In the past two years or so, J.C. Penney (NYSE:JCP) has made enormous progress toward stabilizing its business following a disastrous strategy shift in 2012. After burning more than $2.7 billion of cash in 2013, the company actually generated free cash flow of $57 million last year.
J.C. Penney has continued to bolster its financial results in 2015, with a dramatically smaller net loss and a modest increase in operating cash flow. As a result, it has been able to start paying down debt. This could mark the beginning of a virtuous cycle of rising cash flow and falling debt levels that could finally snap J.C. Penney stock out of its multi-year funk.
Debt reduction begins
In the past few years, J.C. Penney's debt has ballooned as the company invested heavily to remodel its stores and former CEO Ron Johnson's failed strategy led to massive losses. During the 2013 fiscal year, J.C. Penney's debt load increased from $3 billion to $5.6 billion.
Furthermore, due to its dreadful financial position, J.C. Penney didn't have much bargaining power when it issued that debt. It had to offer high interest rates around 8% for many of these borrowings.
About a month ago, J.C. Penney announced that a consortium of banks had agreed to increase its revolving credit facility by $500 million, to $2.35 billion. This allowed it to pay down a $500 million term loan last week without compromising its liquidity. (If it needs cash on a short-term basis, it can use the larger credit line.) These transactions will reduce J.C. Penney's annual interest expense by $20 million.
Paving the way for more debt retirement
Since issuing a massive amount of high-cost debt a few years ago, J.C. Penney has been burdened with excessive interest payments. Last year, its interest costs totaled $406 million, or 3.3% of revenue.
Reducing that by $20 million is just a drop in the bucket. However, this $20 million savings will add to the underlying improvements in free cash flow stemming from J.C. Penney's sales growth, gross margin expansion, and expense cuts.
J.C. Penney could then use whatever free cash flow it produces in 2016 to retire more high-cost debt. This would further reduce interest expense, bolstering free cash flow in 2017 and driving a virtuous cycle of rising free cash flow and declining debt levels.
Indeed, J.C. Penney has $78 million of debt paying a 7.65% coupon maturing next year and then $220 million of debt paying a 7.95% coupon that matures in 2017. (It also has smaller ongoing principal payments for some of its debt.) If the company can pay down all of this debt from free cash flow, annual interest expense would decline by another $25 million or so.
In 2018, J.C. Penney has nearly $2.5 billion of scheduled debt payments. It will only be able to pay off a small portion of that amount, but its ongoing debt reduction efforts and improving cash flow could enable it to refinance at lower interest rates. Every one percentage point reduction in the interest rate would cut its annual interest expense by almost $25 million.
Debt reduction can drive stock gains
J.C. Penney's debt reduction should be good for its shareholders for many reasons. First, it will reduce the risk inherent in the stock by removing a significant fixed expense (interest payments).
Second, the lower interest expense will improve key metrics like earnings per share and free cash flow that many investors consider when deciding whether or not to buy a stock.
Third, debt reduction will probably lead to upgrades in J.C. Penney's credit ratings. This would help to highlight the improvements in the company's financial results, potentially increasing investor interest.
To remain on this upward trajectory, J.C. Penney will need to continue posting mid-single digit comparable store sales growth, as it has (on average) since early 2014, while keeping costs under control. But assuming it can execute well on these retail fundamentals, debt reduction could be a key tailwind for J.C. Penney's earnings and stock price over the next few years.
Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.