Hedgeye - JCP: Our Take On The Liquidity Debate

JCP issued a release this evening vehemently defending against a letter it received suggesting that JCP is in violation of terms on 11% of the company’s debt. The letter came from a firm claiming representation of over 50% of holders of the 7.4% debenture due 2037 (one of 11 tranches of debt). JCP argues that this is ‘completely without merit and intended to create self-interested trading opportunities in the market’. It’s impossible for us to know one way or another. But right or wrong there’s only one thing that’s certain – liquidity will be talked about more as a key issue with JCP. With that being a near certainty, we thought we’d stress-test our model to see where the risks are to this story.

Before going into the model, here's a few thoughts...

First off, the letter was dated on 1/29/13. Based on today’s close, JCP is down 8.0% since the letter was written. That compares to -0.7% for the S&P, and -1.3% for the broader Retail group (RTH). Clearly, this is news to people reading the general tape – but the market has been acting on the event since last Wednesday.
The claim is that JCP violated the agreement when it entered into its current inventory-backed $1.5bn revolver (which is expandable to $2.0bn) in Jan 2012 without providing for equal security for the debenture holders. Why this would come out 13 months after the issuance is questionable – perhaps because liquidity was not a concern back then and now the bond holders are doing whatever is feasible (or unfeasible) to secure their capital if JCP faces a liquidity crunch in 2013.
From a risk management perspective, the best we can do is assume that the claim is valid.
1. In that case, a worst case scenario would be that the other 10 consortiums of JCP’s debt attempt to step forward and stake claim on inventories. But that, quite frankly, seems ridiculous. It would be a first for any retailer we have ever seen. Maybe we’re missing something, but we don’t see how unsecured lenders could think that they could stake claim over a secured asset.
2. Perhaps a slightly more realistic scenario equity holders should keep in mind would be that the holders of $1.1bn in Senior Notes put the debt back to JCP, which could happen in the event of change in control combined with not meeting certain minimum rating standards. That certainly would not be possible based on what we’ve seen transpire thus far. Not even close.

We think that the key is to do a simple assessment of JCP’s cash, and cash flow needs under a bear-case scenario, and then do a simple check as to the company’s liquidity. Consider the following as it relates to sources of cash.

SOURCES: JCP ended 3Q with $525mm in cash, and the company stands behind its guidance that it will have $1bn in cash by the end of the year. We don’t buy it.
Traditionally, 4Q has the biggest cash flow build of the year. There has historically been 12%-17% incremental cash build as a percent of 3Q revenue.
That mold was broken last year, when JCP only generated 7.8% -- or $422mm in cash.
We assume that 4Q cash build comes in at only 3%, or just $100mm. That leaves JCP with $625mm in cash.
JCP has no debt maturities due until 2015 – and even then we’re just looking at $200mm.
JCP has $1.5bn in its revolver, and that is expandable to $2.0bn
All-in, JCP has between $2.1 and $2.6bn in sources of cash per our estimate.
If they miraculously hit their YE estimate of $1bn, then it bolsters the strength in JCP's liquidity materially.

USES: Assumptions for uses of cash gets a bit more dicey, but let’s start with our P&L and Cash Flow modeling assumptions…

Let’s assume JCP does not earn one red cent until FY16. We’re modeling that it loses $1.0bn in EBIT through 2015. As noted many times, our more constructive view on the stock has been predicated based on the direction of the top line as opposed to profitability, as we think that revenue will pick up on the margin as JCP anniversaries an abysmal 2012 and changes over a third of its store base to a more productive mix by the end of FY13.
We assume that sales are down 35% in the upcoming quarter, and remain negative until the back half of 3Q14.
We’re modeling Gross Margins just under 35% by the end of 2015 – which is a full 500bp below where JCP is planning its business ‘longer term’.
Our SG&A estimate is bottoming out at $4.2bn. Quite frankly, this gives credit for the $900mm in net savings – and if there’s any area where we’re stretching it, this is probably it. JCP needs to invest in its stores.
Our EBIT decline estimate is almost evenly offset by $500mm+ in D&A per year.
We’re assuming that working capital – both inventories and payables move with the business. On one hand, JCP can’t be a pig and expect vendors to bolster its balance sheet. That jeopardizes its partnerships. On the flip side it’s sitting there with 98 days of inventory on hand – which is a level that can be chopped down. Every day is equal to about $25mm in capital.
We tack on about $800mm in cash needed to fund capex and new shops annually. That suggests that JCP will need to use somewhere around $1bn of its revolver ($800mm x 2) = $1.6bn - $625mm in cash on hand.
A key consideration is that the company has the option to slow down the cadence of the new store rollout. Don’t get us wrong…That’s bad. But it is a way to help ward off a liquidity event to the extent that one approaches.
When all is said and done, we get to an extra $500mm-$1.0bn in cash available to draw under what we think is a beared-up model.

The punchline is that we can absolutely see why there’s all the concern about JCP’s liquidity – a $500mm-$1bn pad is not as much as we’d like to see for a retailer this size. But we don’t think that the concern should be the result of this evening's announced claim.

We think we’d need to see a cash balance at year-end below $600-$700mm to get concerned about JCP’s cadence of shop in shop rollouts for 2013. That would lead to either a) a slowdown in the rate of shop-in-shop additions, or b) the need to sell equity to keep the storytelling alive. We’d prefer the former, but due to management’s ego regarding growing the business, we can’t rule out the latter. For now we’re sticking with our modeling assumptions that shouldn’t require either.

As the facts change so will we. For now, we're comfortable with the facts.