Conclusion: We’re taking JCP off of our ‘Long Bench’ and are making some meaningful downward revisions to our model. This is not all about the 3Q print, but rather our confidence in the company’s ability to drive its top line in conditions that are anything other than optimal. Modeling ‘optimal’ conditions for the next four years hardly seems realistic, and irresponsible considering JCP’s debt maturity schedule. To be clear, we’re not making a short call. But now, we think that the likelihood of the stock going to $15 is equally offset by the chance of it going to zero (something we previously assigned a very low probability). That’s hardly a palatable risk/reward with the stock at $7.50.
It’s extremely rare that a quarterly earnings print will sway our opinion meaningfully on a stock. But this is definitely one of those times. While we did not have JCP on our list of top longs we definitely had a positive bias in our view on the company’s recovery and earnings potential. Based on our view of where the department store space is headed, and where JCP’s market share and cost structure are both likely to shake out – we now don’t have JCP turning a profit on the P&L until 2019 vs our previous model of break-even by 2016. If our numbers are right, that means that JCP will have to go through another economic cycle losing money, which matters with the stock trading at 14.5x EBITDA and 6.5x an EBITDA number that’s five years out.
Liquidity is something to consider as it’s no longer a key point of the debate today (nor should it be based on current conditions). To be fair, if we’re going to assume that the economy grows at a normal clip every year for the rest of this decade, then it shouldn’t be part of the debate, as JCP will be just fine. But not having a very bad sales/margin event at some point over the next four years would make this latest expansion one for the record books. We know it’s ‘out there’ to be so focused on what could happen as far as 2018, but the company faces a very big maturity in ’18 – $2.2bn to be exact. If it had to refi that today, it would probably not have a major problem.
But what happens if the company has to do so defensively in the event of a recession/bad economic event in 2016/17? The loan is secured by JCP real estate. It would be backed into having to either a) refinance at a grossly unfavorable rate, b) issue some equity-linked security, or c) surrender the property and then pay market rents if it wants to retain the business. None of those outcomes is attractive. In fact, they’d all send the stock a lot lower from where it is today. This did not matter as much for us with the company growing sales in the mid-high single digits. But our previous assumption seems far too aggressive based on what we’re seeing right now.
Are we making the ‘bagel’ call? No. We are not. We want to be clear about that. But in stress testing the model, we think that a double from here is just as likely as the stock going to $0. That’s not a risk/reward we like to see. We’d simply stay away at this price.
Why Such A Dramatic Change?
Business Changed Very Quickly. Just five weeks ago, JCP lowered guidance to a ‘low single digit’ comp versus previous guidance of ‘mid-single’. That’s usually interpreted as a 2-3% comp, which we think the company implied. But for the quarter, comps came in flat versus a year ago. That means that October must have been an unmitigated disaster. But yet JCP said that September was the worst month of the quarter. Sounds to us like the company was missing materially a month ago, and threw out a ‘low-single’ target with its fingers crossed along with a healthy dose of hope that October would improve. That’s extremely poor risk management.
Gaining Share? JCP only comped 140bps ahead of Macy’s (and KSS based on its preannouncement). Let’s be clear, for this story to even approach something that is palatable, it needs to gain significant share on a reasonably consistent basis without buying it. The problem with this quarter is JCP did not have a merchandising miss, didn’t stumble in a specific category, or suffer anything else that is company-specific other than a 30% decrease in liquidation sales. But that was known when the company provided guidance. It was because of the same old reasons we hear from all the other mediocre retailers – weather, competition, promotional climate, and overall ‘tough retail environment’. Note: Great companies – or even mediocre ones with solid revenue plans – don’t talk about these factors.
What Happens When Things Aren’t So Good Out There? We understand that there are likely to be quarters where JCP performs closer to the peer group than others. This might be one of them. Also, the company put up a stellar 718bp improvement in Gross Margin. It could have easily forgone some of that margin in favor of a better comp. But management said flat-out that it will do mid-single digits longer term…just not this year. What we don’t understand is that this is a company that is in recovery, and is only putting up comp store sales growth (including e-commerce) of 3-4% in a decent enough economy.
What happens if the consumer cracks? What happens if the current 6-year growth and margin retail expansion cycle comes to an end, and ‘re-cycles’. It’s been known to happen from time to time (about twice a decade for the past 40 years). So basically – the company all but admitted that it can only comp msd when the economy is extremely healthy and/or the retail climate becomes ‘easy’. That’s just something that we’re not willing to put in our model for ANY company.
No Store Closures: Sounds like store closures are definitely not on the front burner. Not even close. Maybe down the road, but not now. Management admitted the same exact thing that KSS said a few weeks back – virtually all stores operating today are making money, and are cash flow positive. Furthermore, our work suggests that unlike in past cycles, retail CEOs will avoid closing stores that are otherwise considered marginal as retail stores are inextricably linked with e-commerce. Closing stores – even bad ones – risks losing e-commerce revenue. The only line item (aside from SG&A) growing for any department store is dot.com revenue, and the companies won’t risk shooting themselves in the foot by shutting down one of the biggest assets that enable e-commerce. The point is…no major store closure/cost cutting plan.
Key Assumptions In Our Model
Sales: We assume store sales grow at a 3% clip, with e-commerce growing closer to 10%. That lands us at around 4% top line growth through 2018. It also suggests that JCP gets back to $130 per square foot. That’s a far cry from its former $195 and KSS $210. But it’s better than the $108 JCP is sitting on today.
Gross Margin: We tempered our assumptions here. Assuming JCP adds 200bp over 5 years to 36.4% -- that’s down about 150bp from our previous model. On one hand, the company has been doing a great job in recovering margin, but on the flip side, a lower comp growth base will mitigate occupancy leverage.
SG&A: Growth of 1-2% per year. This is a company that used to have $5.3bn in SG&A on the same store base we have today. Today SG&A is just below $4bn. It’s probably headed higher. No changes in our modeling assumption here.
Capex: $250mm this year ramping to $400mm by year 5. Yes, the $1bn RonJon cap spending was too high. Now JCP is overshooting on the downside. If it wants to gain share, capex will need to rise. As with SG&A, we did not change anything here.
Free Cash Flow: We have FCF within about $100mm of break-even (usually positive) over the foreseeable future. The challenge is that we’ll need more than that to handle debt maturities which total $600mm over the next five years until the big $2.2bn refi in 2018.