Will J.C. Penney File For Bankruptcy And When?

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About: J.C. Penney Company Inc. (JCP), Includes: SHLDQ
by: WYCO Researcher
Summary

It has too much financial and operating leverage to stay out of Ch.11 bankruptcy.

Latest quarterly report showed vendors are becoming stricter with terms.

J.C. Penney has a long history of failed business plans, and the recent addition of selling appliances will be another failure.

Recent note tender offer was successful in reducing debt.

J.C. Penney Company, Inc. (NYSE:JCP) will eventually file for Ch.11 bankruptcy, but not within the next 12 months, in my opinion. Nothing new here. It has too much debt, too many stores, and no inherent reason to exist. It sells functional products to the lower middle class. While its recent quarterly report shows that accounts payable/merchandise inventory ratio dropped to 0.303 from 0.342 year-end, indicating potential problems with vendors, it has no immediate "event" that would push it into bankruptcy this year.

My approach to this article is different than my usual style of only using numbers and legal issues for article content. Much of this article is focused on concepts and my perception of JCP, which I have followed since 1974 when we conducted an in-depth analysis comparing them to the "old" Sears (SHLD) in a class.

First Quarter Problems

The earnings report two weeks ago was a jolt to investors. Not only were the results worse than expected, but also management seemed too unrealistic in its near-term guidance. While same-store sales dropped 3.5% in the first quarter, management maintained its guidance of plus/minus 1% for the year. That implies that it is unrealistically expecting sales to increase over the next nine months. If the company orders too much based on this too rosy of forecast, it could end up with an overstock of seasonal merchandise that would require larger-than-normal end-of-season markdowns to get them off the shelves.

One of the most alarming metrics in the quarterly report was the accounts payable/inventory ratio, which is a critical retail industry metric showing its relationships with vendors. This ratio decreased to 0.303 from 0.342 year-end and 0.340 from the same period last year. This means that some vendors have shortened the due date period and/or are requiring payment upon delivery. This problem is also reflected in the reduction in cash/cash equivalents of $52 million to $363 million from the same period last year.

Business Model - A History Of Problems

One of the problems with JCP is that it does not have a viable business model. Over the last 55 years or so, it keeps changing its focus and business plans, but nothing has been really successful. It reminds me of a student in college that keeps taking different courses trying to decide upon a major. The company sold appliances for about 20 years and closed that department. It also operated a discount chain called Treasure Island, which was like a Wal-Mart (NYSE:WMT) store of today, but it also closed that after about 20 years. JCP had a disaster with discontinuing coupons a few years ago.

A few years back, it tried to become more like a department store focusing on fashion. With new advertising/marketing, JCP tried to create the illusion for customers that were selling fashion. In reality, its clothes are just functional. I doubt Anna Wintour is a regular customer.

J.C. Penny's return to selling appliances, which it sold from 1963 to 1983, is a strategy partially based on two assumptions: 1) Sears Holdings Corp. will continue to close stores, and 2) malls will still be a viable retail way for selling consumer products in the future. While the first assumption most likely is correct, the second assumption is questionable. Shopping at the mall replaced shopping "downtown". Shopping online is replacing malls. OK, maybe not replacing, but having a strong impact.

Part of the company's appliance marketing plan is dependent on traffic flow of regular mall shoppers. I think management does not understand the way many consumers currently shop for large ticket items, including appliances. They compare prices/value online and then go directly to their top 1 or 2 spots, assuming they do not just buy online. They do not just wander into JCP store from the mall to buy appliances.

Since the latest quarterly results showed a 3.5% decline in same-store sales, it would seem that expanding the new appliance department into more stores is neither generating a significant "big ticket" revenue nor pulling in shoppers to buy other products while looking at appliances. One wonders how much further sales would have declined in the quarter without appliances.

It is too soon to judge if using 1,500-3,700 sq ft of floor space for selling appliances, which have a much lower market-up than apparel, jewelry, and cosmetics, is an improvement from its older business model. As I was told by a JCP employee, its only appliance inventories are the appliances on the selling floor and that the company does not carry appliances in the back/warehouses. One of the reasons that it is closing 140 stores is that most of them do not have the floor space to accommodate appliances (the stores were also underperforming).

