Late last Thursday, Reuters reported that J.C. Penney (JCPN.Q) had hired advisors to look into restructuring the company's debt in the hope of avoiding a bankruptcy filing. While the report didn't say the company was preparing for bankruptcy, it did seem to imply that bankruptcy was an option if the out-of-court debt restructuring efforts failed.
This news sent J.C. Penney stock plunging more than 15% on Friday. Shares of the beleaguered retailer continued to move lower on Monday, despite a company statement indicating that it has plenty of liquidity and is not preparing for a bankruptcy filing.
Indeed, based on J.C. Penney's current financial position, it's unlikely that the company would be forced into bankruptcy anytime soon. That said, the department store chain does have too much debt and needs to address this problem to achieve a sustainable comeback.
Leverage is out of control
As of the end of last quarter, J.C. Penney had $3.9 billion of debt, plus another $1.2 billion of lease liabilities. Meanwhile, the company's adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) has plunged in recent years due to strategic missteps and tough business conditions. This has driven J.C. Penney's leverage to unsustainable levels.
J.C. Penney's leverage ratio has surged over the past couple of years. Image source: J.C. Penney.
Adjusted EBITDA totaled $568 million in fiscal 2018 -- down from $1 billion in fiscal 2016 -- putting J.C. Penney's leverage ratio at more than seven times EBITDA. For comparison, most investment-grade companies have debt that is no more than three times EBITDA.
J.C. Penney's management has indicated that the retailer could boost its earnings by hundreds of millions of dollars annually just by improving inventory management and cutting down on shrink (lost and stolen merchandise). In other words, J.C. Penney doesn't need to recapture all of the sales volume it has lost over the past decade for its profitability to rebound. Still, even if annual adjusted EBITDA were to return to $1 billion eventually, J.C. Penney has more debt than would be ideal for that level of earnings.
What is J.C. Penney's aim?
The ultimate goal of an out-of-court restructuring would be to extract concessions from creditors. J.C. Penney could try to give lenders greater certainty of repayment in exchange for reducing the principal balances for its debt.
The good news is that J.C. Penney has plenty of liquidity. It ended the first quarter with $171 million of cash and investments on its balance sheet, plus nearly $1.6 billion of availability on its credit line. Meanwhile, it has just $160 million of maturities over the next four years, plus annual repayments of $42 million for its secured-term loan. As long as free cash flow stays positive or near breakeven, J.C. Penney shouldn't face a liquidity crisis anytime soon.
J.C. Penney has plenty of liquidity -- but way too much debt. Image source: J.C. Penney.
The real problem is looming farther out. J.C. Penney has about $2.5 billion of secured debt that will mature between 2023 and 2025. It also has $1.2 billion of unsecured debt maturing between 2036 and 2097. J.C. Penney needs to whittle down the principal balance of this debt while ensuring that it can extend the maturities of what remains.
J.C. Penney's unsecured debt maturing in 2036 and beyond currently trades for between $0.23 and $0.26 on the dollar. Even some of its lower-priority secured debt trades for less than $0.50 on the dollar. Thus, the market is already factoring in a substantial likelihood that creditors won't be repaid in full. This should motivate them to cooperate with the company's efforts to restructure its debt. It might even make sense to write off some of the principal if J.C. Penney can offer more collateral in exchange (and perhaps some equity warrants to reward creditors if the company manages to turn itself around).
One piece of a bigger puzzle
Without a proactive debt restructuring, J.C. Penney faces a high likelihood of being forced into bankruptcy at some point in the future. While the company has plenty of liquidity for now, high debt and big interest payments have left J.C. Penney with very little room to maneuver -- and even a relatively modest setback could push it over the edge.
On the other hand, J.C. Penney also needs to reverse the recent declines in its gross margin and stabilize its sales to drive a rebound in adjusted EBITDA. No kind of debt restructuring will save the company if its underlying earnings power keeps plunging.
The success of J.C. Penney's out-of-court restructuring efforts may depend on whether the company can show progress in its turnaround over the next couple of quarters. A return to gross margin expansion and stabilizing sales trends would give creditors more confidence that making concessions could put J.C. Penney on a sustainable path. But if results continue to deteriorate, creditors would be more likely to focus their efforts on maximizing the amount they recover in a potential bankruptcy filing.
