Let me begin by saying that I have no position in any J.C. Penney securities (NYSE:JCP), I have never had any, and I don't intend to initiate any. That said, I have watched with great interest the recent developments of the company and I am somewhat surprised by the euphoria of some investors over the most recent guidance. Some bulls are now even implying that the bear case is effectively dead and J.C. Penney is out of the woods completely.
More specifically, what's really surprised me is the lack of skepticism by many investors surrounding this recent guidance. This is particularly true when considering that J.C. Penney's management has a strong incentive to put a positive light on the their operations, given on-going solvency concerns and the resultant need to project financial strength -- in order to support vendor contract negotiations, other potential financing activities, and the security prices (both debt and equity) of the company.
So why wouldn't management be aggressive on guidance and why should investors assume the best with regard to some of the vague terms and the select metrics that were used with the guidance? A strategy to under (or conservatively) promise and over deliver certainly wouldn't seem to be desirable for company in J.C. Penney's position. Furthermore, companies in potential distress, like J.C. Penney, can tend to be specific about what's positive and omit or be vague about what's negative -- and there were plenty of omissions and lots of vagueness in J.C. Penney's guidance. So, let's take a closer look at what was said and what wasn't said.
Comparable store sales: expected to increase mid-single digits;
As previously discussed, investors should consider that J.C. Penney's management has a general incentive to be optimistic with this guidance. In addition, it should be noted that they appear to be cherry-picking the metric that is likely to look most favorable (i.e. providing guidance for same store growth and not actual revenue growth).
Store closures, as have been announced, will drive some existing J.C. Penney customers from the closed stores to those that remain -- benefiting same store growth at the expense of overall revenue growth. What's most important over the long term is overall revenue growth, for which no guidance was provided. Importantly, the trajectory for overall revenue growth should not be confused with the guidance made for same store revenue growth over the next year.
Gross margin: expected to improve significantly versus 2013;
Notice that management gives somewhat specific "mid-single digit" guidance for expected same store growth but use the vague term "significant" for expected gross margin growth. A 100 to 300 basis point improvement can be considered "significant" as would 800 to 900 bps.
Some seem to be assuming the best with respect to what management meant with this term; however, you should ask yourself this question: if management was really expecting such strong gross margin growth why wouldn't they say so more specifically? Is this, perhaps, an example of a strategy to be specific about what's expected to be positive and vague about what's not?
Liquidity: expected to be in excess of $2 billion at year-end;
Many were very positive on this guidance, despite the fact that management gave very few specifics on how this level of liquidity would be maintained. There was no guidance on expected cash burn from the company's operations and questions on that matter were repeatedly avoided on the conference call (a red flag). Furthermore, management indicated that they would use working capital as a source of funding and they could also use an additional $500 million in bank availability.
While maintaining liquidity through working capital burn and additional bank borrowings can buy a company more time, it's not sustainable and it tells you nothing about the underlying free cash flow generating capacity of the company's operations. This underlying free cash flow is what really matters and is what will determine value (and whether or not the company can survive) in the long term. As such, it should also be of some concern that management gave no guidance on (and avoided questions about) this metric.
Capital expenditures: expected to be approximately $250 million;
Again, I suspect that many people took this as very positive although temporarily cutting/delaying capital spending is easy to do and is often just an unfortunate necessity for turnaround companies that need to preserve cash. A low capex spend doesn't mean that capital spending requirements have declined or that the lowered level of expenditures is sustainable, much less optimal.
I have seen very bullish expectations for J.C. Penney's SG&A in 2014 (below $4bn) based on recent trends/reductions. Interestingly, management gave guidance for SG&A for the next quarter ("slightly below last year's levels"), but not for the entire year. The reason for this omission may be reflected in management's comments provided during the conference call Q&A. When asked about SG&A, the company's CFO responded:
"We gave some first quarter guidance where we basically said we thought it would be slightly below the prior year. We don't expect the total year to be vastly different than what we had in 2013."
So, it appears that the story for SG&A reductions in 2014 may not be that positive. Certainly, not in line with the considerable SG&A reductions seen in the last quarter.
There were clearly positive takeaways from the J.C. Penney guidance and a relief rally may well be justified. To be clear, I am purposely looking at things in a negative light and playing devil's advocate. That being said, in the case of J.C. Penney and other turnaround stories, management has a strong incentive to shed a positive light on the company and what's said and what's not said needs to be carefully scrutinized.
I wouldn't blame J.C. Penney's management for trying to put a positive spin on the company's results and for carefully choosing their words with respect to the forward guidance. Boosting market confidence in the company is part of their job. People just need to recognize that reality and view the guidance with an appropriate level of cynicism. It would appear to me that many are not.