California Pizza Kitchen - Analysis

Learning Team 25 Case Summary

Name of Class

Finance

Name of Preparer

Meghan

Case Name

J.C. Penney: Financial Transformation

Assignment Date

Monday, Oct. 29

Takeaways from Last Class

• The moment you have debt you create a tax shield.
• You’re creating value by taking out debt; substituting more expensive equity for cheaper debt.
• If you’re not fully maximized in taking out debt (finding the sweet spot), means the firm is maintaining capacity to take on more in the future (i.e. don’t want to take on too much at the wrong time and potentially go into bankruptcy, e.g. Sears)
• Use solid comparables in the industry to evaluate right level of debt.
• If you raise debt, the expected value of the firm is increased by the amount of the debt.
• Dividend or repurchase doesn’t create fundamental value.

From Previous Class:

• Debt increases, WACC goes down, EV goes up by the tax shield, Cost of equity goes up as Beta levered goes up.
• Beta unlevered is defined by operations
• Risk ←→ return

Mechanics/Formulas:

• FCFs = EBIT (1-tax) - ∆NWC - ∆NPPE
• WCC = Ke * %E + kd (1-tax) * %D
• Ke = rf + B*MRP
• Bl = Bu (1+1+tax) D/E)
• TS = Debt * tax

Broad Topic/ Learning Area

Debt Policy and Financial Distress

High Level Problem(s)

Restructuring, How much debt can JP Penny take on (more than competitors?)

Non-investment grade debt vs. investment grade (no more appealing than equity)

Summary (Cold Call)

Ron Johnson (current CEO of JC Penny, former head of retail for Apple) is tasked with turning around the company; past few years have seen variable results – though they have an ambitious transformation plan to improve the company’s long-term growth and profitability.

While Johnson’s plan was ambitious, JCP sales and profits were continuing to decline, dividend had been ELIMINATED (!!!), and JCP had significant liquidity issues. JCP needs to figure out a way to fund its current operations, Johnson’s bold transformation initiatives, and 7.4% debentures (due in 2037.) Injection of cash is critical to company’s survival.

Details

Activist investor, Bill Ackman, had close to 40M shares – representing 16.8% stake in the company – worth approx. $900M. Thought JCP had the “most potential of any company in his portfolio.” Thought the stock was valued cheaply @ only 5x EBITDA and that the company’s real estate was some of the best in the world.

Under Uhlman’s leadership, JCP announced a $900M buyback program (2010); company made great strides in the 4Q to deliver on operating goals and position JCP as a retail industry leader; e.g. new growth initiatives, improvements across merchandise assortments, redefine the jcp.com experience and drive efficiencies across the company, as well as establish a share buyback plan which will return value to their shareholders.

Uhlman stepped down as CEO; next up: Ron Johnson came over from Apple; huge + for JCP overall (as a result of the announcement stock rallied 17%). (Note: Johnson’s comp structure was majority stock - $500M of restricted stock – vs. cash); brought a great management team of people with him, for example: Michael Francis, CMO, who held the same position @ Target.)  

Changed pricing structure of JCP overall; controversial – no longer discounts, instead “every day, regular prices.” (HBR was weary of this plan stating ‘when selling a relatively undifferentiated product, the only lever to generate higher sales is discounts.’ If competitors drop prices, JCP = sitting duck.)

2012 – sales dropped further (20% relative to Q1’11); losses hit 75 cents per share. Johnson announced 10% reduction of the work force; discontinued the dividend (!!!) that had been paid steadily since 1987.

Q2’12 – capital structure was relatively strong. Debt = secured and unsecured bonds, short-term credit facility (revolver) secured by JCP’s credit cards receivable, AR, and inventory. (JCP has traditionally made limited use of the revolver and had not drawn upon it yet in ’12; credit limit for revolver was $1.5B.) JPM equity analyst thought JCP would require $1B of capital this year to continue transformation @ the pace initially discussed.

2012 financial results = company continued to struggle; JCP lost $985M for 2012 and Q4 earnings along were $1.71/share lower than analysts’ expectations. Cash balance of $930M looked healthy – but significantly below Q4 cash balances of $2.6B in 2010, $1.5B in 2011. (Sources/uses of cash contributing to cash balance decline, Exhibit 6.

