JCP will report earnings after the market close on February 26, starting its earnings conference call at 4:30 pm (Eastern). The purpose of this article is to help investors identify what to look and listen for, and what to ignore. I also briefly discuss some of JCP's recent announcements.
My earlier article provided an overview of J.C. Penney's (NYSE:JCP) business, prospects, and liquidity challenges. My thesis was that JCP faces serious liquidity problems and does not appear to have the resources to surmount them, even if it is able to achieve management's target metrics.
I believe that on Wednesday JCP will report slightly below the analyst-estimated range, which I think is propped-up by analyst reluctance to downgrade. According to Yahoo, analyst EPS estimates range from -$5.60 to -$6.50, with an average of -$6.11. According to the Wall St. Journal, estimates have steadily dropped over the last three months and now stand at an average of -$5.86.
Based on JCP's announced +2% comps for 4Q13, I estimate 4Q13 revenue at $3656mn and full year revenue at $11,734mn. Taking that into account along with its announcements concerning store closings, I expect that FY13 net income was -$1,1809mn, with EPS of -$6.56 (excl. pension, etc.).
(Caveat: I'm a debt guy, not an equity guy. Calling earnings is a personal experiment.)
What To Look And Listen For
Watch Whose Questions They Take On The Conference Call. On recent earnings conference calls JCP declined to take questions from analysts with negative ratings on the stock (my source is a personal conversation with one such analyst). As a result, few or no "hard" questions were asked during the calls. Watch to see if there are any hard questions during this call; watch also to see if each of the major banks covering JCP is allowed to ask at least one question. Unless both happen, that means JCP is still screening questions. Not a good sign.
Gross Margins, Inventory Write-Downs, and End Of Year Inventory. The "bull" theses for JCP all involve gross margins of 36-40%. Margins were about 29% for the first three quarters of 2013, but ranged from 36-39% between 2003 and 2011.
In its 3Q13 earnings call, management attributed low prices (and margins) to the need to get rid of undesirable leftover 2012 inventory, and said this would continue into 4Q. This was a strange thing for them to say: JCP turns over its inventory 4-5x a year, including in 2012 and 2013, so it's difficult to understand how much "leftover" inventory there could really be. Moreover, there was a distinct lack of inventory write-downs in 2013. And if that's not enough to make you skeptical, JCP's inventory assets grew from $2,341mn at the start of the fiscal year to $3,747 at the end of 3Q, on more than $8bn in sales.
So be very skeptical of explanations for 4Q margins that point to 2012 or "legacy" inventory.
If gross margins did not rise significantly in 4Q, then all of the "bull" theses are in serious trouble. If gross margins dropped, even slightly, that would refute the core premise of the business plan JCP has been pursuing since Myron Ullman returned to the company, which is to restore margins and net sales using private label brands and discount promotions.
I estimate that the margin dropped to 27-28% because of the intensity of this year's holiday shopping competition and because of the stream of anecdotal evidence of massive discounting and clearances at JCP. (I also have never thought the private-label/discount-promotion strategy would let a retailer increase margins and sales simultaneously -- competition from discounters and the Internet is too great.)
Letters of Credit. In 2012 and 2013 JCP started purchasing more of its inventory on credit, and its vendors started to decline to sell on credit without backing from a bank. JCP therefore wrote some $600mn in new letters of credit, bringing the total to $718mn. JCP's total capacity for LOCs on its revolver is $750mn. If the amount of outstanding LOCs has not dropped radically, there is a risk that JCP will have difficulty obtaining product. A loss of vendor confidence is very serious, and potentially fatal for a retailer.
Imminent Maturities and Liquidity Needs -- Have They Tried to Exercise the Accordion, and Is There a Plan. Here, the question is whether management starts talking seriously about liquidity and offers any plan or explanation of how the company can survive. JCP has a $650mn debt maturity in 1Q14. That is about half the cash JCP is expected to have on hand. If JCP consumes cash in 2014 at the same rate as 2012 and 2013, it will run out by the end of the quarter and exhaust revolver availability in 3Q or 4Q. If it is successful in reducing capex (I think it will be), closing stores, and reducing costs, JCP might just barely squeak by 2014. But JCP is likely to experience serious vendor problems at the peak of its pre-holiday ramp-up if it is that close to the edge. There is therefore a business need for JCP to increase available liquidity within the next several months.
One potential option for liquidity is an "accordion" feature in JCP's revolver. The revolver documentation says that JCP can request an additional $400mn in capacity (the lenders don't have to agree, and may charge a fee). In my view it's likely that JCP will try to exercise the accordion, if it hasn't already.
Exercising the accordion only addresses JCP's liquidity needs through 2014. I do not believe the accordion will be sufficient to get JCP through 2015. JCP needs a long-term liquidity plan, if it is possible to devise one.
If management starts talking about long-term liquidity and offering a plan (other than hoping sales will improve) that can be implemented in the next 18 months, that's a good sign. If management is silent -- that is a bad sign. And if management doesn't say anything about the accordion, that's a very bad sign -- it may mean that JCP asked, and the lenders said "no."
Store Closings. Will JCP be closing more stores in 2014, and how much does it expect to save? This is crucial to evaluating whether JCP can get its SG&A in line with current revenues. (Before January, I and others looking at JCP spent a lot of our time trying to analyze JCP's SG&A and see what potential for cost-cutting remained.)
On January 15, JCP announced that it would be closing 33 underperforming stores and laying off 2000 employees. JCP projects $65mn in annual cost savings, with a $26mn charge in 4Q13 and $17mn charges in future periods. The 33 stores JCP selected for closure are leased stores where the lease was set to expire shortly, and JCP is incurring closure costs in excess of $1.3mn per closed store.
