clearer, picture.

For JCP to achieve positive EBITDA, let alone positive FCFF, in the foreseeable future, something absolutely extraordinary would have to take place.

There is no non-magical bull case for JCP's shareholders.

Source: J.C. Penney: Straight Talk About Numbers And Models (Is There A Bull Case?)

Additional disclosure: I have a small short position in JCP through derivatives. If the price of JCP or its derivatives changes substantially, my position could grow, shrink, or shift from short to long.