Seeking Alpha
Special situations, debt, short-term horizon, distressed debt/claims-trading
Profile| Send Message|
( followers)  

Summary

  • Using industry-standard measures, J.C. Penney's EPS for 2014 was (-$6.30), at the low end of analyst estimates.
  • As predicted, J.C. Penney is selling non-operating assets and trying to exercise the accordion in its revolver so it can borrow enough to survive 2014.
  • The only natural explanation for J.C. Penney's reduction in SG&A and capex below prior guidance is that the company is allowing its facilities to decline.

When the numbers in J.C. Penney's (NYSE:JCP) 4Q earnings report are adjusted to conform to industry standards, the company lost -$6.30 per share. That is at the low-end of analyst expectations, which ranged from -$5.60 to -$6.50. It's below the analyst average (either -$6.11 or -$5.86, depending on who did the math) but a little bit better than my estimate of -$6.56. (See here for collected pre-earnings estimates.)

Perceptive commentators are right to be skeptical of claims about a JCP "recovery." Actually, as I will explain below, JCP probably did a bit worse than its EPS suggests. The company also confirmed that it is selling non-operating assets to raise cash, and seeking to expand its revolver because it needs more liquidity to get through 2014. (See the second chart in the liquidity section of this article for an explanation of why.)

I'll get into the details below. First...

A Warning

JCP's earnings announcement heralded a veritable explosion of exuberant commentary from claimed experts. But the adjustments to earnings I mention in the first paragraph of this article are fundamental. This is financial analysis 101.

Analysts at the major banks maintained their doubts about its ability to survive. Standard & Poor's maintained its credit rating for JCP's debt at just-barely-above-default. (S&P's latest report reiterated doubts about the company's ability to survive and the current credit rating correlates to a greater than 50% likelihood of default within 5 years.)

If you see commentators claiming that JCP "beat earnings" or "proved doubters wrong" or "proved it can turn a profit," you know those commentators failed to adjust JCP's reported net income and you should be very, very skeptical. JCP managed to not collapse. That's it. For any commentator who claims to be a finance or investment professional to miss the adjustments and corrections discussed here raises very serious red flags about their ability or intent.

Ask some hard questions: How much do you really know about the commentator? Do they have any actual investment training or experience? How old are they? If they claim to manage a portfolio, is it real or "virtual"? Do they claim to be monitoring hundreds of companies at a time? Be especially skeptical of folks who charge for investment "newsletters" but are not members of FINRA. These people try to avoid registering as securities professionals by claiming they are really journalists. Bona fide journalists don't tout the performance of their portfolios and charge extra to tell you their latest picks before they become public. The "newsletter" authors could be making a lot more money actually managing investments if they complied with the SEC's registration rules. So why don't they? Don't be afraid to ask the hard questions. Real professionals won't be offended and they won't evade.

The Earnings Adjustment

Let me explain the adjustments to earnings in a bit more detail.

The first concerns JCP's pension fund. In 4Q JCP changed the actuarial assumptions in its pension plan, and based on that decided that its pension plan is worth $630mn more than it was last year. JCP hasn't explained what those actuarial assumption changes were. Anyway, based on them, JCP claimed a $270mn non-cash future tax benefit. That means that JCP believes that an indefinite time in the future it may pay $270mn less in taxes (if the actuarial assumptions don't change in the meantime), so JCP claimed $270mn in income.

Pension asset changes don't matter much to shareholders because the shareholders can't touch the pension assets.

Pension fund accounting is also notoriously complex, volatile and easily susceptible to manipulation because the size of the pension asset (or liability) depends on complex actuarial, investment-performance and interest rate assumptions.

I used to date an actuary who made those pension fund calculations for public companies. She's wicked smart. Masters degree in mathematics from NYU. One night she was explaining her job, and I asked "so after all that work the estimates must be pretty reliable." She laughed so hard her chewing gum ended up in her riesling.

Analyst earnings estimates exclude pension adjustments for very good reason.

So let's take that $270mn back out of net income.

By the way -- how did $630mn in changed pension assumptions get JCP a $270mn deferred tax asset? I can't figure it out. I spoke to two highly-skilled corporate tax attorneys about it and they were both totally mystified as well. One of them called his ERISA partner for a consultation and he couldn't figure it out either. I don't mean to imply that JCP did anything wrong, but it would be nice if JCP explains that tax benefit when it files its 10-K.

