J.C. Penney Must Exceed Guidance To Provide Long-Term Value For Bulls

Mar.15.14 | About: J.C. Penney (JCP)

Summary

The high end of J.C. Penney's guidance makes it worth around $8 based on historical valuation multiples.

To be worth more than $8, J.C. Penney needs to exceed sales guidance and hit the top end of its gross margin and SG&A reduction targets.

This results in the risk/reward ratio tilting against the bulls at J.C. Penney's current price.

J.C. Penney needs to either achieve bubble valuations or significantly exceed guidance for long-term upside above the $8 to $9 range it currently is trading at.

J.C. Penney (NYSE:JCP) has performed quite well recently, rising to near $9 from under $6 pre-earnings report. However, at its current price, the majority of the long-term risk falls on the bulls as J.C. Penney must execute at the high end of its guidance in all areas for it to be worth over $8 in two years based on historical valuations. If J.C. Penney can significantly exceed its guidance, bulls have some additional room for upside. However, any situation where J.C. Penney doesn't hit the top end of its guidance in all areas would make it worth $8 or less based on J.C. Penney's historical valuations.

J.C. Penney has brought back its former CEO from 2010, is implementing the same promotional strategy as 2010 and is re-introducing the same assortment of goods (private label brands and home goods) as 2010. I am therefore using March 2011 (after the FY2010 report) as a benchmark for J.C. Penney's valuation. This marks the last full year that Ullman was CEO. March 2012 does not appear appropriate since it included a healthy premium for early optimism about Ron Johnson, and March 2008 to March 2010 appears to have worse valuations for J.C. Penney than March 2011. Before 2008 was a different era for the mid-tier department store where J.C. Penney looked like it might get to $3 billion in EBITDA.

Guidance Exceeded Lowered Expectations

A lot of the optimism after guidance seems to stem from J.C. Penney exceeding expectations for when it was at the $5 to $6 level. Certainly its guidance was significantly better than my expectations prior to earnings. However, its guidance was mostly in line with my expectations in January, when it was trading around $7, before both the market and myself got more pessimistic.

Here's a look at my expectations for J.C. Penney from that January article.

Q1 2014

FY 2014

Same Store Comps

+4.6%

+4.8%

Gross Margin %

32.7%

34.9%

SG&A ($ Million)

$1,020

$4,197

Capital Expenditures ($ Million)

$75

$300

Click to enlarge

J.C. Penney guided down capital expenditures to $250 million, and SG&A might be a little on the high side (although $4.2 billion is still "vastly similar" to the 2013 number of $4.15 billion). Generally though, my expectations for J.C. Penney were in line with J.C. Penney's own guidance. I previously mentioned that I anticipated J.C. Penney doing an equity raise to address low liquidity levels in Q3 2014. Instead, J.C. Penney appears to be addressing liquidity via potential utilization of the $400 million accordion feature on its credit facility. Either way, J.C. Penney seems to be overvalued even if it hits its guidance.

J.C. Penney in 2015

Here's a look at J.C. Penney's projected results in 2015 using the high-end of guidance.

Revenue ($ Million)

$13,131

Gross Margin @ 39% ($ Million)

$5,121

SG&A ($ Million)

$3,950

EBITDA ($ Million)

$1,171

Click to enlarge

If J.C. Penney has same-store growth of 7% during 2014 (the high end of its guidance) and 4% during 2015, then it will end up at $13.131 billion sales for FY 2015. Since 2013 had near-flat seasonally adjusted sales, a Q1 2014 growth rate of 5%, a Q2 growth rate of 6%, a Q3 growth rate of 7%, and a Q4 2014 growth rate of 8% (resulting in around 7% same-store growth for FY 2014) would imply a 4% growth rate for Q1 2015. That is why 4% growth is used for 2015.

To get to that $1.171 billion EBITDA number for 2015 would require J.C. Penney perform at the positive extremes of its gross margin and SG&A targets. Ullman has talked about getting to 37% to 39% gross margin at some point, although these numbers are not specifically laid out in guidance. J.C. Penney also did not provide full year guidance for SG&A, but mentioned that the 2014 number should be vastly similar to 2013. It could be slightly lower, the same, or slightly higher, but for the purposes of this exercise, we are using a number that is about $200 million lower than 2013.

Using figures that are at the mid-range of guidance (+5% growth in 2014, +3% in 2015, $4.1 billion in SG&A, and 38% gross margin) would give a 2015 EBITDA estimate of around $750 million.

Comparing 2010 to 2015

In 2010, J.C. Penney had $17.759 billion in revenue, $1.610 billion in EBITDA and was projecting low-to-mid single digit same-store sales growth for the following year. At the high end of guidance, J.C. Penney will report $13.131 billion in revenue in 2015, $1.171 billion in EBITDA and would likely project low-to-mid single digit same-store sales growth for 2016 if things go well. In 2015, J.C. Penney is expecting to do around 74% of 2010's revenue, 73% of 2010's EBITDA, and have a similar forward growth rate. Therefore, I am using 73.5% as the relative valuation ratio.

J.C. Penney's average enterprise value during March 2011 was $8.729 billion. Taking 73.5% of that would give us an enterprise value of $6.416 billion. However, net debt is estimated at $4 billion in 2015. Current net debt is around $4.09 billion at face value and J.C. Penney's guidance allows that to increase up to $4.5 billion at the end of 2014. The market value of J.C. Penney's debt will likely be much closer to face value if J.C. Penney produces positive cash flow in 2015, so allowing for some positive cash flow and a slight discount of debt to face value gets us to that $4 billion net debt number.

With net debt at $4 billion, the estimated value per J.C. Penney share in March 2016 is $7.94 at the top-end of its guidance ranges for sales growth, gross margin and SG&A. The main difference between March 2016 and March 2011 is that J.C. Penney had minimal net debt back then, and most of the value was in the equity. J.C. Penney is significantly smaller now and has $3.5 billion extra in net debt, so the majority of value is in its debt now.

FY 2010

FY 2015

2015 as % of 2010

Revenue

$17,759

$13,131

74%

EBITDA

$1,610

$1,171

73%

Next Year Comp Sales Growth

Low-to-mid single digits

Low-to-mid single digits

Same

Enterprise Value

$8,729

$6,416

73.5%

Net Debt

$477

$4,000

839%

Market Cap

$8,252

$2,416

29%

Value Per Share

$7.94

Click to enlarge

Conclusion

Essentially, any real upside for bulls at near $9 rests on J.C. Penney either achieving bubble valuations, or exceeding guidance for sales growth, hitting 39% gross margin and simultaneously reducing SG&A by at least $200 million. That is why I believe that the majority of long-term risk resides with the bulls at its current price. J.C. Penney's recent guidance is already priced in and then some. Should J.C. Penney only match its guidance or miss its guidance, then it would be significantly overvalued at its current price. At $9 J.C. Penney would trade at 9.0x 2015 EBITDA based on the mid-range of its 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.