J.C. Penney: A Ray Of Hope, But Be Careful Of Being Blinded

| About: J.C. Penney (JCP)

J.C. Penney (NYSE:JCP) delivered solid Q4 2013 results on the back of substantial SG&A reductions that more than offset lower than expected gross margins (affected by some one-time impacts from discontinued brands). More importantly, it provided guidance for growth in 2014 and minimum expected liquidity levels. If J.C. Penney meets its guidance, it will remove from the table the most bearish scenarios of dilution or a bankruptcy filing. It also removes from the table the most bullish scenarios of a return to $1.5 billion to $2 billion EBITDA.

Basically we are left with guidance for the scenario where J.C. Penney muddles through and avoids bankruptcy. How much does this make J.C. Penney worth? Dante, one of the bullish SA authors, once identified this scenario as making J.C. Penney worth approximately $4 to $12 per share. My calculations using enterprise value to EBITDA indicate a value of anywhere from $1 to $11 per share. J.C. Penney will probably have some bullish momentum from the guidance, but long-term where it settles in that range will be determined by how well J.C. Penney can perform relative to its guidance.

J.C. Penney's guidance certainly did exceed my expectations for negative growth in Q1 and low single-digit growth in 2014 overall. However, J.C. Penney's guidance was more in line with my expectations for 5% growth back in January before I became even more bearish as monthly results tanked. It also is falling well short of the $13.9 billion revenue target mentioned when I tried to write a bullish article before and the more bullish expectations for a return to $14 billion in sales. It'll take around four consecutive years of mid-single digit growth to get to that point, while sales growth appears likely to slow into the low-single digit range for 2015 based on what was implied in the guidance.

Guidance and Impact on Valuation

J.C. Penney provided guidance for Q1 2014 comparable store sales to increase by 3% to 5% and comparable store sales to increase by mid single digits (I'm defining this as 4% to 7%) in 2014. Assuming there is progressive improvement throughout the year, we can calculate an estimated 2015 growth rate as well. If comps are +5% in Q1 2014, a natural progression to get close to +7% overall would involve +6% in Q2, +7% in Q3 and +8% in Q4. This progression would imply a roughly +4% year-over-year growth. If comps are +3% in Q1 2014 and +4% in 2014, then year-over-year growth would be roughly +1% entering 2015.

Therefore the guidance range implies expectations for approximately $12.4 billion to $13.1 billion in sales for 2015.

2014 Growth

4%

5%

6%

7%

2014 Sales ($ Million)

$12,263

$12,381

$12,498

$12,616

Implied 2015 Growth

1%

2%

3%

4%

2015 Sales ($ Million)

$12,365

$12,608

$12,853

$13,100

Click to enlarge

The following scenarios outline J.C. Penney's EBITDA with 37% to 39% gross margin. This assumes that J.C. Penney can get back to Ullman's historical targeted levels by 2015. Personally, I think J.C. Penney is likely to end up at the low end of this range, partially due to increasing Internet sales (which for Kohl's had 12% lower gross margin due to shipping costs), as well as heavier promotional activity.

I am assuming SG&A of $3.95 billion for 2014 and 2015. This is based on 2014 guidance for SG&A to not be "vastly different than what we had in 2013." The SG&A total for 2013 was $4.114 billion. The SG&A levels are assumed to be similar to 2014 in 2015.

Net debt is pegged at $3.5 billion, and the EV/EBITDA multiple is at 6.0x, which is what a number of both bear and bull articles have used for valuation calculations.

At 37% gross margin, this valuation calculation would make J.C. Penney worth anywhere from $1 to $6 per share. Realistically, with bankruptcy off the table, J.C. Penney would likely trade in the $4 to $6 per share range long term if fairly valued. Even with two years of recovery at the high end of guidance, J.C. Penney would barely be cash-flow positive in 2015 if gross margins are at 37%. Interest costs of nearly $400 million, plus capital expenditures that could be in the $350 million to $500 million range will use up most of the cash flow.

2015 Sales ($ Million)

$12,365

$12,608

$12,853

$13,100

Gross Margin @ 37% ($ Million)

$4,575

$4,665

$4,756

$4,847

SG&A

$3,950

$3,950

$3,950

$3,950

EBITDA

$625

$715

$806

$897

Value Per Share

$0.82

$2.59

$4.38

$6.18

Click to enlarge

At 38% gross margin, this valuation calculation would make J.C. Penney worth anywhere from $3 to $9 per share.

2015 Sales ($ Million)

$12,365

$12,608

$12,853

$13,100

Gross Margin @ 38% ($ Million)

$4,699

$4,791

$4,884

$4,978

SG&A

$3,950

$3,950

$3,950

$3,950

EBITDA

$749

$841

$934

$1,028

Value Per Share

$3.26

$5.08

$6.91

$8.77

Click to enlarge

At 39% gross margin, this valuation calculation would make J.C. Penney worth anywhere from $6 to $11 per share. At the high end of guidance, J.C. Penney would be able to generate a couple hundred million in cash flow while being able to expand capital expenditures to a higher number like the $500 million that was mentioned on the call if needed.

2015 Sales ($ Million)

$12,365

$12,608

$12,853

$13,100

Gross Margin @ 39% ($ Million)

$4,822

$4,917

$5,013

$5,109

SG&A

$3,950

$3,950

$3,950

$3,950

EBITDA

$872

$967

$1,063

$1,159

Value Per Share

$5.70

$7.56

$9.45

$11.35

Click to enlarge

Conclusion

With bankruptcy and dilution off the table if J.C. Penney can successfully execute its plans and make guidance, its shares will likely have a floor that is above the $4 level. That part of the short thesis has been disrupted if J.C. Penney can meet guidance. The guidance has also disrupted the more bullish ideas for $1.5+ billion in EBITDA and a J.C. Penney that is vastly undervalued at its current price.

However, another part of the short thesis has been that J.C. Penney is overvalued even without dilution based on historical metrics that include its debt burden. That remains intact, along with the part of the bull thesis that J.C. Penney will avoid bankruptcy and dilution.

What we are left with is a J.C. Penney that will likely do between $600 million and $1.2 billion in EBITDA for 2015, with capital expenditures scaling up or down depending on performance, and free cash flow ranging from minimal to a few hundred million per year.

Valuation metrics that both bulls and bears have previously used indicate that J.C. Penney should be valued at up to $11 per share if it can reach a 39% margin or as low as under $6 per share if it settles for a 37% to 38% margin.

J.C. Penney may have some positive momentum for an upward run now that bankruptcy and dilution is apparently off the table if it can meet its guidance. However, it remains a strong short candidate based on valuation if the price runs up a lot since J.C. Penney has also taken the prospect of recapturing significant portions of lost sales and getting to $1.5 billion in EBITDA off the table as well based on guidance.

Disclosure: I am short JCP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.