To say that department store chain J.C. Penney (NYSE:JCP) had a rough year in 2018 would be an understatement. Comparable sales dropped 3.1%, with an even worse decline in the fourth quarter. The company lost $296 million on an adjusted basis, down from a small profit in 2017. Some progress was made improving the balance sheet, but the company is still sitting on $4 billion of debt and capital leases.
One silver lining: J.C. Penney managed to produce positive free cash flow in 2018, and it expects to produce positive free cash flow in 2019 as well. That's a sign that the company will be able to further reduce its debt load and, at least ostensibly, that the situation may not be quite as dire as it seems.
New CEO Jill Soltau has already made some big changes, like dumping the ill-fated appliance business. But one thing that hasn't changed is J.C. Penney's wonky definition of free cash flow. The retailer conveniently adds in proceeds from operating asset sales, juicing what's supposed to be a measure of cash generation from the business.
J.C. Penney's actual operations were not free cash flow positive in 2018. And they probably won't be free cash flow positive in 2019.
Worse than it looks
J.C. Penney reported free cash flow of $111 million for 2018. That's down from $213 million in 2017 but still in positive territory.
But J.C. Penney sold off some assets last year, and those asset sales are part of that free cash flow number. Proceeds from operating assets totaled $144 million in 2018. If you back that out, J.C. Penney's free cash flow transforms into a loss of $33 million.
That doesn't seem all that bad, especially given the company's adjusted net loss of close to $300 million. But free cash flow got a boost in another way as well. J.C. Penney has been reducing its inventory as it clears out slow-moving products. Inventory was 13.1% lower at the end of 2018 compared to one year prior.
This inventory reduction increases the free cash flow, but it's an inherently temporary effect. J.C. Penney can't reduce inventory forever. Changes in working capital, which includes changes in inventory, provided a $128 million boost to J.C. Penney's free cash flow in 2018, compared to no boost at all in 2017. If you back that benefit out, 2018 free cash flow falls to a loss of $161 million.
The bottom line: J.C. Penney's actual retail operation was nowhere close to free cash flow positive in 2018. And when the company says it expects "free cash flow" to be positive in 2019, that guidance comes with some pretty major caveats.
J.C. Penney can whittle down its debt by selling off pieces of itself, and it can claim that it's free cash flow positive in the process. But don't be fooled: A J.C. Penney comeback is a long shot.