It keeps going from bad to worse for JCPenney (NYSE:JCP). JCP stock touched an all-time low just above $1 last month. Even after a recent rally, JCPenney stock still is down 58% over the past year.
This isn’t a new problem. JCPenney stock traded above $40 at the beginning of 2012. Since then, its margins have been pressured and its losses have mounted, leading JCP stock to continually make lower highs and lower lows.
For that to change, JCPenney’s results need to improve. But at this point, it’s truthfully difficult to see how that is supposed to happen. U.S. brick-and-mortar retail continues to lose share to e-commerce. JCP’s move into appliances has helped its sales, but hurt its gross margin. The company retracted its full-year guidance after its disappointing Q3 results and remains weighed down by over $4 billion of debt.
In short, JCPenney’s decline looks poised to continue. And, barring a miracle, JCP stock looks like it’s headed to zero.
How JCP Stock Could Theoretically Rise
JCPenney often gets compared to now-bankrupt Sears Holdings (NASDAQ:SHLD), but that comparison is a bit unfair. While Sears Holdings’ same-store sales have plunged, sinking 13.5% in fiscal 2017 and 7.4% in FY16, JCPenney’performance hasn’t been that bad. Its comparable store sales were flat for the last two years before declining 1.7% through the first three months of fiscal 2018, which ended in January.
Similarly, the retailer’s profits aren’t as bad as one might think after looking at the JCP stock chart. Its operating income has been about zero over the past four quarters. The company’s trailing twelve-month adjusted EBITDA of $715 million implies a reasonable EV/EBITDA multiple of around six. That’s roughly in-line with stronger department store stocks like Nordstrom (NYSE:JWN) and Kohl’s (NYSE:KSS).
And JCP’s profits can get better, given its relatively thin margins. The company’s EBITDA margins are under 6% over the past four quarters. If JCP can raise its margins one percentage point, its EBITDA would rise roughly 17%, and its operating income would go from zero to $120 million. And given that JCPenney is still guiding for positive free cash flow this year, in that scenario JCP stock could look a lot more attractive.
JCP’s Debt Problem
The problem with that hypothetical example is JCPenney’s debt. As of Q3, the company had $4.1 billion of debt. Add to that another $2.5 billion of operating lease commitments, which will go on its balance sheet next year under new accounting rules.
The interest on its debt is over $300 million per year. That, in turn, suggests that JCPenney needs its margins to improve by some 2.5 percentage points to simply get its bottom line to break-even. Moreover, its cash flow is now minimal, since subtracting its interest costs and its $350-$400 million in annual capital expenditures from its $700 million in EBITDA results in little or nothing.
Given JCP’s debt load, minimal cash flow and negative earnings aren’t enough. The retailer’s business simply has to get better, and its margins have to improve. But accomplishing those goals won’t be easy.
Even flat sales, for retailers, generally lead to margin compression. That’s particularly true now, when labor costs are rising and investments are needed to keep with the e-commerce efforts of rivals like Kohl’s and Target (NYSE:TGT), let alone Amazon.com (NASDAQ:AMZN).
So JCP’s recent performance hasn’t been good enough. Yet JCP has to improve that performance despite margin pressure and in the ninth year of an economic expansion. What will happen to JCPenney if the economy enters a recession?
Why Not JCP Bonds?
There’s another headwind to the bull case for JCP stock. At this point, investors willing to gamble might be better off with JCPenney bonds instead.
Most of JCPenney’s long-term debt have become cheap as well. That’s not a good thing, as it reflects the bond market pricing in an increasingly likely chance of restructuring. But it also creates an opportunity to bet on a turnaround while preserving a chance of getting some money back even if JCPenney winds up going bankrupt.
For instance, JCPenney’s 6.9% notes maturing August 2026 now are priced at just $41.15. Those bonds offer a yield-to-maturity of nearly 24% a year. For JCPenney stock to be a better buy than those bonds, JCP stock would have to rise 350% over those eight years.
Admittedly, those bonds are unsecured, so they, too, could be worthless after a restructuring. But given the assets on the company’s balance sheet – including some $3.2 billion in inventory at the moment – it’s possible the bonds may not be totally worthless. And it would take something close to a best-case scenario for JCP stock to outperform the debt if those bonds mature.
There Are Better Bets Than JCP Stock
All told, there’s just too much that can go wrong with JCP stock to gamble on it. Its sales have to improve and its margins have to rebound, even though clearances are hurting those margins at the moment, and tariff hikes could further pressure retailers. It will then take JCPenney years to pay down its debt to the point where it would be able to distribute cash to its shareholders.
And for investors willing to take that risk, there are reasonably high-reward bonds that, unlike JCP stock, could be worth something if JCP goes bankrupt. There seems to be easier ways to make money than JCP stock.
As of this writing, Vince Martin has no positions in any securities mentioned.