S&P Affirms Corp. Ratings on JCPenney (JCP); Assigns 'B' to $1.85B Revolver

Standard & Poor's Ratings Services said that it had assigned a 'B' issue level rating to J.C. Penney Corp. Inc.'s (NYSE: JCP) $1.85 billion ABL revolving credit facility and $500 million senior secured first-in last-out term loan with a '1' recovery rating, indicating our expectation for very high (90%-100%) recovery in the event of a payment default. Concurrently, we are affirming all other ratings, including the 'CCC+' corporate credit rating on parent company J.C. Penney Co. Inc. The outlook is stable.

According to the company, proceeds from the new $500 million senior secured first-in last-out term loan will be used to repay borrowings outstanding under the revolving credit facility.

The ratings on Penney reflect 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 lose the company market share to other players, such as Macy's, Kohl's Corp., other department stores, or off-price retailers.

Performance trends continue to improve from very weak levels, commensurate with our expectations. The company reported same-store sales of 6.2% in the first quarter of 2014 and a gross margin increase of 230 basis points (bps). We believe the company will demonstrate further gains over the next few quarters, resulting in same-store sales growth in the mid-single digits. We forecast enhanced merchandise, stronger traction from private-label products, the reintroduction of promotions and coupons, and good expense controls will result in EBITDA margins in the mid-single digits in the next year--a substantial turnaround from last year. Our forecast over the next year includes the following assumptions:

-- U.S. GDP and consumer spending to increase in the low-single digits;
-- Same-store sales to be in the mid-single digits;
-- EBITDA margins to be around 4% as a result of gross margin recovery and good expense controls; and--
-- Capital expenditures to be substantially lower than recent years and in the $250 million range

We assess Penney's financial risk profile as "highly leveraged", given the very weak credit protection measures and our view of an unsustainable capital structure. Although we project some improvement in credit measures because of EBITDA growth, we believe credit protection measures will remain very thin over the next year. Even with significant improvements in EBITDA, we forecast leverage will remain in the double digits, interest coverage will be around 1.0x, and funds from operations (FFO)-to-total debt to be under 5% over the next 12 months.

The stable outlook reflects our view that liquidity will be "adequate" over the next year and that sources of cash will exceed uses by at least 1.2x. However, we believe the company's capital structure is unsustainable in the longer term, but it does not have any meaningful maturities over the next 12 months and so we do not see a clear path to default. It incorporates our opinion that the company will also realize modest, sequential performance gains because of the recent strategy changes, which include merchandise repositioning and the reintroduction of sales and promotions.

We could consider lowering our rating if the company experienced a reversal of its performance gains because of merchandise missteps or an erosion of consumer spending. At that time, we believe the company could likely default within the next 12 months. In such a scenario, the company is unable to stabilize operations, leading to a cash burn of around $750 million, which is meaningfully higher than our forecast. Under this scenario, vendors would tighten terms leading to a substantial decline in cash on hand.

Although we consider the possibility for an upgrade to be remote because EBITDA would have to be around $1 billion versus our forecast of about $500 million, drivers would include performance recovery much earlier than we currently expect as the company implements its revised strategy. Another important component would be sustained cash flow from operations that covers ongoing working capital needs and capital expenditures. Additionally, we would look for indications that the company has taken steps to reduce its funded debt, which, in our opinion, result in a sustainable capital structure. Any consideration for an upgrade would require sustained leverage below 7.0x and interest coverage above 1.5x.

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