J.C. Penney: Q4 Consensus Earnings Beat Is Reasonable

| About: J.C. Penney (JCP)

This past Feb. 4, before the market open, J.C. Penney (NYSE:JCP) provided a financial update titled "Turnaround Remains On Track" (an 8-K press release). In the update the company disclosed relatively little substantive information about the much-anticipated period, Q4 FY 2013. Investors have been eagerly awaiting the full earnings release, scheduled for Feb. 26 after the market closes. In the meantime, they were likely hoping for more nitty-gritty content.

The company disclosed just three nuggets for analysts to mull over:

1. The company reported comparable YoY store sales growth of 3.1% for the period including November and December combined.

2. They reported a 2.0% increase of comparable YoY store sales growth for the full third quarter. While the precipitous fall in sales seems to have slowed, this figure missed estimates and indicates a tougher December and January than the bulls had been hoping for. Presumably, this was the catalyst for the ~12% fall on the day of the release.

3. The release states: "In addition, the company closed its 2013 fiscal year with total available liquidity in excess of $2 billion."

So, Where Are We Now?

Much recent discussion and speculation has ensued, mostly spurred by the information provided in items No. 1 and No. 2 above. With the top-line revenues now divulged, the conversation has turned to speculation about present gross margins and the new SG&A in order to understand the net income for Q4 and to predict operating performance for FY 2014 and beyond. Shorts are forecasting thinner-than-historical margins, a result of presumed heavy discounting due to the fierce retail environment this past holiday season.

Additionally, the short thesis touts the dismal performance of 2012 and qualifies the recent gains as falling short of expectations despite a decidedly easy comparative YoY figure. Longs are pleased about the "first time since the second quarter of 2011 that J.C. Penney has generated a positive quarterly sales result" and point to key turnaround initiatives that have only just begun (primarily the return of private label brands and the re-implementation of promotions) to recapture the core customer base that was alienated in 2012. Long bargain hunters, that like the recent discount in the stock, are perhaps hoping for a short squeeze now that nearly one-third of the outstanding is sold short -- nearly half of the float is short as of Jan. 15, 2014 (Nasdaq short interest)

Total Available Liquidity in excess of $2 Billion

To me, the most intriguing part of the release was this statement -- not that it went unnoticed by any means. Most of those interested in JCP -- which is an unprecedented amount of people by the way (average daily volume is ~32M shares) -- are very interested in total available liquidity (TAL). TAL is the measure of all cash and cash equivalents plus the available amount of established credit lines. The TAL is vitally important, especially in an ailing business. A business with insufficient TAL will struggle to dispose of short-term payables and may not be able to reliably support its cash needs throughout the year. A low TAL leaves a business without an adequate cash buffer to sustain further losses or to weather a business disruption or downturn. A low TAL is generally an unsustainable position for very long and it will drive management to raise capital one way or another.

To the chagrin of the JCP bears, the JCP bulls are actually pleased with the "excess of $2 billion." Most analysts believe that this TAL will amply sustain JCP as the turnaround matures and the company rejiggers their business to the new landscape. The naysayers predict continued deep losses and new liquidity issues in Q3 FY 2014, the historic cash low point for retailers. I haven't seen a salient model that demonstrates this, but I have to concede that it's within the realm of possibility.

Reverse Engineer EPS From Total Available Liquidity

While I'm certainly interested in the liquidity outlook for JCP and their ability to muddle through, I had an idea: Could I derive an estimate of the FY 2014 Q4 EPS without predicting margins, without even knowing sales, and without speculating about SG&A or other operating expenses? Could I arrive at a more accurate or prescient forecast than others? My answers are yes and maybe, respectively. But, with relatively sound information now defining the Δ (change) in TAL, it is possible -- while employing other somewhat-knowns and making other different assumptions (other than gross margin, etc.) -- to derive an estimate of EPS.

The TAL at EOQ 3, as per the earning release on Nov. 20, 2013, was $1.71B. The new TAL at EOQ 4 (on Jan. 31, 2014), as per the recent release, was "in excess of $2 billion." Clearly, that's more than $2B -- but how much more? For the purposes of this exercise let us hypothesize that "in excess of" would not be used if the actual number were nominally close to $2B, rather one might say "about $2B" or simply "$2B" if the figure were less than $2.025B. Conversely, if the actual number were substantially greater than $2B, "in excess of" would just be coy. So, I peg the upper end of reasonable at $2.075B, meaning that at sufficiently close or just over $2.1B, one would just say "$2.1B," or even "in excess of $2.1B." A nice clean figure in the latest release would have saved me this laborious discourse, but it would have cost you your last chuckle.

To get to EPS from ΔTAL as well as other inputs, the math is relatively simple algebra -- for those interested, I encourage you to work it out for a good time. For the purposes of this article, you'll have to take the following at face value:

- Depreciation
+ Interest Expense
+ Capex
+ ΔInventory
- ΔA/P
+ Real Tax Expense
- Financing Activity
+ Additional Investing Activity
+ ΔA/R
- ΔLine of Credit ((NYSE:LC))
+ ΔLC limitations

EPS = EBIT - Interest Expense - Tax
Outstanding Shares, 304.6M

So, Let's Get EBIT

Before we begin, we can simplify the above a bit by discarding certain inputs that are likely zero, de minimis, or inconsequential.