The other adjustments also involve taxes. If you look at the table in JCP's earnings press release that shows how JCP calculated adjusted net income and earnings per share, you'll see that JCP made the adjustment net of its taxes at its statutory rate of 38.5%. The adjustments should have been made at the company's effective tax rate. JCP's effective tax rate is 0%.

Make that correction, and watch what happens to net income and EPS...

Free Cash Flow

Some folks have touted JCP's positive free cash flow for 4Q. JCP is a seasonal retailer. It converts dollars to inventory in 2Q and 3Q, then in 4Q it converts inventory to cash. I'm not aware of anyone who believed that JCP would be free cash flow negative in 4Q.

For the year, using industry-standard calculations, free cash flow to the firm was -$2.49bn. That's how much cash JCP burned during the year. Unless JCP can find a way to reduce its burn-rate, that's how much it will have to spend to survive FY14. Right now it only has $2bn.

Claims that 4Q showed that JCP is now cash-flow positive, or that 4Q showed JCP will be cash-flow positive in FY14, are just wrong. During JCP's earnings conference call one participant asked the CFO whether JCP expected positive free cash flow this year. I think the answer stammers for itself.

Liquidity

JCP's reported liquidity and its guidance for FY14 liquidity are consistent with, or a little worse than, I and others forecasted.

Consistent With -- Asset Sales and More Borrowing. I say "consistent with" because JCP's press release revealed that it has been selling non-operating assets to raise cash. $33mn in 4Q. JCP sold these assets for less than it paid for them, recording a charge to income. (It also took $18mn in additional impairment charges during the quarter. We don't know what was impaired.)

And on the earnings conference call JCP reported that it was already speaking to its lenders about exercising the $400mn accordion on its revolver. Meaning JCP wants to add $400mn in liquidity. JCP said those talks are going well, but the lenders haven't said "yes" yet. JCP may have to pay either a one-time financing fee or a higher interest rate.

That's important because JCP has to repay $650mn on its revolver this quarter. (See page 7, here.) It can immediately borrow money on the revolver to cover the debt maturity -- but not at the same interest rate -- and if it's negotiating with its lenders for more capacity at the same time...

Worse Than -- Letters of Credit. I also said "a little worse than" forecasted. That's because JCP wasn't able to reduce its outstanding letters of credit. The LOCs are outstanding because JCP vendors won't sell to JCP without a guarantee of payment from a more credit-worthy party. JCP's use of LOCs skyrocketed in 2013. By the end of 3Q it had $718mn outstanding -- out of a total of $750mn capacity in the revolver.

I thought that JCP would be able to close-out $300-400mn of that in January as it repaid vendors, but apparently that wasn't the case so JCP has less revolver capacity than I expected.

This is a serious threat to JCP -- if JCP's vendors stop trusting JCP's credit the company may find itself facing greater and greater difficulties through 2014 as it builds inventory for 4Q.

SG&A and capex

JCP reported spending $200mn less in 4Q on SG&A than expected, and $40mn (22%) less on capex than it said it would at the start of the quarter. When asked how JCP avoided spending that money, management coyly avoided any concrete answers.

These are very large deviations from expectations. Something happened.

Every year between 2003 and 2012 JCP's 4Q SG&A was 20%-50% higher than in other quarters. That makes sense because part of SG&A is variable rent tied to revenue, it costs more to advertise during the holidays, JCP uses seasonal workers, it's open more hours in 4Q, and so on. But in 2013 SG&A somehow dropped between 3Q and 4Q.

The picture gets worse the closer one looks inside JCP's SG&A. Advertising and rent expense are easy to estimate (at a total of $375mn). SG&A also includes things like utilities, IT, administration, and so on that shouldn't change much from year to year. With all of that factored in, the gap is $400mn that JCP didn't spend on... something. A lot of SG&A is employee compensation but there were no layoffs in 4Q. So what got cut?

As for capex, in November JCP said it expected to spend $175mn in 4Q. That should have been a reliable estimate since the quarter had already started and capital expenditures are usually planned. But JCP only spent $137mn. That's a big difference. Looking inside JCP's capex, historically about 85% went to building new stores, renovations, upkeep, and the like. What didn't JCP spend $38mn on?

