J.C. Penney Cash Drain Imperils Makeover Plan: Corporate Finance

J.C. Penney Co.’s plan to fund its turnaround with cash from operations is in jeopardy as the department store chain’s biggest quarterly loss since 2004 boosts the chances it will need alternative sources of capital.

While Chief Financial Officer Ken Hannah said this week that the retailer was committed to financing its plan to make its stores more attractive with operating cash, a 32 percent decline in the fourth quarter from a year earlier helped drag its balance below a $1 billion target. That may lead Plano, Texas-based J.C. Penney to tap a $1.85 billion credit facility or issue debt or preferred shares, according to bond-research firm CreditSights Inc.

Creditors are fleeing J.C. Penney, whose debt rating Standard & Poor’s cut yesterday to a grade that indicates vulnerability to nonpayment, as Chief Executive Officer Ron Johnson struggles to shift course after reporting the lowest annual sales in more than two decades. Deteriorating operations have left the retailer with credit-default swaps that have converged with those linked to Sears Holdings Corp. and about a year before it runs out of cash at its current burn rate.

“It’s not profitable, and there’s not much in the way of near-term impetus that’s going to turn that around,” James Goldstein, a senior analyst at CreditSights in New York who rates J.C. Penney bonds “underperform,” said in a telephone interview. “That means they’ll likely plug the hole with some sort of financing.”

‘Interim Borrowing’

The company, which spent $810 million on capital expenditures in the fiscal year ended Feb. 2, has adjusted cash of about $850 million, Hannah said on a Feb. 27 conference call to discuss fourth-quarter earnings. That means it can operate without financing for about 12 months, based on a free cash flow deficit of $822 million for the past year, according to data compiled by Bloomberg.

Daphne Avila, a J.C. Penney spokeswoman, said the company doesn’t comment on analyst speculation.

“There might need to be some interim borrowing under the credit facility as cash should not really be allowed to go too much lower than it is now,” said Carol Levenson, director of research at Chicago-based Gimme Credit LLC. Gimme Credit rates J.C. Penney’s debt “deteriorating.”

Bonds Fall

J.C. Penney’s $400 million of 5.65 percent, senior unsecured bonds due June 2020, which traded as high as 102 cents on the dollar a year ago, dropped to a record-low 80.75 at 10:44 a.m. in New York, giving it a yield of 9.37 percent, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Credit-default swaps linked to the retailer’s debt have surged 93 basis points since it reported earnings to 1,005 basis points at 11:03 a.m. The contracts, which pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt, were as low as 308 a year ago and compare with 932 basis points for swaps linked to Sears, the only other U.S. department-store chain burning cash. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Johnson, the former Apple Inc. retail chief who joined as CEO in November 2011, has reversed his everyday low pricing strategy in recent months by adding sales, promotions and new price displays. Johnson has said his transformation of the firm, presented to investors in January 2012, would take four years.

Joe Fresh

J.C. Penney seeks to attract more fashion-conscious consumers by partnering with Canadian retailer Joe Fresh and making shop-in-shops with designers such as Nanette Lepore and Marchesa’s Georgina Chapman.

Investor confidence is waning after the company lost $4.3 billion in sales last year, bringing revenue to $13 billion, the lowest since at least 1987. Its net loss in the quarter ended Feb. 2 widened to $552 million from $87 million a year earlier.

S&P responded by lowering J.C. Penney’s ratings to CCC+ with a negative outlook, calling the company’s liquidity position “less than adequate” based on the view that it “will need to draw substantially on its revolver to fund operations, or seek additional financing to continue its transformation.”

The company is graded B3 by Moody’s Investors Service, one level higher than S&P. Sears has the same ratings.

J.C. Penney’s market value has declined almost $3 billion since Johnson, recruited by its largest shareholder Bill Ackman, took the helm.

Lender Permission

“We’ve never seen retailing results as bad as those presented by J.C. Penney,” Levenson wrote in a report Feb. 27. “Penney cannot go through another year like the last one without raising cash and/or drawing down its facility, which would structurally subordinate existing bondholders.”

The company reported its results after receiving clearance from lenders to sell billions of dollars in stock and debt if needed. Bank lenders also increased a credit line to $1.85 billion and gave the company permission to expand it to as much as $2.25 billion, according to a Feb. 12 regulatory filing.

“Our intentions are to fund this transformation out of our cash from operations,” said Hannah, who had forecast in November that the company would have $1 billion of cash at year-end. “We are committed to this strategy.”

Analysts from Barclays Plc to JPMorgan Chase & Co. and Morningstar Inc. said they were skeptical the company would refrain from tapping alternative sources of funds. J.C. Penney’s access to short-term capital, which includes the revolver and cash, is about $3 billion, Hannah said.

‘Bleeds Cash’

“Maybe increasing the availability on their revolver is meant to allay investors’ concerns on their liquidity position, but personally, it’s just exacerbated mine,” Joscelyn MacKay, a credit analyst at Chicago-based Morningstar, said in a telephone interview. “They’re reaching out for more credit on an undrawn credit facility -- that tells me that they’re padding their pillows for what could be a really hard landing.”

The retailer may burn through as much as $500 million of cash in the first quarter, Matthew Boss, an analyst at JPMorgan in New York with a neutral rating on the shares, wrote in a Feb. 27 note. “Despite a continued intention to ‘self-fund’ the transformation, a draw-down of the revolver appears increasingly likely,” he said.

J.C. Penney may use its credit facility by the second quarter, which may be a catalyst for boosting the cost of insuring the company’s debts against default, according to Hale Holden, a credit analyst at Barclays. Holden rated J.C. Penney “underweight” in a Feb. 27 report.

“There’s quite a bit of capacity on the revolver,” said CreditSights’s Goldstein, who estimated the cost to issue second-lien bonds would probably exceed 8 percent. “The concern over the longer term is that if your business bleeds cash, you get into a cycle where you’re living off the revolver, and that’s certainly not a long-term viable solution.”

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