J.C. Penney's Financial Condition: Worse Than It Looks

After losing $985 million in fiscal 2012 on sales of $13.0 billion, J.C. Penney (NYSE: JCP  ) assured analysts in February that liquidity was not an issue, pointing out that it had access to a $1.85 billion credit facility that can be expanded to $2.25 billion. Add in $850 million of adjusted cash on hand at year-end, the company said, and you've got access to short-term capital of approximately $3.1 billion. This week, the company announced that it has drawn $850 million from the line of credit. Let's look at why this is problematic for Penney's, and why investors seeking a value play may want to wait a few quarters before visiting the clearance rack of this retailer.

Background on the line of credit
It's important to note that Penney's credit facility is an asset-based line of credit. Penney borrows against its credit card and trade receivables, as well as its inventory. As a condition to the line, the lenders have a perfected security interest in substantially all of Penney's receivables and inventory -- the assets provide collateral for the loan.

Penney's credit card and trade receivables are so small that they do not warrant a separate line item on the company's balance sheet. The only receivables Penney lists are income tax receivables, which the company can't borrow against. So the company's borrowing base is made up almost entirely of its inventory of $2.3 billion, at an advance rate (the percentage amount it can draw) of 85% against liquidation value of the inventory.

The rub
The key term here is "liquidation value." In asset-based credit lines, the lender sets the terms, and Penney's terms are rather onerous. Companies with decent credit can borrow against "net realizable value," which is the selling price of the inventory less selling costs. Companies with not-so-glamorous credit ratings borrow against liquidation value, which is the value of the inventory under liquidation sale conditions. The lender sets the rate by which inventory value will be discounted. Incidentally, companies with stellar credit, like competitor Kohl's (NYSE: KSS  ) , for example, can borrow totally unsecured. Kohl's has an investment grade rating and a $1 billion unsecured credit line.

Out of the $1.75 billion total credit line at year-end (the last $100 million was added a few days after year-end), how much was actually available to borrow against the liquidation value of Penney's $2.3 billion of inventory? We don't have the specifics of how much the inventory is discounted by the syndicate of lenders administered by J.P. Morgan, but the company's SEC filing at year-end shows that total availability on the line was only $1.24 billion. This is after a $281 million reduction for issued but undrawn letters of credit that Penney uses for corporate self-insurance and import purposes. Acknowledging again the caveat that the discount percentage is unknown, it is possible that the company has drawn down about 70% of total line availability in the last seven weeks. And this is the crucial point to understand: Penney's credit line availability on any given day is based on a fluctuating amount of receivables and inventory, and this can be a vastly different number than the face-value amount of the line. If Penney's balance sheet continues to shrink, it will have less and less to borrow against.

A parting gift
In his brief tenure at Penneys, ousted CEO Ron Johnson moved quickly and boldly on many fronts. One of his most significant actions from a working capital perspective was to reduce what he saw as excess and bloated inventory. Using tools which included clearance sales and negative selling margin strategies, Johnson removed $575 million of inventory, almost 20%, from Penney's books in a single year, reducing inventory to a level not seen since the late 80s. In his final earnings call, Johnson explained, "It is incredibly comforting to me to be relieved of the massive inventory overhang with which we began last year." This may be cold comfort to Penney's shareholders, as it also sliced away at the very borrowing base which Penney could have benefited from as it seeks to stem its current cash bleeding.

Going forward
It's going to take some time for Penney to recoup its losses and stabilize its cash flow. Until the company can rebuild its balance sheet, current management is absolutely correct to pick up the phone and schedule some lunches with the shrewd investment bankers at Blackstone Group, who have a pretty sharp restructuring/reorganization team in-house. As reported last week by several news organizations, Penney has engaged Blackstone to help it figure out how to raise $1 billion.

While this billion will come at a cost, either from expensive debt, perhaps collateralized by Penney's real estate, or by selling equity on the cheap, it's preferable to raise it now. Expect that part of the billion will be used to pay down the line, as the current utilization may be too close to the line's availability cap for management to sleep well at night. And without new funds, the company will step into a sort of cash flow quicksand. It will receive less cash from operations by having to discount heavily to draw customers back in, while funding the final renovations from Johnson's store refresh program, all the while paying concerned vendors in a timely fashion and keeping the lights on and the payroll made. It's an exceedingly difficult task, and value seekers should give this one a couple of business quarters at least before committing investment funds.

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