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S&P Comments on JCPenney (JCP) Following Executive Shift, Financing Draw

April 18, 2013 11:21 AM EDT
Standard & Poor's, of McGraw-Hill (NYSE: MHP) issued commentary on retailer JCPenney today following recent management shakeups and draw downs on revolving credit lines. It explores recent performance in the company, in addition to potential steps the retailer might take to regain some footing.

How did JCPenneyenney (NYSE: JCP) get to where it is? How was the company allowed to undertake such a risky transformation with regard to its "shops" concept and promotional strategy? It all began when an activist shareholder group allowed then-CEO Ron Johnson and his management team to enact a "bet the farm" strategy.

Pershing Square Capital Management (Pershing) had aggregate economic exposure to approximately 25 percent of JCPenney shares outstanding and Vornado Realty Trust (Vornado) had about 6 percent as of March 5, 2013. Although Vornado subsequently sold off some its holdings, these two entities combined control more than 20 percent of the shares outstanding, which gives them considerable influence over the company.

JCPenney's risk profile began to ramp up even before Mr. Johnson took the helm as CEO when it began to shift its financial policies in early 2011. At that time, the company was carrying a significant amount of cash on its balance sheet. One of the first things Pershing advocated after acquiring a sizable stake in the company was to undertake a $900 million share repurchase program using cash on hand. Although no additional debt was used to fund the repurchases, in our view the program was a large drain on cash that the company could have used to turn the business around.

The implementation of JCPenney's transformation strategy stands in marked contrast to what other retailers have carried out. In our experience, retailers tend to be very methodical when they change strategies. The ultimate fear is alienating customers, which can hurt performance. The department store segment, like most other retail segments, is fiercely competitive. Once customers are lost, it can be difficult to regain them.

Retailers typically test a market first, and then review the results. They will tweak the strategy if needed, and roll out the final version to a larger set of stores. We almost never see a retailer put into place a major, untested shift in strategy. In our opinion, Pershing and Vornado backed Mr. Johnson and his management team to undertake a complete makeover of JCPenney without trying it out on a limited basis first, which we believe was a very risky move. We note that the recent replacement of Ron Johnson with JCPenney's prior CEO Myron (Mike) E. Ullman III is an acknowledgement that the strategy was poorly executed and that significant changes need to be made quickly to stem the operational declines and cash burn. We believe there could be further meaningful changes over the next few months as the new CEO reassesses the "shops," promotional, and marketing strategies that contributed to JCPenney's poor performance over the past year.

We assess management as "weak," under our criteria. We view the frequent shifts in pricing, promotion, and marketing plans over the past year as indicative of a strategy that has confused and alienated the core consumer. Although JCPenney's latest iteration of a pricing and promotion strategy that returns to weekly sales and coupons is an attempt to recapture some of the substantial market share lost over the past year, we think success remains uncertain. In addition, the frequent and significant changes in management over the past year underscore our view of weak corporate
governance by the board.

Strategy

In our view, JCPenney undertook an untested strategy. JCPenney is moving to a "store within a store" plan similar to what it historically had with brands like Sephora. The company plans to roll out this concept to the entire retail space and populate it with kiosks selling well-known, established brands. By early February 2013, JCPenney had transformed about 10 percent of the floor space and expects to have converted more than 30 percent by May. However, this has created two JCPenneys.

The first, with its new, branded products, appears to be doing fairly well. The legacy areas, however, do not look as visually appealing, and performance has suffered. We believe that having these two side-by-side JCPenneys caused some of the underperformance, but that's not the only reason for the poor results.

We believe the root of JCPenney's problem is the promotional and pricing strategy shifts over the past year, which have alienated the core customer. The company started out with three-tier pricing--everyday low price, month-long values, and clearance--but no coupons or sales. Later in the year, management added promotional events to entice customers, such as free kids' haircuts in the back-to-school period. In the third quarter of 2012, the company eliminated month-long value pricing and moved to a two-tier strategy--everyday low price and clearance. But after traffic declined sharply, JCPenney changed course again in February 2013 by reverting to weekly sales and coupons.