What could Johnson do?

• Manage cash flow by stretching payables, reducing inventories
• Turn to JCP’s credit facility, $1.5B of available credit (Note: Revolver was short-term source of funds that the banks could choose to not renew if they perceived JCP was using the revolver as permanent financing.)
• For permanent financing, turn to debt market or equity market. (Note: In this case, prospect of debt was no more attractive to equity; why? The debt would carry a non-investment grade credit rating.)
• Stock was currently selling @ $19.88/share, a much larger issuance would be req. than earlier in the year (when selling @ $42/share). Could JCP carry more debt than the competition?

Assignment Questions, Solutions, or Recommendations

1. What challenges does JCP face? Should the new management team be concerned about declining cash balances? Why?

CHALLENGES:

• Declining Cash Balances (while $930M looked healthy – significantly below Q4 cash balances of $2.6B in 2010, $1.5B in 2011.)
• Continuous management turnover, even when it seems they’re doing well?
• Negative aftermath of dropping the dividend that had been paid steadily since 1987 – sends a bad message to both shareholders and the external world.
• Both sales and share price declining.
• No A/R (?) p. 15, Negative EBIT (vs. all comparable) p.15
• Price/share (vs. all comparable) p.15, Beta Levered = higher than comparable (2.04)

CONCERNED ABOUT DECLINING CASH BALANCES: Yes, but can be adjusted potentially; Johnson mentions he could look to adjusting cash flow by stretching payables and reducing inventories, which could help. (Note: Inventory is already down from both 2010 and 2011, p.7, as well as “Prepaid and other; no A/R (?) p.15 $0

2. J.C. Penney management team is planning to meet to discuss the financing needs. Please quantitatively evaluate JCP’s financing needs assuming that it will implement its restructuring plan under the following assumptions:

• JCP stabilizes sales;
• Maintains 2012 sales margins;
• Maintains 2012 NWC and PPE turnover;
• Maintain a cash balance that is at least 7% of its revenue.

3. How would your estimate change if JCP returns to 2010 margin (EBIT/Revenue)?

2010 margin is much better (4.63% = 823/17,759), so estimate would be much more optimistic.

4. How would you characterize JCP NWC turnover (Sales/NWC ratio) and PPE turnover (Sales/NetPPE) over time and relative to competition? Do you believe there is space for efficiency gains in these areas that would help cover the financing needs?

Relative to comparables, JCP is not far off on NWC turnover. That being said, the industry seems to be low overall (Walmart being the greatest.) A high NWC turnover ratio “shows a company is running smoothly and has limited need for additional funding. Money is coming in and flowing out on a regular basis, giving the business flexibility to spend capital on expansion or inventory.” (Investopedia)

More intel: A high ratio may also give the business a competitive edge over similar companies. However, an extremely high ratio — typically over 80% — may indicate that a business does not have enough capital to support its sales growth. Therefore, the company could become insolvent in the near future. The indicator is especially strong when accounts payable is also very high, which indicates that the company is having difficulty paying its bills as they come due. (Investopedia)

PPE turnover, they’re on the lower side of the industry with the given comparables. (Note: A company that generates a lower PPE turnover, other things being equal, isn’t using its assets as efficiently as a company with a higher one. -Business Literacy.com)

For both NWC turnover and PPE turnover JCP has space for efficiency gains that would help cover financing needs – for NWC would want the turnover to be higher, for PPE would want the turnover rate to be higher as well.)

5. Assuming that J.C. Penny returns to 2010 margin and stabilizes sales, what level of debt should management consider appropriate in the long term? How did you arrive at this number? What does it imply about JCP debt capacity?

6. Should J.C. Penney issue debt or equity to cover their financing needs?

NOTES:

Usually debt would be cheaper/better (i.e. tax shield), but the prospect of issuing debt is no more appealing than issuing equity in this case because the debt would likely carry a non-investment grade credit rating of Ba3 or even CCC.

7. Should the new management team be concerned about default? Why? What are the implications/consequences of default?

(Note: ΔNetPPE + ΔNWCA = NI – Dividends + ΔDebt + ΔEquity)