If you are reading this, odds are that you've been following the drama surrounding J.C. Penney. In addition to posting large losses and declining sales in recent years the company, the retailer has also been the cause of drama surrounding several fund managers including Bill Ackman who recently sold his entire stake in the retailer at nearly a 50% loss. Given all these headlines, can it be that this once iconic American retailer is in an irreversible state of decline?
For the three-year period ending in its 2011 fiscal year, the company had the following metrics:
What we have here is a return on equity that has averaged 8.73%, which is respectable but far from good. For instance, Kohls Corp. (NYSE:KSS), a rival retailer, averaged a superior return on equity of 13.2% over the same period of time. Additionally, we have a net profit margin and a free cash flow margin that are poor, especially compared to Kohls Corp.'s 5.7% and 6.3%, respectively, but at least the company's profitable, right? In an effort to reinvent the company, CEO Mark Ullman was replaced with Ron Johnson, a former executive at Apple, who had acted as the Senior Vice President of Retail Operations there. So far, so good, right?
A turnaround gone wrong
With an ambitious restructuring plan that involved removing the company's massive advertised discounts, Johnson hoped to bring the company to the new age of everyday low prices. This was further complemented with the idea of developing high-quality mini-stores within a store to have brand-name items.
In its first year of trials for the new plan, the company's revenue declined by 2.8% and net income fell from $389 million to negative $152 million. The next year, the company's revenue fell by another 24.8% to about $13 billion, whereas net income amounted to negative $985 million as customers left the store for some of its competitors. Shortly after these disastrous results, Johnson was removed from the company and Mark Ullman stepped back in as CEO.
Since this failure of a turnaround attempt, the company has continued on a downward spiral with revenue declining and net losses for the 2014 fiscal year amounting to $934 million. Even its balance sheet, which has seen the company's current ratio decline from a five-year average of 1.99 to 1.42 in its most recent quarter, and its long-term debt/equity ratio (inclusive of capital lease obligations) rise from an average of 0.74 to 2.12, appears to be deteriorating.
At this rate, if management fails to come up with an innovative way to bring back customers, it is highly likely that J.C. Penney won't last long. The sad but harsh reality is that once a retail store develops a poor reputation, word spreads and losses are maximized as fewer and fewer customers decide to return.
Debt and cash flows
From an analytical perspective, J.C. Penney's financial situation is terrible. In the first two quarters of its 2014 fiscal year, the company had cash flows from operations amount to negative $1.46 billion while free cash flows were negative $2.1 billion. In comparison, Kohl's Corp. had positive cash flows from operations amount to $762 million and free cash flows amount to $478 million. Meanwhile, the cash flows from operations and free cash flows for Macy's (NYSE:M) and Dillard's (NYSE:DDS) come to total $664 million and $348 million, and $131.7 million and $90.9 million, respectively.
The only thing that has helped the company to some degree has been the issuance of $2.25 billion from a term loan facility and a tender offer on existing debt, combined with a credit facility that totals $1.85 billion, $850 million of which the company has already tapped into.
In making investment decisions, the unfortunate reality is that you have to rely on numerous assumptions as opposed to relying entirely on concrete facts. If we were to assume that J.C. Penney continues to exhibit the kind of losses it has over the past two quarters, its cash on hand of $1.54 billion, combined with it's untapped credit facility of $497 million (without factoring in the restrictions it imposes on the company), would result J.C. Penney being unable to meet all its requirements in a little more than one quarter from August 3 of this year.
However, don't rush for the exits yet! Companies are usually very resourceful in raising capital when they need it. Additionally, some capital expenditures can be delayed if need be and the possibility to issue more equity or increase borrowing limits should never be underestimated.
In all actuality, while J.C. Penney's situation appears dire, the company could continue to operate for years before shutting down, or it could make a dramatic turnaround while on the verge of bankruptcy like Apple once did! What is for certain though, is that the Foolish investor should carefully evaluate the risk-reward opportunities of holding a distressed company like J.C. Penney before buying into its shares. While a turnaround in its business could grant the shareholder a handsome return, a failure to do so could cause a complete and total loss of capital.