The company altered the marketing strategy along the way. Initially, its marketing plan was "image-based" rather than "action-based," but it didn't provide a compelling reason for customers to shop. Later in 2012, the company shifted course to include more events and communications that highlighted value pricing. In February 2013, the marketing message was retooled again to remind customers to compare prices on JCPenney's key items to those of other retailers. Will these marketing and promotional revisions help the retailer bring customers back in? Given how hard it is to win back customers, we don't think these changes will reverse the sales trends, though they may help to slow the substantial erosion. At the same time, the viability of the store-within-a-store strategy remains unproven because the rollout is not complete. In addition, the changes in the CEO could cause the company to shift strategies once again.

Performance

JCPenney posted extremely weak performance during all four quarters of the previous year primarily due to a drastic reduction in store traffic. In addition, we believe that a few shifts in pricing, promotion, and marketing strategies during the past year led to customer confusion, which also hurt performance. As a result, sales dropped by 24.8 percent, and same-store sales declined by 25.2 percent on an annual basis. We estimate that EBITDA was a negative $365 million as of Feb. 2, 2013, compared with $1.3 billion for the prior period.

Over the next 12 months, we expect further operational disruptions are in store as JCPenney refines its strategy. We believe that customer traffic is likely to remain negative, thus leading to revenue declines and additional markdowns. In our opinion, the timing of the management change also signals to us that first-quarter performance will be very weak. In our view, the performance declines at JCPenney have more to do with internal factors than the weak macroeconomic recovery. While we believe that the traditional JCPenney customer is more susceptible to the rise in payroll taxes and persistently high unemployment, other moderate department stores that compete for the same customer demographic generally had a good year. For example, Macy's and Dillard's reported same-store sales of 3.7 percent and 4.0 percent, respectively. We think JCPenney's performance declines reflect the transformation and its execution, rather than the economy. In our opinion, far fewer customers entered JCPenney stores, and sales plummeted because they weren't given a reason—such as coupons--to shop.

Real Estate

In the face of extremely poor performance, JCPenney decided to divest noncore assets to generate cash. Because we think this year will be another difficult one for Penney, we expect this trend to continue. Still, the company retains meaningful real estate ownership, which we estimate to be around 39 percent of its stores either owned or ground-leased. Over the past year, JCPenney received net proceeds of $526 million from the sale or redemption of nonoperating assets, including real estate investment trust (REIT) shares or units, leveraged lease assets, real estate joint venture investment, and a building used in its former drugstore operations.

Liquidity

In our opinion, JCPenney is no longer able to fund its transformation with internally generated operating cash flow. We think it will supplement funding for any maintenance or acceleration of its transformation with borrowings under its revolving credit facility or other forms of external financing. On April 15, Penney borrowed $850 million under its credit facility. The company monetized much of its noncore assets over the past year, and we believe further opportunities for meaningful cash flow generation are limited. However, JCPenney could look to sell real estate.

According to JCPenney's maturity schedule, there will not be a significant call on cash for an upcoming maturity. The next sizable maturity is $200 million in 2015, followed by another $200 million in 2016. Results of the company's transformation will have likely played out by then, so we do not view these maturities as a major concern.

Looking Ahead

Because we believe JCPenney will seek additional financing or borrow under its revolver to fund operations, we will be monitoring the situation closely with regard to its capital-raising activities. We will be watching performance over the next two quarters to determine if the combination of the most recent management change and the revised marketing and pricing strategies can reconnect with customers. In addition, we would look to gain a better understanding of how these new shops are performing vis-à-vis the legacy space, and what the ultimate strategy will be with regard to further rollouts. We believe that the new management team will revisit the shops strategy and may slow their growth or make other meaningful changes over the new few months.

Although we do not expect to see positive same-store sales during the next six months, a meaningful deceleration of the steep declines could signal the start of some modest success. The best-case scenario would be a stabilization of same-store sales later this year and moderate margin gains as JCPenney is able to lower its markdown levels.

Conversely, we could consider lowering our rating if performance weakened further such that we believed the company would likely default within the next 12 months. One scenario could be that JCPenney lacked sufficient borrowing capacity under its revolving credit facility to carry out its transformation and, in our assessment, would not be able to raise sufficient funds from alternative sources. We could also lower our rating if vendors tightened terms such that cash declined precipitously from current levels.


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