J.C. Penney (JCPN.Q) has struggled with weak sales and profitability for nearly a decade due to a failed makeover attempt and falling mall traffic. The COVID-19 pandemic was the last straw for the long-suffering department store chain, forcing it to file for bankruptcy in May.
Despite the bankruptcy filing, J.C. Penney shares still trade for around $0.30, giving the company a market cap of nearly $100 million. It appears that many shareholders think (or hope) that the stock will still be worth something at the end of the bankruptcy process. Unfortunately, that is extremely unlikely to be the case.
Shareholders want a seat at the table
Last Wednesday, a group of J.C. Penney shareholders filed a motion requesting that the bankruptcy court judge appoint an official shareholders' committee. This would put the company on the hook for covering substantial legal and research fees to fight for shareholders' interests during the bankruptcy proceeding.
The general argument in the filing is that J.C. Penney is not hopelessly insolvent. If it were, then it would be a foregone conclusion that shareholders would be wiped out. In fact, the shareholders claim that the company is probably worth enough to satisfy all creditors' claims, leaving some value leftover for equity holders. They point to what they describe as better-than-expected financial results over the past few months and the liquidation value of J.C. Penney's assets to support their arguments.
However, whether or not the shareholders realize it, these claims are built on extremely flimsy evidence.
Business results are weak, and cash flow is not what it seems
One piece of the shareholders' argument is that J.C. Penney's go-forward business could be worth approximately $10 billion: more than the value of its liabilities. Yet this estimate relies heavily on rosy projections made by management around the time of the bankruptcy filing.
Even J.C. Penney's leaders don't think revenue growth is feasible. J.C. Penney generated annual revenue of over $17 billion less than a decade ago. By fiscal 2019, that figure had fallen to around $11 billion. Management's long-range forecast calls for revenue of around $9 billion in fiscal 2024. Nevertheless, it projects substantial growth in earnings before interest, taxes, depreciation, and amortization (EBITDA), driven by massive cuts to marketing spending, store labor, and overhead, with virtually no incremental investment in IT. Considering how competitive the retail environment is, cost cuts of this magnitude would almost certainly cause revenue to plunge at a much faster pace.
The shareholders group claims that management is actually too pessimistic. They point to better-than-expected financial results since the bankruptcy filing. Notably, net sales fell just 21% in June after plunging 73% in May. Furthermore, gross margin improved to 42.6% in June, up from 36.2% a year earlier.
However, one month of results is not very meaningful. Soon after the shareholders filed their motion, J.C. Penney reported that net sales fell 30% in July and gross margin tumbled to 23%, compared to 39% in July 2019. As a result, while operating income surged year over year in June, it decreased significantly for the full second fiscal quarter.
The shareholders also make much of J.C. Penney's cash flow beating expectations. Indeed, the company generated hundreds of millions of dollars of free cash flow last quarter. This was driven by working capital movements, though. J.C. Penney has been selling hundreds of millions of dollars of inventory purchased before its bankruptcy filing. Payments to vendors for those purchases have been halted pending the outcome of the bankruptcy process. Clearly, this is a short-term phenomenon and not representative of J.C. Penney's long-term (or even medium-term) cash flow potential.
Finally, the shareholders argue that J.C. Penney's e-commerce business represents a valuable growth driver. Unfortunately, incremental margins are much lower for e-commerce than for in-store sales. As sales volume shifts from stores to the digital channel, J.C. Penney's earnings will fall, not rise. In recent years, this process has played out at every department store chain with a strong digital business.
Asset values are lower than they seem and falling
J.C. Penney's shareholders also claim that the company's liquidation value exceeds its liabilities. This view is built upon misconceptions, too.
First, the shareholders point to J.C. Penney's book value being positive. This was true in early July; it was not true by the end of the month. Furthermore, book value has fallen by $1 billion over the past year and will continue declining, all else equal.
Second, the filing estimates an orderly liquidation value for the company exceeding its liabilities. However, that estimate is based on several faulty assumptions. Most notably, it uses appraisals that assume the properties remain occupied (by J.C. Penney). In a liquidation scenario, the "dark" appraisals are appropriate, slashing J.C. Penney's real estate value by $1.7 billion. That alone wipes out any hope of an equity recovery. The estimate also uses an inflated value for J.C. Penney's e-commerce business, which is nearly worthless in a liquidation scenario.
Mr. Market may well be underestimating the recovery chances of stronger department store chains. However, J.C. Penney does not fit that description. A share price of $0.30 is about $0.30 more than it is worth. Shareholders should take what they can get and move their money to companies with better prospects.