Credit markets are grossly overstating the credit risk of J.C. Penney Company, Inc. (NYSE:JCP). CDS is at 865bps compared to an Intrinsic CDS of only 253bps, while cash bond YTW is at 10.570% relative to an Intrinsic YTW of 3.900%. Credit markets may be overlooking JCP's current substantial liquidity, which gives them a multi-year runway to solve profitability issues before they face their next material debt headwall in 2019.
Moody's is also overstating JCP's credit risk with a Caa1 credit rating three notches too high. Valens rates JCP at HY2+, or a highly speculative B1 equivalent using Moody's ratings scale.
Cash Flow Profile
This analysis uses Uniform Adjusted Financial Reporting Standards (UAFRS) metrics, or adjusted metrics, which remove accounting distortions found in GAAP and IFRS to reveal the true economic profitability of a firm. This allows us to better understand the real historic economic profitability of a firm as well as allows for better comparability between peers. To better understand UAFRS, please refer to our explanation here.
Below, we've included our Credit Cash Flow Prime™ chart for JCP. The chart provides a far more comprehensive view of credit fundamentals than traditional ratio-based analyses. By using Uniform Adjusted Financial Reporting Standards based metrics, it shows the cash flow generation and cash obligations related to the credit of the firm, adjusted for non-cash financial statement reporting distortions from GAAP. The blue line indicates the gross cash earnings (UniformFRS adjusted cash flow number) expected to be generated based on consensus analyst estimates and Valens Research's own in-house research team. The blue dots above that line include the cash available at that time while the blue triangles indicate that same amount plus any existing, available lines of credit.
The colored, stacked bars show the cash obligations of the firm in each year forecast. The most difficult obligations to avoid are at the bottom of each stack, such as interest expense. The obligations with more flexibility to defer year to year, such as pension contributions and maintenance capital expenditures, are at the top of the stacked bars. All of the calculations are adjusted for non-cash distortions that are inherent in GAAP accounting, including the highly problematic and often misused statement of cash flows.
If the company generates and has cash levels that are above their obligations, the risk of default is extremely low. Even if the cash generated yearly is close to the levels of the stacked bars, a company generally has the flexibility to defer payments of various kinds. For example, they can allow assets to age a little longer, or they can cut certain maintenance costs such as maintenance capex. While decisions such as those can create other business concerns, the issue in credit risk is simply this: Does the company have enough cash to service their credit obligations?
JCP's cash flows, combined with their cash on hand, would be sufficient to handle all operating obligations and debt maturities through 2018. However, their $2.45bn debt headwall in 2019 necessitates refinancing to avoid a cash crunch. One option is to decrease their yearly capex over the next three years to reduce the amount they need to borrow in 2019, given they still have a revolver until that year. However, even if they were able to overcome their 2019 headwall, they still have an $892mn debt maturity in 2020 that also needs to be refinanced.
That said, JCP's recovery rate on their credit facility is robust at 166% while their recovery rate on unsecured debt is at a neutral 58%. Given the company's strong +$2bn market capitalization, JCP should therefore have the ability to refinance their debt maturities and avoid a liquidity crunch.
Like most people, senior executives and board members do what they are paid to do. This is why JCP's Form DEF 14A is key to understanding this company's fundamentals, something that credit agencies seem to be missing. Valens' Incentives Dictate Behavior™ analysis focuses on JCP's senior executive compensation and governance. This analysis is meant to help investors understand corporate governance, how aligned a management team may be with shareholder interests, and the potential consequences of a management compensation framework to the business.
JCP's management compensation framework is positive for credit holders. Management's short-term compensation is based on sales, operating profit, and gross profit return on inventory (GPROI) while their long-term compensation is based on EBITDA and FCF.
This compensation framework incentivizes management to improve margins and grow the business. Furthermore, the FCF and GPROI metrics encourage management to drive said growth in an asset-efficient manner. These are positive for JCP since they need to improve profitability, increase revenue, and efficiently manage their asset base so they can manage the high fixed costs that they have struggled to cover since sales plunged in 2012.
Valens provides analyses of companies' statements on earnings calls, termed Earnings Call Forensics™. This analysis is meant to help assess a management team's confidence in their conference calls when discussing certain areas of the business such as operations, stability, strategies, their ability to manage business risks, and especially, their liquidity and solvency.
The analysis of JCP's Q3 2015 earnings call (11/13) highlighted highly questionable markers from management. Management appears concerned about sustaining their adjusted EBITDA, and may be overstating the enormous growth potential of their Men's, Women's, Home, E-commerce, and omnichannel segments going forward. (More about Valens' innovative research tools is available here.)
Ultimately, a company's credit risk (or lack thereof) is driven by cash available against cash obligations. JCP's credit risk is being grossly overstated by credit markets and overstated by Moody's. Although JCP needs to refinance its material debt headwalls, they have a few years to solve their profitability issues and/or refinance their upcoming debt maturities. JCP's credit ratings are expected to improve, and credit market spreads should tighten once the company's credit risk profile is correctly recognized.
Valens Credit Ratings are those made by the Valens Credit organization, determined by a ratings committee in a systematic process, and not the opinion of any single person.
Our Chief Investment Strategist, Joel Litman, chairs the Valens Credit ratings committee. Litman served as final editor of this Seeking Alpha article and the related reports supporting the findings published herein.
Disclosure: I am/we are 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.