Part of the company's new business model is cutting costs, which includes cutting advertising. In 2016, advertising was $769 million (6.23% of sales), which is a decline from $792 million (6.27% of sales) in 2015 and $886 million (7.23% of sales) in 2014. While cutting advertising reduces costs, it has had a negative impact on sales. In my opinion, this cutting has an overall negative impact on the bottom line and is just another example of poor management.

Its business model has been impacted by demographic changes. For example, the buying of the correct amount of merchandise and inventory control based on demographics. Decades ago, store buyers had an easier time ordering the correct amount of clothes for each size. Today, it has become a real challenge because of the increased Asian population who tend to be smaller/thinner and the expanding number of obese people needing XL or even XXXL. Not having enough of a particular size results in lost sales and too much of a size often means sharp price reductions to get that garment sold.

Potential Gains From Sears

JCP and Sears are in the same 400 malls. If one of those stores closes, many are assuming that the other would gain customers. That is most likely partially correct, but there is a demographic difference between the two. Sears is aimed more towards male shoppers looking for tools and lawn mowers whiles JCP is more female oriented with a focus on female fashion and household products. Plus, if one store closes, some shoppers may not even bother to go to that particular mall. There could also be a temporary negative impact on the other store from extreme discounts offered during going out business sale.

Overly Leveraged

JCP has too much debt. There is $42.33 of debt per sq ft of retail space (not factoring stores slated to close). Last year's revenue only covered debt 2.82x. The current equity capitalization is $1.43 billion compared to $4.37 billion in debt (total of long-term and debt maturing within one year) or $3.31 in debt per $1.00 market capitalization. These figures do not even factor in lease obligation liabilities. As retail sq ft decreases with more stores closing and the stock price continuing to drop, these metrics could get worse in the near future. Bankruptcy would give JCP the opportunity to deleverage.

To deleverage and raise cash, the company sold its home office and the land surrounding the property for total net proceeds of $296 million. Additional assets are expected and its term loan covenants (starting on page 67) are not overly restrictive for asset sales.

Despite these weak debt ratios, S&P raised its corporate rating to B+ from B in March. Currently, it is having a tender offer for its 5.75% 2018 and 8.125% 2019 notes. The company purchased $300 million in principal under the early tender. That included 69.31% of the outstanding 2018 notes and 84.23% of the 2019 notes. This will help get the potential for a bankruptcy "event," maturity of debt, out of the way for the next two years.

Why Bankruptcy?

JCP has too much debt/leverage. As more stores are closed, it will be even more difficult to support the debt. It will be able to discharge this debt in bankruptcy. In addition, its business model has too many underperforming stores that need to close. Under Section 365 of the Bankruptcy Code, JCP will be able to cherry-pick which leases it wants to reject, but could however face challenges from shopping mall landlords to their assumption/assignment of leases (I covered this important issue in a recent article about SHLD). A bankruptcy reorganization plan could include a rights offer to raise needed new cash.

When Will It File?

First, there is no "event", such as maturity of a major debt issue, in the near future that could force it to file for Ch.11. Second, assets sales have been a cash infusion for operations and the recent debt reduction could get it through this year and 2018. It is not close to violating loan covenants at the present time. While vendors are beginning to be stricter with their terms, it not yet critical, unlike SHLD. As more and more retailers go bankrupt, vendors will become more careful, especially since the vendor's bank could force them to change their policies as banks get stuck with worthless receivables.

I am therefore not expecting a bankruptcy filing in the near future. The key date could be June 1, 2020, when $400 million in notes mature. The negatives impacting JCP could collectively force a Ch.11 filing then.

Oddly, the sooner it files, the greater the expected recovery would be for unsecured noteholders. I would expect that there would be no recovery for JCP equity holders no matter when the company files unless they receive "gifting" of a modest recovery from a priority class under a prepackaged plan. If JCP files without a prepackaged plan, equity holders should expect to get nothing.

Conclusion

J.C. Penney has been on the "B" list of retailers for the last 50 years. It always seemed behind the leaders in the industry. The company's current business plan is too dependent on malls, which are being replaced by e-commerce retailing. With so much debt and anemic growth prospects, it will eventually be forced into filing for Ch.11 bankruptcy. While it may survive a few more years, June 1, 2020, may be a date to watch.

JCP equity is a long-term sell. I do not expect any recovery for equity under a Ch.11 reorganization plan. The note issues should be avoided because it is uncertain the amount of recovery that would be paid to holders under a plan.

Disclosure: I am/we are short SHLD. 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.

Additional disclosure: I am naked SHLD call options