S&P Lowers JCPenney (JCP) Unit Term Loan From 'B' to 'B-'; Outlook Negative

On May 21, 2013, Standard & Poor's Ratings Services lowered its rating on J.C. Penney Corp. Inc.'s (a subsidiary of J.C. Penney Co. Inc. (NYSE: JCP)) senior secured term loan to 'B-' from 'B' and revised the recovery rating to '2' from '1'. The '2' recovery rating indicates our expectation for a substantial recovery (albeit at the high end of the 70%-90% range) in the event of a payment default.

The lower ratings reflect a decline in recovery estimates for term loan lenders because of the upsizing. The company plans to use the proceeds from the term loan to fund operating needs, working capital requirements, and the tender for its debentures due 2023.

At the same time, we affirmed all other ratings on the company, including the 'CCC+' corporate credit rating. The outlook is negative.

Rationale

The rating on Penney reflects Standard & Poor's assessment that the company's business risk profile is "vulnerable" and its financial risk profile is "highly leveraged." Our business risk assessment incorporates our analysis that the department store industry is highly competitive, with large, well-established participants. Based on this environment, we believe further performance difficulties may cause the company to lose market share to other players, such as Macy's, Kohl's Corp., Sears, other department stores, or off-price retailers. 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 Penney's poor performance over the past year. In our opinion, the company will implement these changes over the next few months, but its ability to stabilize operations remains highly uncertain.

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. The board enabled the prior CEO to implement a highly risky strategy without undergoing any testing to see the effects on the customer. This had devastating consequences for performance over the past year. In addition, the frequent and significant changes in management over the past year underscore our view of weak corporate governance by the board. In our opinion, we now believe the new CEO's involvement is instrumental to a potential turnaround, and his absence would be viewed negatively.

Performance remained extremely weak in recent quarters, as traffic was severely hurt by the new strategy. Additionally, we believe that a few shifts in pricing, promotion, and marketing strategies during the past year resulted in customer confusion, which also impaired performance. As a result, sales continued to decline with comparable-store sales falling 16.6% in the first quarter ended May 4, 2013, following a same-store sales decline of 25.2% last year. Margins eroded significantly due to increased clearance and negative sales leveraging, resulting in negative EBITDA. Over the next 12 months, we expect Penney to experience further operational disruptions as it refines its strategy. We believe that customer traffic is likely to remain negative, thus resulting in weaker revenue performance. Our assumptions for the company for 2013 include:

• Sales per square foot to decline in the mid- to high-single-digit area;
• EBITDA margins to increase to the 2% area due to fewer markdowns and benefits from cost reductions;
  
• Capital expenditures to be around $900 million; and
  
• Free operating cash flow to be substantially negative, in the negative $1.5 billion range.

We assess Penney's financial risk profile as "highly leveraged," as our view of liquidity remains "less than adequate" and credit protection measures have deteriorated over the past year because of performance declines. Given our forecast for some EBITDA recovery over the next 12 months and the substantial increase in funded debt since year end, credit protection measures are largely meaningless. We expect leverage to be more than 30x, interest coverage to be substantially less than 1.0x, and funds from operations (FFO)-to-total debt to be less than 5% over the next 12 months.

Liquidity

We assess Penney's liquidity as "less than adequate," with meaningful cash uses over the next year. Since its fiscal year-end, the company has drawn $850 million under its $1.85 billion asset-based revolving credit facility and will be issuing a $2.25 billion term loan. We believe the these two fundraising activities (in conjunction with cash on hand of $930 million at Feb. 2, 2013) will be sufficient to cover cash needs over the next year, which we estimate to be around $700 million for working capital, $900 million for capital expenditures, and around $255 million for the debt tender principal. However, we do not believe that the company will generate sufficient operating cash flow to cover its working capital and capital expenditure needs over the next year, especially given the additional interest expense on the new term loan.

We forecast that the company's free operating cash flow will be about negative $1.5 billion for 2013. Other factors and views contributing to our liquidity assessment include the following:

• We estimate liquidity sources to cover uses by more than 1.2x;
  
• We expect that net liquidity sources would be positive even with a 15% decline in EBITDA;
  
• We believe that the company has well-established and solid relationships with its banks; and
  
• Penney has manageable debt maturities over the next two to three years.

Recovery analysis

An updated recovery analysis report will be published shortly after this release on RatingsDirect.

Outlook

The negative outlook reflects our view that further operational issues are likely over the next year as the company refines its "shops", marketing, and promotional strategies and that success remains uncertain. Although we believe the company has alleviated some of the very near term concerns with the recent draw down and term loan issuance, we do not believe that the company will generate sufficient operating cash flows to cover working capital and capital expenditures. Although we expect some recovery of EBITDA over the next 12 months, we do not believe credit protection measures will be meaningful with coverage substantially below 1.0x.

We could consider lowering our rating if performance weakened further such that we believed the company would likely default within the next 12 months. In such a scenario, the company is unable to stabilize operations, leading to a cash burn that is meaningfully higher than our forecast. Under this scenario, vendors would tighten turns leading to a substantial decline in cash on hand.

Although we consider the possibility for an upgrade to be remote, key positives would include performance recovery much earlier than we currently expect as the company implements its revised strategy. Another important component would be sufficient cash flow from operations that cover ongoing working capital needs and capital expenditures. Any consideration for an upgrade would require sustained leverage below 7.0x and interest coverage above 1.5x.

---

Serious News for Serious Traders! Try StreetInsider.com Premium Free!

---

You May Also Be Interested In

• Lowe's (LOW) PT Lowered to $275 at Guggenheim
• Walmart (WMT) PT Lowered to $130 at Guggenheim
• Okta, Inc (OKTA) PT Raised to $170 at Cantor Fitzgerald Ahead of Q2 Results