On Tuesday, J.C. Penney (NYSE:JCP) issued a press release stating that comparable-store sales for the troubled department store operator rose approximately 2% last quarter. That marks the company's first comparable-store sales growth in more than two years. CEO Mike Ullman proclaimed that "the steady improvements in our business show that the Company's turnaround is on track."
Investors shouldn't take that declaration at face value. In fact, J.C. Penney is in big trouble. Based on its current sales momentum -- or the lack thereof -- J.C. Penney is more likely than ever to seek bankruptcy protection within the next year or two.
The bigger picture
While J.C. Penney bulls will be happy to see any level of sales growth, the company's 2% gain last quarter was not enough to improve the company's long-term health.
First of all, J.C. Penney had reported in early December that comparable-store sales grew 10.1% in November. The latest update implies that comparable-store sales must have declined in both December and January. In other words, J.C. Penney's big Thanksgiving weekend deals pulled sales forward into the month of November more than they stimulated additional spending.
Additionally, J.C. Penney faced its easiest year-over-year comparison last quarter. The company did not offer significant holiday promotions in Q4 of 2012, causing a 31.7% drop in comparable-store sales that quarter.
J.C. Penney's meager sales growth last quarter means that it regained only a small fraction of the revenue it lost in the previous year. Put a different way, J.C. Penney's Q4 comparable-store sales are still down nearly 30% since 2011 -- when the company was already barely profitable.
Liquidity problems ahead
J.C. Penney's ongoing poor performance puts the company on a path toward severe liquidity issues later this year, which could intensify further in 2015 -- if the company gets that far. J.C. Penney achieved its goal of ending the 2013 fiscal year with more than $2 billion of liquidity (cash and investments plus a credit line), but that shouldn't give investors much comfort.
The problem is that J.C. Penney burned $3 billion of cash through the first three quarters of its recently concluded fiscal year. In other words, at last year's rate, J.C. Penney would be out of cash by the fall.
In reality, J.C. Penney's situation isn't quite that dire. The company increased its inventory level during 2013 in order to improve in-stock levels and expand its private-label selection. It also spent an unusually high amount on capital expenditures to remodel its stores. Without these unusual expenditures, J.C. Penney's cash burn would have been around $2 billion for the first three quarters of last year.
Nevertheless, without a substantial improvement in J.C. Penney's revenue and gross margin trends, the company will be dangerously short of liquidity by the fall. Suppliers may be reluctant to provide holiday goods on credit if the company seems to be on shaky ground, which would further aggravate the problem. In short, if comparable-store sales growth of 2% is the best J.C. Penney can manage, the company could hit a crisis point before the end of the year.
Obviously, the best solution for J.C. Penney would be a miraculous rebound in sales and gross margin to stabilize free cash flow. However, even after its ongoing cost cuts, J.C. Penney would probably need its sales to rebound to $14 billion annually to break even on a cash flow basis. That would imply a more than 15% jump in sales, something that seems increasingly unlikely.
Barring an immediate bounce in operating performance, the second-best option for J.C. Penney would be significant asset sales. (The company raised a lot of debt and equity in 2013, and it would be difficult or impossible to convince investors to hand over any more cash through another debt or stock sale.)
However, J.C. Penney has been selling off non-core assets in a piecemeal fashion for two years, so there probably is not much left of value aside from its headquarters and store real estate. Moreover, J.C. Penney mortgaged most of its real estate assets last year as collateral for a $2.25 billion term loan. Even if it did sell off real estate, a significant part of the proceeds would have to go toward paying off that debt, rather than bolstering the company's liquidity.
Moving closer to bankruptcy
Given the pace of J.C. Penney's cash burn and the lack of other financing alternatives, filing for bankruptcy may be the only option if conditions don't improve soon.
That wouldn't necessarily mean the end of J.C. Penney. A bankruptcy restructuring could buy J.C. Penney some extra time to reduce its costs and hopefully win back customers. Bankruptcy would also give the company an opportunity to restructure its debt, which would reduce interest expense and lower its break-even point to a more manageable level.
However, J.C. Penney shareholders would get little or nothing in a bankruptcy proceeding, as the company's unsecured debt holders would be compensated for their losses with stock in the reorganized company. As a result, investors should continue to steer clear of J.C. Penney.