The Real Story Behind J.C. Penney Co. Inc.'s Free Cash Flow

Shares of beleaguered retailer J.C. Penney (JCPN.Q) slumped after the company reported a loss for the holiday quarter. While things are slowly improving at J.C. Penney, the company is still unprofitable, reporting a net loss of $771 million in 2014.

Despite this massive loss, J.C. Penney managed to post a positive free cash flow of $57 million for the full year. An argument can certainly be made that the free cash flow is a more meaningful number than net income, since it represents the actual cash coming into the business. But in J.C. Penney's case, this positive free cash flow was the result of some unsustainable practices, rendering the metric a poor representation of the true health of the business.

How J.C. Penney boosted its free cash flow
Why is the discrepancy between J.C. Penney's net income and free cash flow so large? Let's break it down:

Source: J.C. Penney.

There are three items that stand out here, and each of them provided a boost to J.C. Penney's free cash flow. First, J.C. Penney includes $70 million related to the sale of operating assets in the free cash flow calculation. It's a small amount in the grand scheme of things, but it's obviously a one-time item, and it's a dubious addition. J.C. Penney's free cash flow turns negative simply by removing this item.

The other two items are far more meaningful. Did you notice the difference between J.C. Penney's depreciation charge and its capital expenditures? During one of the company's conference calls a year ago, it guided for $250 million in capital expenditures, with the CFO stating that the company could "live on a diet for a little while." In 2013, J.C. Penney had spent $951 million on capital expenditures.

This diet can't last forever. The depreciation charge is typically a decent ballpark estimate of the level of CAPEX needed to simply maintain a company's assets, and J.C. Penney is spending well below that level. It guided for $250 million in CAPEX for 2015 as well, so the diet will continue into this year. But CAPEX is eventually going to have to rise again if J.C. Penney wants to adequately maintain its stores.

With J.C. Penney trying to maintain its liquidity in light of its continuing losses, underspending on CAPEX for a while makes sense. The company is underspending by somewhere around $300 million per year, possibly more, and that provides a big boost to the free cash flow. But this boost isn't sustainable, and treating it as such is a mistake.

The last item is a $379 million benefit from changes in working capital. Most of this comes from J.C. Penney's reducing its inventory levels compared with last year, and while it certainly makes sense for the company to optimize its working capital, freeing up cash where it can, this benefit to the free cash flow won't happen every year. Inventory can only be reduced by so much, especially if the company expects to grow its sales.

If we adjust for these three items, the result is a much better representation of the health of the business:

Source: Author's calculations.

This adjusted free cash flow doesn't represent the actual cash flow, but I think it gives a better idea of where the business stands right now. The fact that J.C. Penney managed to report a positive free cash flow is important: It allows the company to maintain its liquidity, which it desperately needs to do. But it doesn't mean the business is healthy. J.C. Penney is still very unprofitable, unable to turn a net profit even during the holiday season. A retailer that can't make money during Christmas is doing something wrong.

J.C. Penney guided for flat free cash flow in 2015, again driven by underspending on capital expenditures, and probably further gains from working capital. The business will probably improve this year, with sales rising, but the company is still years away from being able to post a net profit. These measures to boost the free cash flow will only work for so long. Eventually, the free cash flow will have to reflect the true health of the business. And if J.C. Penney hasn't returned to profitability by then, it won't look pretty.