The U.S. economy is booming. Consumers are spending. Brian Cornell, CEO of retailer Target, called the current consumer environment "perhaps the strongest I've seen in my career."
But you wouldn't know it looking at J.C. Penney's (JCPN.Q) results. The department store reported abysmal second-quarter numbers, featuring a massive loss and extremely sluggish comparable sales growth. Its full-year guidance was slashed, and the stock unsurprisingly plunged.
If J.C. Penney is doing this poorly when times are good, it will take a miracle for the century-old retailer to survive when times are bad.
J.C. Penney posted a net loss of $101 million during the second quarter, more than double its loss in the prior-year period. The company was forced to mark down prices to clear out slow-moving seasonal inventory, knocking down gross margin.
But the company's inventory problems go beyond seasonal merchandise. J.C. Penney took actions during the quarter to clear excessive inventory across many categories, beyond seasonal products or fashion misses, according to CFO Jeffrey Davis. The plan going forward is to buy less merchandise instead of simply filling up the stores by default. That probably should have already been the plan, given that the company's sales have been depressed since 2012.
Markdowns seem to be a theme for J.C. Penney. The company blamed markdowns aimed at clearing out seasonal inventory for a slumping gross margin in the first quarter. In the third quarter of 2017, the company also took "aggressive actions" to clear slow-moving inventory, mostly related to apparel, according to then-CEO Marvin Ellison.
Amazingly, both e-commerce sales and appliance sales were down in the second quarter. Those declines were on purpose -- J.C. Penney was trying to reduce unprofitable sales. So much for appliances being the retailer's savior.
I'm starting to think that J.C. Penney doesn't have a good handle on what its customers want to buy -- or who its customers are, for that matter. Merchandising is a core competency for any retailer. If you can't get merchandising right, that's the ball game.
Up to its eyeballs in debt
J.C. Penney has been able to reduce its debt load a bit in the past few years, but the balance sheet is still in rough shape. The company's cash balance at the end of the second quarter was just $182 million, and it was still staring at about $4.2 billion of debt and capital lease obligations. Annual interest payments are roughly $300 million.
The retailer does expect to produce positive free cash flow this year, although inventory reductions and the sale of operating assets will be the main drivers. J.C. Penney has boosted its free cash flow and paid down debt in recent years by selling off assets, including its headquarters campus, a distribution center, and corporate jets. That's a strategy that works until you run out of assets to sell.
J.C. Penney expects to lose between $0.80 and $1 per share on an adjusted basis this year, which works out to a net loss as big as $315 million. Free cash flow coming from the business itself, excluding asset sales and working capital machinations, will almost certainly be negative.
The good news is that J.C. Penney doesn't have all that much debt maturing anytime soon. The company completed a tender offer for some of its debt maturing in 2019 and 2020 earlier this year by taking on $400 million of new debt maturing in 2025. This move was expensive -- the new debt comes with an 8.625% interest rate -- but there are now only small debt maturities until 2023, when nearly $2 billion of debt comes due.
That may seem to buy J.C. Penney time, but if the economy goes into recession at some point in the next few years, it's not hard to imagine the company's results deteriorating to the point where paying interest becomes a problem. More assets can be sold and working capital can be plundered. But only for so long.
J.C. Penney is a money-losing retailer loaded with debt, struggling to grow sales during a veritable boom in consumer spending. The time to turn things around was yesterday. Whenever the economy turns sour, as it will inevitably do at some point, J.C. Penney will be wholly unprepared.
Time is the enemy of the mediocre business, according to Warren Buffett. That quote appears tailor-made for J.C. Penney.