Let's initially assume the following:

Real Tax Expense = 0
JCP will not incur a real tax expense in Q4. And the IRS will not be sending them a refund check for their carry-forward, either. We will consider the soft tax gain later on for the purposes of generating a consistent EPS, once we obtain the EBIT estimate.

Financing Activity = 0
It sounds as if financing activity could be nominal.

Additional Investing Activity = 0
Let's assume additional investing will be nominal.

ΔA/R = 0
Both A/R and the ΔA/R are inconsequential to this exercise for a retailer like JCP.

ΔLine of Credit (LC) = 0
I'm assuming the $1850M line of credit will not materially change from last quarter. (p. 7, Credit Facility, of the FY 2013 Q3 10-Q)

ΔLC limitations = 0
The LC is reduced by the sum of the face value of outstanding LOCs (letters of credit). The remainder, after short-term debt, is further reduced by a risk ratio. That leaves the amount of credit available to the TAL sum. I'm just assuming the existing LOCs and the risk ratio do not change materially for this exercise.

Now that we have this reduced:

- Depreciation
+ Interest Expense
+ Capex
+ ΔInventory
- ΔA/P

EPS = EBIT - Interest Expense - Tax
Outstanding Shares, 304.6M

The Relatively Easy Assumptions

ΔTAL = $315M to $365M (from above)
Split the difference at $340M, meaning current TAL is $2050M.

Depreciation = $165M
(per Company Outlook, Nov. 20, 2013)

Interest Expense = $99M
(Same as Q3)

CAPEX = $175M
(per Company Outlook, Nov. 20, 2013)

ΔInventory = $2850M - $3747M = $-897M
(per Company Outlook, Nov. 20, 2013 and Q3 Balance Sheet)

And, now the tricky one, ΔA/P:

The higher the proposed EPS loss, the more chance that A/P has been stretched (via exacerbated or continued slow paying) in order to preserve TAL. If for some reason the A/P is lower than expected, then, based on the affirmed TAL, and holding the other assumptions constant, EPS must be "handsome" -- comparatively speaking. In math speak: ΔA/P is proportional to ΔTAL, but inversely proportional to EPS.

I put the following range on ΔA/P: (remember, change in A/P)

ΔA/P = $-459M to $-246M

At FY2013 Q3, A/P was $1409M
A Δ of$-459M would represent just the average reduction in A/P from Q3 to Q4 for the last four years, about 32%. I think this is possible, but let's call it the bull case anyway. The high of the range, $-246M, reflects a slowly paid or expanded A/P, similar to FY 2012, just a 17.47% reduction in A/P from Q3 to Q4, our bear case. A reasonable Δ might be -$309M, which reflects a nearly 22% reduction in A/P from Q3 to Q4 -- worse than most years, but better than FY 2012. A Δ of -$309M leaves the A/P balance at $1100M at the end of Q4, a believable figure. The high of the range of the delta would result in a Q4 A/P of $1163M, and the low of the range puts Q4 A/P at $950M, which would be somewhat low.

EPS Conclusion

So, considering the above assumptions, a conservative (reasonable) estimate of Q4 FY 2013 based primarily on the reported ΔTAL winds up at -$0.51/ share. That is substantially better than the recent consensus EPS of -$0.81. (Incidentally, in other models, a $.51 loss, may support a 33.5% gross margin, which is not too shabby at all.)

If you apply the ranges, the realm of possible EPS with this approach is actually fairly narrow. More importantly, the high and low both beat the current consensus. But keep in mind this exercise is assuming that additional investing activity, beyond Capex, was nil -- any sold assets in the period would bring the EBIT and EPS down.

See the table I created below for the "reasonable," bear, and bull results:

Q4 FY 2013 EPS Estimates

Click to enlarge image.

As it turns out, and not too surprisingly, if you know JCP's merchant A/P balance as of Jan. 31, 2014, then you are likely armed with all you need to drastically narrow the EPS forecast range even further.

What Does All This Mean?

It means the Street consensus could be far too pessimistic based on the information at hand. Despite the volatility and inherent risks, I recommend strongly considering a long position for now, before the earning release on Feb. 26, but only if your philosophy allows you to play in this territory.

I see a short argument that needs a Chapter 11 filing soon in order to pay out. Otherwise, there is no near-term upside, and the short and wait strategy is just reckless at this price. A filing soon looks to be out of the cards at the moment, all things considered. Like it or not, JCP is not Kmart, and their offerings have staying power in today's retail landscape. I'm always surprised when I hear folks flippantly remark that a $12B retailer with a thriving dot-com has no place in America.

Best of luck to both sides, to CEO Mike Ullman (the pressure is on), and to an iconic American brand, founded before many had electricity or a telephone, before most had a car, and 81 years before JCP.com began.

Disclosure: I am long 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.

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