The cost savings are not impressive: The closed stores account for about 2.5% of JCP's total retail sales space, but JCP is projecting that SG&A will drop by just (about) 1.5% (their estimate of savings divided by my estimate of SG&A).
Nearly everyone who's looked at the company closely agrees that JCP has to find a way to reduce the size of its operation to have any hope of surviving. But the January announcement seems to be saying that JCP will have a hard time trying to reduce costs by closing stores. So look and listen closely to what management says about the prospects for future closures in 2014.
That Land Deal in Texas. On February 12, JCP announced that it had reached a deal to develop unencumbered land near its Texas headquarters. It has kept the terms of the deal a closely-guarded secret. It says that it "hired" real estate developers and might see some cash from the project within a few months. Other sources suggest the project is a joint venture and say JCP might ultimately see $200mn out of the project, but they don't identify a source for that or explain whether it is rent, an expected sale, when the money would be received, or what hurdles would have to be hit for JCP to receive that amount.
Watch closely to see what JCP says about the deal, and whether it discloses the deal documentation. My suspicion: this is going to turn out to be a joint venture where the real estate developers are paying the development cost and taking the bulk of the potential returns. Perhaps the agreement also has the developers providing cash to JCP early on. (If that's the case, then we can think of the agreement as a hybrid loan structured to avoid restrictions in JCP's credit documents on its ability to borrow or sell this land.) Perhaps the agreement also has some sort of term that would allow JCP a larger cut if the project passes very steep hurdles. That, in my experience, is the typical structure of a real estate development joint venture where the party contributing the land does not have the funds to develop it.
If JCP fails to disclose the terms of the deal (my expectation), for purposes of forecasting JCP's future income we should treat the deal as a simple loss of the land in question.
Comps, Comps, Comps. JCP's managers love talking about comps. I think this is because when the focus is on sales it is easy to point the finger at 2012 and the prior CEO, and when they're talking about sales they aren't talking about the more important issues of SG&A, liquidity, and margin. Expect JCP to put as much focus as it can on the positive 2% reports comps for 4Q, and to say a lot about goals and prospects for higher comps in 2014.
Be very careful in interpreting JCP's reported comps. They're not as straightforward as one might think:
- First, when JCP talks about 4Q performance keep in mind that 2% comps means net sales for the quarter dropped 4-6% from 2012. (4Q12 had an extra week.)
- Second, keep JCP's forecasts and goals for the future in perspective. The "bull cases" for JCP require years of sustained aggregate net sales growth (not just comps) in excess of 6%.
- Third, remember that the store closures will push comps higher since JCP is closing the weaker stores. But, the store closures will also change the relationship between comps and net sales (and what we really care about is net sales). The more stores JCP closes, it will have to hit higher comps just to maintain current net sales. As an example, if JCP stops closing stores after the 33 announced, 2% comps for 2014 would imply that net sales growth increased by only about 0.3%.
- Fourth, JCP's comps aren't the same as other retailers' comps. JCP's reported comps include sales from jcp.com. JCP's reported comps also exclude the revenue JCP receives from its credit card program. JCP doesn't tell us how much that is, but from what it does say I feel comfortable estimating approximately $200mn per year. Since jcp.com is growing very quickly, but the credit card revenues seem to be growing slowly or not at all, including the former and excluding the latter pushes JCP's reported comps up.
Impairment. JCP's balance sheet includes $268mn in goodwill from its 2011 acquisition of Liz Claiborne. What happens to that goodwill may tell us something about JCP's prospects. (In JCP's 10-Qs, this goodwill is part of "other assets" and the separate line item labeled "goodwill" is always zero. The quality of JCP's presentation of its financials is a discussion for another time.) GAAP required JCP to test that goodwill for impairment in 4Q.
JCP's method of testing the Liz Claiborne goodwill for impairment requires it to estimate future cash flows from the Liz Claiborne mark. Management has a good deal of discretion in the assumptions used in that calculation, but not unlimited discretion -- the accountants are involved. By analogy, earlier in FY13 JCP's managers and accountants concluded that there is a less than 50% chance of JCP using accrued net operating losses (in other words, of being profitable) and JCP therefore took a valuation allowance for the NOLs.
An impairment charge for the Liz Claiborne goodwill would therefore tell us something about how JCP's managers and accountants view the company's prospects for future cash flows.
(My view is that there is a good chance that JCP's accountants will require it to record impairment of the Liz Claiborne goodwill; I have not included such a charge on my estimates in this article because without knowing more about the testing method than JCP has disclosed I can't estimate the amount of a likely charge.)
The SEC Investigation. JCP's 3Q13 10-Q announced that the SEC was investigating whether JCP's disclosures of its liquidity and ability to survive in connection with its secondary stock offering. We haven't heard anything since. Look carefully in the 10-K to see if the investigation has been resolved.
My first JCP article included a chart of historical and projected performance. I provide an update of the chart below. The update takes into account JCP's announced store closings and reports of 4Q performance. It continues to accept management's guidance that capex will be $75mn/quarter going forward, assumes that JCP reaches its target 37% gross margins (while I doubt this will actually happen), assumes sustained 2% comparable store sales growth (which I also believe is generous), and assumes that JCP is able to make its operations more efficient, reducing working capital and SG&A as a proportion of net sales (generous again).
Please note that although the table includes 2016, my model forecasts that on these assumptions the company would default and begin some form of insolvency proceeding by 3Q15.
Additional disclosure: I have a small short position in JCP through derivatives. If the price changes, I may adjust, change, close, or flip the position.