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Summary

  • Q4 SG&A drop was probably mostly due to timing and accrual reversals.
  • If J.C. Penney meets or exceeds guidance, bonus payments and merit increases will affect future SG&A.
  • J.C. Penney is likely looking at three-plus years of tight liquidity conditions if it doesn't do an equity offering.

After taking a look through J.C. Penney's (NYSE:JCP) 10-K filing, it appears that the surprising Q4 SG&A drop is likely mainly due to timing and accrual reversals. The full-year SG&A number is an accurate reflection of J.C. Penney's financial position, but Q1 to Q3 were likely overstated a bit initially, resulting in a reversal that affected Q4.

Aside from that, J.C. Penney's SG&A in upcoming years will be influenced by its performance. If J.C. Penney misses guidance, SG&A will likely be reduced further. If J.C. Penney meets or exceeds guidance, there will be upward pressure on SG&A. The main implication of this is that J.C. Penney may be able to avoid needing extra funding (beyond the accordion feature) if it misses guidance by a bit, but will also face tight liquidity and be unable to significantly reduce its debt burden for several years, even if it makes guidance.

Looking At Q4 SG&A

The drop in SG&A for Q4 was primarily affected by three items. The first item was a decrease in salaries of approximately $98 million. Another item was an increase in private label credit card income of $63 million, which is expressed as a reduction in SG&A. The third item was a decrease in miscellaneous items of $33 million.

The size of the increase in private label credit card income was a bit surprising, since it was a significant increase from the $7 million year-over-year change in Q3 and the $13 million year-over-year change in Q2. J.C. Penney did extend the term of its private label credit card agreement in October, so it is possible that some bonus payment related to the new agreement took place in Q4.

The $98 million decrease in salaries was partially related to the 14-week Q4 period in 2012. The reduction to 13 weeks in Q4 2013 likely saved J.C. Penney over $40 million in salaries and related benefits. As well, the salary run-rate in 2013 was around $15 million per quarter less than 2012 due to the impact of layoffs in early 2013. That still leaves $43 million in unexplained salary reductions, despite increased operating hours for Thanksgiving/Black Friday this year. There hasn't been any news about mass layoffs that would have affected Q4 salaries by that extent ($43 million in salary during Q4 is probably equivalent to nearly 10,000 non-corporate jobs). My conclusion is that much of this reduction may have been due to the reversal of some bonus accruals that took place during the year.

Companies would typically accrue for any year-end bonuses throughout the year. Although J.C. Penney produced weak results overall throughout 2013, the results were still much closer to its target numbers than in 2012. So J.C. Penney may have done a partial accrual for bonuses during 2013 (vs. no accrual during 2012) in anticipation of paying out some bonus this year, after mostly eliminating it in 2012. However, the weak finish to Q4 meant that most of the bonuses were not going to be paid anymore, and the accrual could be reversed in Q4, lowering that quarter's SG&A results.

The miscellaneous items are hard to figure out, but there was a $30 million increase in miscellaneous items in 2012, so the decline in 2013 could be mainly a reversal to the mean.

SG&A Going Forward

Going forward, it appears that further changes to SG&A will be significantly correlated to J.C. Penney's sales and margin performance. A J.C. Penney that misses guidance will not have to pay out much in terms of employee bonuses, and merit increases will likely be delayed for another year. A J.C. Penney that meets or exceeds guidance will be paying out employee bonuses this year, and will have merit increases that would affect 2015 SG&A rates. The merit increases for 2015 might be larger than average due to compensating for the stagnation in employee pay over the last couple years.

What this means is that J.C. Penney will have lower SG&A, leading to smaller losses if it misses guidance, but will also have upward pressure on SG&A if it meets or exceeds guidance, limiting top-end EBITDA.

Below is a look at SG&A for J.C. Penney under various scenarios. If J.C. Penney misses guidance for 2014, there will be no bonus payments in 2014 and no merit increase for 2015. If it meets guidance, bonus payments of $75 million have been factored in, while bonus payments are estimated to reach $100 million if it exceeds guidance.

2014 performance also affects 2015 SG&A, with missing guidance resulting in a slight decrease in SG&A, while meeting or exceeding guidance results in a 2% to 2.5% increase in SG&A.

