J.C. Penney Looks Like a Long-Term Bankruptcy Candidate

Earlier this month, retail analyst Charles Grom of Sterne Agee initiated coverage on troubled department store operator J.C. Penney with a buy rating and a $23 price target, which is about 30% above its recent trading range. Grom bases his valuation on a long-term view that J.C. Penney could generate EPS of $2 by 2017. That implies that J.C. Penney would more or less replicate its adjusted EPS of $2.16 from 2010, before the company's recent turmoil.

Grom's bullish call on J.C. Penney is refreshingly courageous; most Wall Street analysts tend to be overly focused on short-term results, rather than long-term trends. By contrast, Grom is clearly focused on long-term opportunities at J.C. Penney, not short-term sales or profit results.

Unfortunately, even from a long-term perspective, there's not much to like about J.C. Penney. The company was already under pressure before its missteps under Ron Johnson. The mid-price department store segment is not a great place to do business these days, as Sears can attest. Moreover, J.C. Penney has taken on billions of dollars in new debt to fund its capital expenditures and operating losses, adding over $100 million of annual interest payments.

Regaining the $5 billion in sales that it has lost over the last six quarters could take more time than the company can spare, raising the likelihood of an eventual bankruptcy restructuring.  As a result, investors should be very wary of this stock.

Transformation gone awry
Ron Johnson was hired two years ago in order to transform J.C. Penney because the department store concept was going stale and financial results were starting to go sideways. In the last year of CEO Mike Ullman's previous tenure -- Ullman was recently brought back as CEO, just a year and a half after his ouster -- the company posted a dismal 0.2% comparable-store sales gain.

The external environment has not improved since then, while J.C. Penney has gone into a tailspin; the company lost more than $1.5 billion before taxes last year. Moreover, J.C. Penney's performance has continued to slide year to date. While analysts expect sales to improve and losses to narrow later this year, the company's full-year loss will probably be similar to its 2012 results.

To regain its level of sales from 2010 -- the last time the company earned more than $2 per share -- J.C. Penney will need to increase its revenue by 43% beyond its expected 2013 total. In order to accomplish that task by 2017, J.C. Penney would need to achieve a compound annual sales growth rate of more than 9%! Even the most successful department stores today are not growing that quickly.

To some observers, it appears that J.C. Penney should be able to get back to $17 billion or $18 billion in annual sales, because the company "only" has to win back the customers it lost last year. In reality, J.C. Penney's task is not so simple. Sears has seen its domestic comparable-store sales sink every year for the past decade. Total revenue peaked at $53 billion in 2006, but has plunged to less than $40 billion last year.

Weak results in one year have not made it easier for Sears to "recapture" revenue in later years. While Sears lost 25% of its revenue over six years and J.C. Penney lost that much in just one year, the two situations are quite similar. Time has passed these retailers by, and it's unrealistic to hope for more than modest sales growth going forward.

A short lease on life
J.C. Penney recently closed on a $2.25 billion term loan with Goldman Sachs . This gives the company much-needed liquidity, but longer term, this deal looks more likely to be an anchor than a solution for J.C. Penney. The loan will reportedly bear interest at LIBOR plus 5 percentage points, with a LIBOR floor of 5%. Thus, the interest rate will be a minimum of 6%, meaning that J.C. Penney will be on the hook for annual interest payments of $135 million.

This loan will allow J.C. Penney to repay the $850 million it recently drew from its credit line, and it has also been used to pay off almost $250 million of debentures at a substantial premium to face value. These two actions will leave a little more than $1 billion to cover operating losses.

However, J.C. Penney did not generate any operating cash flow in 2012 -- and is on pace for a similar performance in 2013 -- yet the company plans to invest $1 billion in capital expenditures this year . In other words, the $1 billion cushion created by the recent loan transaction will only cover one year of negative free cash flow. After that, the company will need to raise more capital or dip into its revolving credit line again if free cash flow remains negative. This would lead to even higher interest payments, aggravating the company's losses.

Summing it up
The J.C. Penney of today reminds me a lot of Rite Aid a few years ago. While Rite Aid has made a bit of a comeback in the last few years, it is struggling under a mountain of debt -- totaling roughly $6 billion -- that perennially hamstrings its profitability. As a result, Rite Aid's equity is worth just 31% of the company's total enterprise value (the other 70% represents the value of the company's debt). To put it another way, the company is always one wrong step away from a trip to bankruptcy court.

J.C. Penney could face the same situation in five years. Even if Mike Ullman manages to win back lots of customers over that time period and the company approaches 2010 levels of operating profit, it may need to take out billions of dollars in debt to keep the ship afloat until then. That will burden the company with hundreds of millions of dollars in annual interest payments.

Any delay in returning to profitability would just add to those interest payments. As a result, J.C. Penney's short-term problems have serious long-term implications. Its turnaround attempt may be an interesting story to watch over the next few years, but it's not a good investment candidate. Given the company's rapid cash burn and heavy debt load, any further mistakes could quickly send J.C. Penney into bankruptcy.