I don't know for sure, and if JCP's 10-K is as opaque as its last few we may never know. But I have an educated guess. You may remember those pictures of JCP stores in decay and disarray that appeared at the start of the year, like this one:

(Originally posted at http://www.huffingtonpost.com/2014/02/19/jcpenney-photos_n_4810896.html)

I think that's what JCP didn't spend $400mn in SG&A and $40mn in capex on -- maintaining its stores. I think management decided the company needs to preserve cash so badly that it's willing to let the stores fall apart.

(By the way -- think of what JCP's EPS would have been if it either spent the money to maintain its stores, or took an impairment charge for their reduced value.)

This does not bode well for JCP's ability to improve margins or net sales going forward. And it certainly isn't good for creditors.

Realistic Prospects for Survival

A few weeks ago, I wrote an article discussing what combinations of SG&A, net sales growth, and gross margins JCP would have to hit and sustain to reach operating break-even and then profitability.

The math has not changed.

SG&A. JCP reduced SG&A substantially in 4Q, but I suspect it will either end up spending the same dollars later, or make up the difference with lost sales and asset impairments. The SG&A drop is so unusual that it's appropriate to remain skeptical until JCP provides a concrete and sensible explanation for the savings. (It could, say, provide a breakdown of SG&A in its 10-K, instead of lumping 60% into "other.")

Margins. JCP's gross margins have not improved. (I thought they'd drop to 27-28%; they dropped to 28.4%.) Of course management is still giving guidance that margins will improve drastically, but it's been giving that same guidance for a year without result. Gross margins remain stuck at 28-29%. JCP needs to hit 36% and stay there to have a chance.

Sales. Management's guidance for next year is 3-5% comps. Taking store closings, that's 2.3%-3.3% in net sales growth. (Or it could mean that management is planning more store closings than it said. I would not be surprised to see a steady stream through the year as store leases expire and are not renewed.)

Every bull case for JCP offered on this site over the last 3-4 months assumed net sales growth of greater than 4%. Some went as high as 7%. Management is forecasting 3.3% at best.

Creditors, and The Bottom Line

JCP managed to not collapse during the holidays, which is something for shareholders to be happy about I suppose. But it's on the same path it's been on. It spends more money on its operations than it takes in. That means it will need to keep borrowing, and in not-very-long-unless-something-extraordinary-happens it will run out of sources of cash and that will be it.

To be clear, even if JCP can meet the sales growth, SG&A, and margin hurdles discussed above, that would not mean a cent for JCP's shareholders. It would mean that the company can ultimately achieve positive free cash flow to the firm, which means that if JCP declared bankruptcy it might be able to restructure and survive as a going concern. Positive earnings for shareholders don't seem to be even on management's horizon.

As for the price, JCP's stock is still trading as an out-of-the-money call option. The price will go up on good news, it will drop on bad news. It's a volatile stock.

By the way, while JCP's 4Q performance didn't do much for shareholders, it sure didn't help creditors. Selling non-operating assets while letting operating assets fall apart buys the company a little time and marginally improves the chances of a recovery, but definitely means less value for creditors if the firm fails.

In the meantime, while event-driven traders and the easily-misled drive the price up, now is an excellent entry point for those who want to take short positions on the debt through CDS or other derivatives.

Finally

I don't think I'm going to be writing much about JCP on this site in the future. I originally wrote about it because I had already analyzed it in great detail in valuing the company's debt, because there was just so much misinformation and distorted analysis out there that I felt a correction was in order, and because I thought it might be fun.

But at this point JCP is a problem I've already solved. The company is doing just about exactly what I thought it would.

Plus, with the changes to SG&A and capex, JCP now has earnings and financial-reporting quality issues that are going to be a real bear to penetrate.

I wrote this article because a number of people asked me to update my views in light of the earnings announcement. I may comment a bit on future JCP articles, and I may have something to say when the 10-K comes out, or if there's a major corporate announcement. But I'm getting out of the JCP fray.

It's time to start looking at more interesting companies.

Source: Back To Reality: No, J.C. Penney Did Not Beat Earnings (In Fact It Has New Problems)

Additional disclosure: I briefly held a small short position in JCP stock through derivatives because someone dared me to. Also I bought a suit there once. I was in college and a friend of the family was getting married. I liked that suit - had it for years.