Can J.C. Penney Survive?

Mar.12.14 | About: J.C. Penney (JCP)


Despite recent cutbacks and success during the holiday season, investors seem bearish on J.C. Penney.

What is the company's vision for the future, given its recent liquidity and dilution?

Can J.C. Penney continue to compete with giants such as Macy's and Costco?

When major investment gurus try to jump ship, it is generally a good indication that the company is not headed anywhere good. This seems to be the case with J.C. Penney & Co. (NYSE:JCP), which has not been performing anywhere above the red line in the past couple of years. This is not to say it is not trying, especially since comps improved in the last two months of 2013. However, as we will see below, there are major problems and the outlook for 2014 does not look bright at all.

The Good News First

JCP managed to post positive comps data in November and December 2013, showing a rise of 3.1%. This is in fact better than that of Sears, which declined 9% in the nine weeks ending Jan. 4. Furthermore, JCP has recently closed 33 stores, most of which were located in small neighborhoods and were not driving much traffic anyhow. These stores are expected to save JCP about $65 million a year, which, though not very significant, can still be counted as a plus.

However, one should keep in mind that JCP had the luxury of comparing to a period when it had been floundering. Any improvement therefore appears to be exaggerated. On the other hand, Macy's (NYSE:M) witnessed rise in comps to the tune of 3.6% in the same time frame. Unlike JCP, Macy's did not have the bleak late-2012 performance to exaggerate its current performance.

Stock Dilution, Major Investors Exiting JCP

Even if we consider the rise in comps to be an indicator of better things to come, what cannot be regarded as such is the 39% share dilution that the company saw in 2013. Its shares at the start of the year stood at 220 million, but have now risen to 305 million. This was perhaps the reason Kyle Bass-led Hayman Holdings decided to exit its position in JCP. The firm sold its 5.7 million shares for $52 million, thus incurring a substantial loss.

Add to this the bitter Valentine's Day news that George Soros' Soros Fund Management had sold its entire holding of the company in Q4 2013. Soros had been the biggest shareholder of JCP with about 20 million shares. Finally, these moves come on the heels of similar exits by David Tepper and Richard Perry. Even earlier, Bill Ackman's Pershing Square had sold its stake in the company.

Liquidity Woes

The primary reason behind the share dilution was the cash burn that the company is suffering from. Over the past year, JCP had a negative operational cash flow of $1.5 billion. Moreover, it has a debt to equity ratio of 2.1, which is far worse than Macy's 1.3. It is marginally worse than Sears' 2, but this will not give much cheer to investors.

According to Charles Grom, JCP may fall into liquidity trouble in late 2014:

We had always expected a sales recovery at J.C. Penney, but running our model at the current pace of recovery raises concerns about J.C. Penney's liquidity in a few quarters. To this point, our base case currently incorporates a 2.0% comp in FY 2014 and a potentially generous gross profit margin recovery to 35.5%, but this still results in ~$800 million in cash burn, including ~$1.26 billion burn through Q3 2014's peak seasonal inventory build -- as a result, cash levels fall to very low sub $250 million levels in Q3 2014, which we believe may be too tight for vendors' comfort…

In our view, dangerously low liquidity levels augment the odds of another capital raise and we believe the company may/should choose to act sooner rather than later (particularly with the stock rallying from $5 to $6 recently) when options are more limited. To this end, we estimate the company may need a $500-$750 million liquidity infusion given the current pace of sales/margin recovery.

This translates into further share dilution and more exits by investors.

JCP's Outlook for the Future

JCP has done away with the everyday low prices introduced by Ron Johnson, but its core customer base, the baby boomers, are yet to return to it. Furthermore, they too have started looking for bargains, as more and more of them are retiring. This makes it imperative that JCP lower its prices. This may raise sales, but it cuts into its profit, since JCP has never quite been the low-price store that Wal-Mart (NYSE:WMT) or Dollar General (NYSE:DG) have been. On the other hand, it is not a store catering to high end customers like Michael Kors (NYSE:KORS).

Finally, JCP lacks the connect with millennials, who prefer to shop through various media, online and offline, and prefer to have it as integrated as possible.

Investors' Takeaway

JCP seems to be making credible attempts to beat the gloomy forecasts and turn itself around. Indeed, its plunging sales may indeed be bottoming out. However, if it has to raise its sales and win back customers, it will have to be at the cost of lower profit margins, which will translate into worsening cash situation. If this goes on, share dilution will continue. Since share dilution was one of the main reasons for the exit of big investors, this will only worsen the already low investor confidence. In such circumstances, it is hard to see where JCP's turnaround will come from. Investors are advised to stay away from JCP stock even if it is falling, while new investors would be better off looking at options like Macy's and Costco (NASDAQ:COST).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.