J.C. Penney: What Are The NOLs Worth?

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 |  About: J.C. Penney Company Inc. (JCP)
by: Elephant Analytics

Summary

J.C. Penney will likely generate taxable income at revenues above $13.75 billion. At that point, its accumulated NOLs will become useful.

The present value of NOLs is likely around $2.50 per share in bullish scenarios, but under $1 per share in bearish scenarios.

Valuation calculations involving post-tax numbers (such as EPS) should be adjusted, due to the temporary effect of NOLs in reducing taxes.

This article will attempt to put a value on J.C. Penney's (NYSE:JCP) net operating losses (NOLs). J.C. Penney could have approximately $3 billion in NOLs by the end of 2014 that can be carried forward and used to offset future taxable income. Depending on J.C. Penney's growth trajectory, the NOLs could have a present value (based on tax savings) of under $1 per share in bearish scenarios, or $2.50 per share in bullish scenarios.

When Will NOLs Become Useful?

The accumulation of NOLs will not actually benefit J.C. Penney until it can generate some taxable income. The NOL carryforward starts expiring in 2032, so J.C. Penney does have a lot of time to return to profitability so it can use its NOLs.

J.C. Penney will likely report positive income before taxes if it can get revenues above $13.75 billion, with 37.5% to 37.6% gross margin. This assumes approximately $4.175 billion in SG&A and approximately $1 billion in combined depreciation and amortization expense, interest expense, pension expense and any other miscellaneous expenses.

Revenue ($ Million)

$13,750

Gross Margin ($ Million)

$5,167

SG&A ($ Million)

$4,175

Depreciation & Amortization ($ Million)

$600

Interest Expense ($ Million)

$392

Income Before Taxes ($ Million)

$0

Click to enlarge

For every billion in revenue above this mark, J.C. Penney will increase income before taxes by approximately $290 million. At an average revenue of around $14.8 billion per year, J.C. Penney will take approximately 10 years to use up its NOLs. At average revenues of around $15.8 billion per year, J.C. Penney will take approximately 5 years to use up its NOLs. This does assume a relatively static state of affairs, as J.C. Penney's profitability point would change if it did something like close a couple hundred stores.

Present Value of NOLs

With $3 billion in NOLs, J.C. Penney could potentially save $1.05 billion in taxes, based on a 35% effective tax rate. The present value of those NOLs changes depends on when J.C. Penney can use them, though. With an 8% discount rate, the present value of the NOLs will likely be around $2 per share if it can achieve profitability within a few years.

In a strong scenario for J.C. Penney (high-single digit growth from 2014 to 2016, followed by 5% growth in 2017 and 2018, 4% growth in 2019 and 3% growth in 2020), the PV of the tax savings from its NOLs is estimated at $743 million, or $2.44 per share.

2016

2017

2018

2019

2020

Revenue ($ Million)

$14,522

$15,249

$16,011

$16,651

$17,151

Gross Margin ($ Million)

$5,460

$5,733

$6,020

$6,261

$6,449

SG&A ($ Million)

$4,250

$4,325

$4,400

$4,465

$4,515

Depreciation & Amortization ($ Million)

$600

$600

$600

$600

$600

Interest Expense ($ Million)

$392

$392

$360

$315

$260

Income Before Taxes ($ Million)

$218

$416

$660

$881

$1,074

Taxes Saved From NOLs ($ Million)

$76

$146

$231

$308

$288

PV of Tax Savings From NOLs ($ Million)

$66

$116

$170

$210

$182

Remaining NOLs ($ Million)

$2,782

$2,365

$1,705

$824

$0

Click to enlarge

In a more moderate growth scenario for J.C. Penney (mid-single digit growth from 2014 to 2016, slowly decreasing to 1% growth by 2022, the PV of the tax savings from its NOLs is estimated at $563 million, or $1.85 per share.

