On Tuesday morning, J.C. Penney (NYSE: JCP ) reported another quarter of declining sales and steep losses. Total company sales of $2.66 billion missed the average analyst estimate by approximately $100 million . As a result, J.C. Penney lost $586 million during the second quarter, or $477 million excluding several one-time items.
Despite these poor results, J.C. Penney stock actually gained 6%, and several industry analysts had good things to say about the company's turnaround. The investment community had already expected another bad quarter, and the stock has dropped more than 70% since its early 2012 high. In many people's minds, this offset the revenue and earnings misses.
Nevertheless, J.C. Penney still looks like a bad investment. In fact, the company's second-quarter results support the argument I laid out in June, that J.C. Penney is eventually headed for bankruptcy. The company is hemorrhaging cash, and the management team's attempts to stem the bleeding are likely to be too little, too late.
Burning cash like it's firewood
During the recently ended second quarter, J.C. Penney completed a $2.25 billion term loan arranged by Goldman Sachs, which yielded proceeds of more than $1.8 billion after the company repaid some of its other debt. This financing came just in the nick of time, as J.C. Penney used $708 million in its operations and spent another $439 million on capital expenditures during the quarter.
Over the last six months, J.C. Penney's debt load has grown by more than $2.5 billion, yet the company's cash balance has increased by only $657 million. This is perhaps the most dramatic indication of the company's cash flow problems.
Cash burn should be more moderate in the second half of the year, as the company has already completed the bulk of its capital expenditures and inventory investments for 2013. That said, the company stated that total company liquidity would be "in excess of $1.5 billion" at year-end. Based on the company's current credit line availability, this means that J.C. Penney used another $350 million in cash over the next two quarters, for a total cash burn of more than $2 billion this year.
This performance is clearly unsustainable. J.C. Penney is planning to reduce its capital expenditures to just $300 million next year, down from nearly $1 billion this year. Economizing on capital expenditures will save around $650 million of cash year over year, but that only addresses 30% of the company's overall cash burn. J.C. Penney will also have to significantly improve its operating results to reach breakeven on a cash basis.
A number of analysts interviewed by the Associated Press were surprisingly upbeat about J.C. Penney's sales and earnings prospects going forward. Most notably, Bernard Sosnick of Gilford Securities expects the company to return to profitability in the fourth quarter and thinks the company could grow sales by 10% to 15% in the first half of 2014.
This scenario -- while not impossible -- seems highly unlikely. There is certainly an opportunity for improvement over the next 12 months insofar as construction in the stores has disrupted sales over the past 12 months. Without those disruptions, sales trends would have been better. The return to a heavier emphasis on sales and coupons should also help, particularly in the highly promotional holiday period.
However, investors should remember that J.C. Penney reintroduced sales and coupons before the beginning of last quarter. Furthermore, construction activity was lower than in previous quarters, particularly after the new home sections opened in early June. None of these "improvements" were sufficient to prevent a sixth consecutive double-digit decline in quarterly sales. J.C. Penney may be able to return to sales growth next year, but double-digit growth is just wishful thinking at this point.
Scrambling for viability
J.C. Penney is currently on pace for revenue of approximately $12 billion this year, down by more than $5 billion from fiscal year 2011. At this level of revenue, the business is probably not viable. On the company's earnings call, CFO Ken Hannah stated that J.C. Penney is hoping to eventually return to its historical gross margin level of 37%. With $12 billion of revenue, that would produce $4.44 billion in gross margin dollars.
In fiscal year 2011 -- before the "transformation" -- J.C. Penney incurred operating expenses (excluding one-time items) of $5.7 billion. The company has since reduced expenses by around $700 million, net of various investments. J.C. Penney's search for liquidity has also increased interest expense to roughly $400 million annually. As a result, with annual sales of $12 billion, there is a gap of nearly $1 billion between gross margin dollars and expenses, even if J.C. Penney returns to historical gross margin levels.
In order to reach breakeven at historical gross margins, revenue would have to increase 20% to 25% from current levels. In other words, $14 billion to $15 billion is the minimum level of sales for J.C. Penney to remain a viable business based upon its current footprint.
It looks increasingly unlikely that J.C. Penney will make it to that level before its cash hits a dangerously low level yet again. With nearly all of the company's assets already pledged as collateral and the stock price having slid to multiyear lows, J.C. Penney will have a hard time raising debt or equity. As a result, bankruptcy could be in the cards for this storied retailer two to three years from now.
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