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Image source: J.C. Penney.

J.C. Penney (NYSE:JCP) has made some serious progress over the past couple of years. Sales tumbled in 2012 and 2013 as the company's efforts to reinvent itself floundered, and it took the return of the previous CEO to stabilize the business. Revenue in 2013 was just $11.86 billion, down a staggering 31% compared to 2011. That sharply lower revenue brought with it a massive $1.4 billion net loss, bad enough that bankruptcy seemed like a possible, if not likely, outcome at the time.

The worst is now over for J.C. Penney. The company returned to sales growth, posting 10 consecutive quarters of comparable sales increases through the fourth quarter of 2015. Gross margin has recovered, reaching 36% last year, only a few percentage points below peak levels. Costs have been slashed, with operating expenses declining by 25% between 2011 and 2015, and the company is producing positive free cash flow, allowing it to chip away at its debt load.

But the turnaround at J.C. Penney is far from over. It is still unprofitable, with a net loss of $513 million in 2015, and sales are still far below historical levels. Free cash flow is being boosted by declines in working capital and the company underspending on capital expenditures, a situation that is not sustainable in the long run. Both are good ways to preserve cash, but J.C. Penney's positive free cash flow can only persist if net income improves dramatically.

J.C. Penney is in better shape than it was a few years ago, but a successful turnaround is not a sure thing.

Debt and free cash flow

J.C. Penney had about $4.8 billion of debt at the end of 2015, down from $5.4 billion at the end of 2014. Interest payments last year still totaled a whopping $415 million, eating up about 9% of gross profit. J.C. Penney is closing in on producing a positive operating profit after an operating loss of just $89 million last year, but interest payments create a huge hurdle that the company must get over before it can return to net profitability.

Much of the decrease in debt over the past year was the result of J.C. Penney reducing its cash on hand. The company's cash balance fell by $418 million in 2015 to $900 million, something that probably can't be repeated. However, J.C. Penney is considering selling its headquarters and leasing it back, a move that would create a windfall that could be used to pay down the debt further.

Beyond cash on hand and real estate transactions, J.C. Penney will need to rely on its free cash flow to pay down its debt in the coming years. The company produced around $120 million of free cash flow in 2015, and it expects this number to improve in 2016. But all of J.C. Penney's free cash flow is coming from sources that aren't sustainable.

First, J.C. Penney has been working to reduce its working capital, thus freeing up cash. This is a perfectly fine thing to do, but it can't be done every year. As sales grow, working capital will eventually need to start increasing again to support those higher sales, turning what is now a source of cash into a use of cash. In 2015, changes in working capital contributed $139 million to the free cash flow. Without this item, J.C. Penney's free cash flow would have been negative.

Second, the company is very likely under-spending on capital expenditures. Just $320 million was spent in 2015, far below the company's $616 million depreciation charge and historical levels. J.C. Penney did spend heavily on capex during 2012 and 2013, warranting a period of lower spending, but it can't go on forever. It's difficult to estimate what level of maintenance capex is necessary on average, but I'm willing to bet that its substantially more than what J.C. Penney spent last year.

Net income will need to drastically improve going forward for the free cash flow to remain positive, and that requires sales growth to continue. J.C. Penney's streak of comparable sales growth ended when the company reported a 0.4% decline during the first quarter. The company still expects comparable sales to grow by 3%-4% this year, but it will need to make up ground in order to achieve that goal.

J.C. Penney's biggest problem is that it doesn't sell enough stuff. While cost cutting is helping the bottom line, increasing sales is the only way that J.C. Penney will return to profitability. In the meantime, the company will have a limited ability to pay down its debt, with its free cash flow being propped up by temporary measures. A lot can still go wrong for J.C. Penney, and despite the company's progress, its turnaround is still uncertain.

Timothy Green 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.