2017

2018

2019

2020

2021

2022

2023

2024

2025

Revenue ($ Million)

$13,933

$14,212

$14,496

$14,714

$14,934

$15,084

$15,234

$15,387

$15,541

Gross Margin ($ Million)

$5,239

$5,344

$5,451

$5,532

$5,615

$5,671

$5,728

$5,785

$5,843

SG&A ($ Million)

$4,190

$4,220

$4,250

$4,270

$4,290

$4,310

$4,320

$4,340

$4,350

Depreciation & Amortization ($ Million)

$600

$600

$600

$600

$600

$600

$600

$600

$600

Interest Expense ($ Million)

$392

$392

$392

$392

$375

$350

$320

$285

$245

Income Before Taxes ($ Million)

$57

$132

$209

$270

$350

$411

$488

$560

$648

Taxes Saved From NOLs ($ Million)

$20

$46

$73

$95

$123

$144

$171

$196

$183

PV of Tax Savings From NOLs ($ Million)

$16

$34

$50

$60

$72

$78

$85

$91

$78

Remaining NOLs ($ Million)

$2,943

$2,811

$2,603

$2,333

$1,982

$1,571

$1,083

$522

$0

Click to enlarge

There is a risk that J.C. Penney will end up with flat or negative growth in the long run, which would further reduce the value of its NOLs. J.C. Penney is also likely to have cash flow that is greater than income before taxes for a while (due to depreciation and amortization expense exceeding capital expenditures). In that scenario, J.C. Penney is able to tread water (cash flow-neutral or positive), but may not be able to take full advantage of its NOLs (as actual income before taxes may be negative). For example, a J.C. Penney that has revenue growth flatten out at around $13.5 billion is likely to report negative income before taxes, but also generate slightly positive cash flow. If J.C. Penney has revenue that stays stuck in the $14 billion to $14.5 billion range, it will generate income before taxes of approximately $100 million to $200 million per year, with the result that some of its NOLs carryforwards will expire without being used. In that case, the present value of its NOLs may be under $1 per share.

Effect On Valuation Metrics

If J.C. Penney makes it back to profitability and can utilize the NOLs, care must be taken to account for the effect of the NOLs when calculating valuation metrics. I think the best way to approach valuation metrics would be to operate as if J.C. Penney was actually paying regular income tax rates, and then add the present value of the NOLs to that calculation.

Here's a fictional example of how NOLs can affect net income and therefore related valuation metrics. The company makes $500 million before income taxes. Without NOLs, it needs to pay 35% income tax, and ends up with net income of $325 million. With NOLs of $500 million or more, it can fully offset its taxable income, and thus does not need to pay income tax. Net income is $500 million in this case.

In $ Million

Without NOLs

With NOLs

Income Before Income Taxes

$500

$500

Income Taxes

$175

$0

Net Income

$325

$500

Click to enlarge

If we were to apply a 15x multiple to trailing year net income, it would suggest a valuation of $7.5 billion with the usage of NOLs and a $4.875 billion valuation without NOLs. This is obviously problematic, since $500 million in NOLs (resulting in a tax savings of $175 million) creates a $2.625 billion increase in market capitalization if we just apply the 15x multiple.

$ Million

Without NOLs

With NOLs

Net Income

$325

$500

Market Cap @15X Net Income

$4,875

$7,500

Click to enlarge

A more effective way of doing the calculation would be to use the 15x multiple on a net income number calculated as if there was no NOLs usage, and then add the present value of the NOLs to that figure. In this particular example, the $500 million in NOLs that were used in the previous year would raise the estimated market capitalization value from $4.875 billion to $5.050 billion. If the company had $3 billion in NOLs, using $500 million in the trailing year, with $2.5 billion used over the next four years, the resulting PV would be $639 million at a 8% discount rate. This would change the estimated market capitalization from $4.875 billion to $5.514 billion.

$ Million

Without NOLs

With $500 million in NOLs

With $3 billion in NOLs

Market Cap

$4,875

$5,050

$5,514

Click to enlarge

For valuation calculations involving EBITDA, the EBITDA number does not change due to the NOLs. However, the present value of the NOLs should be added to the valuation calculation. For example, if one valued J.C. Penney at an EV/EBITDA ratio of 6.0x and J.C. Penney made $1 billion in EBITDA, its enterprise value would be estimated at $6 billion. To this, we could add the present value of its NOLs (perhaps $600 million), which would bring its estimated enterprise value up to $6.6 billion.

Conclusion

Although I haven't paid overly much attention to the potential value of J.C. Penney's NOLs in the past, it would be prudent to estimate the present value of the NOLs and use them as an additive factor to any valuation calculations. There is some uncertainly about the value of the NOLs currently, since that value depends on when J.C. Penney can return to a positive level of income before taxes. In the more bearish scenarios, the present value of the NOLs may be under $1 per share. With stronger growth, the present value of the NOLs may reach $2 to $2.50 per share.

Disclosure: The author is short JCP. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: My position on JCP is best classified as short long term and neutral short term.