As J.C. Penney (OTC:JCPN.Q) looks to continue its turnaround efforts, debt reduction has to be a key priority. The company's high debt burden raises its risk in the event of an industry downturn and drives up costs in the near term.
Fortunately, J.C. Penney has already started to turn its attention to paying down debt. The company retired a $500 million term loan late last year using its free cash flow and an increase in its credit line. Now, J.C. Penney is considering a sale-leaseback deal for its headquarters building to fund further debt reduction.
Debt is a key issue
As losses piled up a few years ago, J.C. Penney's debt level increased from less than $3 billion in early 2013 to $5.6 billion by the end of that year. As a result, interest expense has surged from just $226 million in fiscal 2012 to around $400 million annually recently.
This is a tremendous burden, representing more than 3% of J.C. Penney's sales, compared to a little more than 1% of sales a few years ago. High interest expense could potentially be the difference between J.C. Penney returning to profitability or posting yet another loss in 2016.
A real estate deal could help
In recent years, department store chains have increasingly sought out real estate deals to free up cash for debt reduction and share buybacks. Most notably, Macy's (NYSE:M) hopes to form partnerships to redevelop portions of four flagship stores that are collectively worth billions of dollars. Macy's is also looking to sell other stores for which the real estate is more valuable than the retail business.
J.C. Penney doesn't have the same kind of flagship real estate assets as Macy's. Many investors think that Macy's real estate could be worth more than $20 billion in total.
By contrast, when Cushman & Wakefield appraised J.C. Penney's real estate in 2013, it valued the company's owned and ground-leased stores at $3.3 billion and its distribution centers and home office at $762 million. Real estate prices have risen since then, but there's still a huge gap between Macy's real estate value and that of J.C. Penney.
Last week, J.C. Penney announced that it is considering a sale of its 1.8 million square foot home office building. It would lease back most of this space. However, it is not fully utilizing its office space today due to its downsizing over the past few years. Thus, the buyer would be able to lease more than 650,000 square feet to other tenants.
Based on the strong real estate market, analysts think that J.C. Penney could raise hundreds of millions of dollars by selling its headquarters building. Furthermore, since the company wouldn't lease back the entire space, it expects to fully offset its rent expense through lower maintenance costs, property taxes, and interest expense.
Looking for steady progress in reducing debt
J.C. Penney is already starting to reduce its debt burden and interest expense by producing a modest amount of free cash flow and carrying less cash on its balance sheet. A sale leaseback for its headquarters would generate a nice chunk of cash to continue this process.
It will probably take a while for J.C. Penney to negotiate and finalize a major real estate sale like this. However, if the company succeeds, there could be a big payoff for investors. The lower J.C. Penney's debt level, the better its chance of securing a higher credit rating. This could help it refinance its remaining debt at lower rates, which would have a tangible impact on earnings.
More broadly, the less debt J.C. Penney has, the less risky it will be to invest in the company. Over time, this should lead to a higher valuation for J.C. Penney stock.