If J.C. Penney continues to miss guidance, its SG&A will go down further in 2016, while meeting or exceeding guidance will result in a 1.25% to 1.8% increase in SG&A in 2016. For reference, Kohl's is anticipating a 1.5% to 2.5% increase in SG&A in 2014.

SG&A

($ Million)

2014

2015

2016

Misses Guidance

$3,950

$3,925

$3,900

Meets Guidance

$4,025

$4,100

$4,150

Exceeds Guidance

$4,075

$4,175

$4,250

Effect on Future Finances

One of the implications of the effect of bonus pay and merit increases on SG&A is that J.C. Penney's financial situation will likely be fairly similar whether it misses guidance or exceeds guidance (provided the miss or beat is not too extreme). In either case, J.C. Penney is looking at negative free cash flow (excluding working capital changes) of around $400 million to $500 million in 2014. Free cash flow in 2015 is likely to be around $0, ranging from slightly negative to slightly positive. Free cash flow in 2016 is expected to be barely positive.

In the below situation, J.C. Penney misses guidance, but still delivers slight growth of +2% in 2014 and 2015, followed by +1% in 2016. Gross margin increases to an average of 34% in 2014 and 37% in 2015 and 2016. SG&A uses the numbers from the "Misses Guidance" scenario above, while capital expenditure is set at a low $300 million in 2015 and 2016. The result is that J.C. Penney will have FCF of negative $508 million in 2014, and negative $83 million in 2015, and negative $12 million in 2016.

2014

2015

2016

Sales ($ Million)

$12,036

$12,276

$12,399

Same-Store Sales Growth (%)

2%

2%

1%

Gross Margin ($ Million)

$4,092

$4,542

$4,588

Gross Margin (%)

34%

37%

37%

SG&A ($ Million)

$3,950

$3,925

$3,900

EBITDA ($ Million)

$142

$617

$688

Interest ($ Million)

$400

$400

$400

Capital Expenditures ($ Million)

$250

$300

$300

FCF ($ Million)

-$508

-$83

-$12

Net Debt ($ Million)

$4,594

$4,677

$4,689

In this second situation, J.C. Penney exceeds guidance and delivers growth of +8% in 2014 and +5% in 2015 and 2016. Gross margin increases to an average of 34% in 2014 and 38% in 2015 and 2016. SG&A uses the numbers from the "Exceeds Guidance" scenario above, while capital expenditures are set at $400 million in 2015 and 2016, which is around the expected normal range for capital expenditures. The result is that J.C. Penney will have FCF of negative $392 million in 2014, and positive $110 million in 2015, and positive $289 million in 2016. Despite exceeding guidance and restoring margins to 38%, J.C. Penney will still have around the same net debt in three years as at the end of 2013 ($4.086 billion).

2014

2015

2016

Sales ($ Million)

$12,744

$13,381

$14,051

Same-Store Sales Growth (%)

8%

5%

5%

Gross Margin ($ Million)

$4,333

$5,085

$5,339

Gross Margin (%)

34%

38%

38%

SG&A ($ Million)

$4,075

$4,175

$4,250

EBITDA ($ Million)

$258

$910

$1,089

Interest ($ Million)

$400

$400

$400

Capital Expenditures ($ Million)

$250

$400

$400

FCF ($ Million)

-$392

$110

$289

Net Debt ($ Million)

$4,478

$4,368

$4,079

Conclusion

The challenge for J.C. Penney is that any result near its guidance (ranging from a moderate miss to a moderate beat) is going to result in negative free cash flow in 2014, necessitating the use of the accordion feature on its credit facility, and adding more debt to an already heavily indebted company. 2015 and 2016's results are likely to be better, but with near $0 free cash flow in either scenario, J.C. Penney is still flirting with disaster.

Even if J.C. Penney is able to meet or slightly exceed guidance, it is looking at a situation three years from now where it has around the same net debt and same tight liquidity issues as currently. I believe that it is very likely that J.C. Penney will do an equity offering at some point to attempt to reduce its debt burden, rather than trying to walk the liquidity tightrope for three or more years. The current situation leaves J.C. Penney extremely vulnerable to any stumbles in its turnaround or problems in the macro environment. An optional equity offering will be positive for J.C. Penney's financial health, but will further limit J.C. Penney's upside.

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.

Source: J.C. Penney: Walking The Liquidity Tightrope