J.C. Penney's Feet to the Fire

NEW YORK ( TheDeal) -- When J.C. Penney Co. ( JCP) selected Ron Johnson as its CEO in November 2011, investors expected the wunderkind former Apple Inc. store designer would work some of his magic at a retail chain desperately seeking a 21st century makeover.

It's now the second year of Johnson's tenure at J.C. Penney and industry watchers are not only taking bets on when he will be fired but whether the old-line retailer will join be relegated to the final markdown of retail history.

According to industry sources, vendors are tightening credit and private equity firms are already circling. J.C. Penney shares have lost 55% in the past 12 months months. Shares were gaining 1.4% to $15.67 on Monday.

If J.C. Penney can use its assets to buy time, and Johnson can pull off the much-hoped-for transformation of the dowdy retailer, backers such as Bill Ackman's Pershing Square Capital Management LP will have their "I told you so" day.

J.C. Penney's board is certainly keeping Johnson's feet to the fire, slashing his pay 97% in 2012 and refusing to award bonuses to its CEO and most top executives, according to regulatory filings.

Any sane board would take those steps after the dismal figures that were the fourth quarter 2012, which ended Feb. 2: a 28.4% decrease in sales to nearly $3.9 billion, with comparable store sales down 31.7% and Internet sales dropping 34.4% over the same time in the prior year. The company also had a net loss of $552 million for the quarter, while operating cash flow was $645 million compared to $953 million for the fourth quarter of 2011.

And industry observers are already predicting poor first-quarter results.

Former Morgan Stanley retail analyst Walter Loeb, who now writes for Forbes, predicted that first-quarter sales could decline another 22%.

Anthony Karabus, president of financial advisory firm Hilco Trading LLC's SD Retail Consulting practice, said that the transformation of J.C. Penney was needed and the concept of a store-within-a-store, which would help introduce new brands to attract a younger customer, is the right path.

The problem is that as J.C. Penney tried to modernize its image, it also alienated its older core customers by doing away with its popular coupon programs, Karabus said, and the influx of new customers wasn't happening fast enough to make up for the outflow of the old.

And while the company is overhauling its stores, a process that will cost it many millions of dollars, it is not spending enough on advertising to introduce its new product lines, such as Joe Fresh. Retail analysts agree that the concept is something that really could launch the chain into a whole new customer base.

In what would be a dire sign for any retailer, sources said J.C. Penney's vendors are tightening lines of available credit, requiring more cash to get new inventory in its stores.

According to Howard Davidowitz, chairman of Davidowitz & Associates Inc., a national retail consulting and investment banking firm, CIT Group Inc.'s trade finance unit has already increased its charges for vendors shipping to J.C. Penney. CIT sets the standard for factors, Davidowitz noted, so when the company increases its charges in response to risk, others follow suit.

CIT declined to comment.

Normally, a retailer would ask for vendors to send it more merchandise on credit to free up cash flow, Karabus said. But the reverse is happening at J.C. Penney, reducing free cash flow even further.

Vendors tightening lines of credit is the first step in a slide to bankruptcy, noted one source. Then there is the Martha Stewart Living debacle.

Somehow, J.C. Penney executives thought that if they made a deal with the lifestyle doyenne to have her own store-within-a-store for her housewares merchandise, that wouldn't infringe on her exclusive agreement with Macy's Inc. Macy's disagreed and promptly sued J.C. Penney and Martha Stewart Living Omnimedia Inc. The parties are in court-ordered mediation, but J.C. Penney can't sell Martha Stewart products until at least the April 8 deadline the New York state court judge set for the end of the mediation process. And J.C. Penney could still lose that battle if a settlement isn't reached.

Because the Martha Stewart in-store concept has already been built in J.C. Penney locations, losing her brand could result in Johnson quickly losing his C-suite office, one source said.

But even if Martha Stewart stays and Joe Fresh catches, cash is still going out the door faster than the retailer's coupon sales items. And J.C. Penney carries a heavy debt load -- nearly $3 billion.

A March 25 BMO Capital Markets Corp. report from analyst Wayne Hood estimated that the company will burn through $2.3 billion in cash over the next three years.

Hood isn't ruling out a Chapter 11 filing by 2014: "In our view, a Chapter 11 reorganization could potentially enable the company to overcome restrictive covenants and reaccelerate capital spending and emerge a stronger company. We believe the company would be able to get DIP financing to effect this transformation as we believe underlying real estate could be more easily lined up."

The company owns 38.7% of its store base, or 429 locations, for an estimated 55 million square feet. The company has 123 ground-leased locations and 552 leased locations, the report said.

Filing for Chapter 11 clearly "would not be supported by Pershing Square Capital Management, where the economic interest in the company is about 25.1%," Hood wrote. However, a bankruptcy filing would allow the company to shed legacy assets and eliminate the challenge of developing a business model that works for its large and small stores, the report said.

Which is where private equity could come in. Sources said that firms such as Apollo Global Management LLC and Leonard Green & Partners LP are studying a potential buyout of J.C. Penney. Firms such as these could provide the kind of capital injection J.C. Penney would need to complete its transformation.

J.C. Penney said it wouldn't comment on market rumor or speculation. Pershing Square declined comment. Apollo and Leonard Green didn't return calls seeking comment.

Then, there's the real estate portfolio, always something to examine in a relatively cash-poor, asset-rich situation.

"There is real estate value at J.C. Penney, both in the owned real estate and in the leased real estate," said Cedrik Lachance, managing director at Green Street Advisors Inc., a real estate and REIT advisory firm.

He stressed, however, that the issue is not whether the real estate is owned or leased, but where the property is located.

For example, last year, Sears Holdings Corp. sold 11 properties to General Growth Properties Inc., six of which were leased. But because they were long-term leases with value, Sears asked, in essence, to be paid to leave those properties and General Growth was happy to oblige.

When "leases run for an extended period of time, while it's not ownership, it's a tremendous amount of control on the part of the store for a long time," Lachance said.

But to place a value on mall holdings is tricky, he said. In the Sears example, the chain got $200 million out of $270 million for one box in the Ala Moana mall in Honolulu, which is one of the most productive U.S. malls. On the other hand, for a location in the Woodlands Mall in Houston, Sears got $15 million, Lachance said.

Green Street's analysis of J.C. Penney locations is a bell curve of sorts, with 24% of the stores in "A" grade level malls, fully half in "B" grade level malls, and 24% in "C" and "D" grade level malls.

The possibility of putting the store's property into a REIT isn't one that analysts are going for either. Lachance, for one, said that wouldn't provide the company with enough value. The issue for that type of structure is that it would be a single tenant REIT and there are credit quality issues, Lachance said. "If you're J.C. Penney REIT, credit concentration is a legitimate risk, especially given the credit quality. It's not going to trade like Simon Property Group, for example."

Yet he also credits Ackman's long history of successful investing in real estate. But with Vornado Realty Trust partially exiting its investment -- it sold down its more than 10% stake to a little more than 6% last month -- it could be seen as a vote of no confidence for a real estate solution.

Eventually, Lachance said, "as J.C. Penney seeks to create cash to implement their vision, we will see sales of real property assets .

Karabus said that J.C. Penney would be better off selling 25% its poorest locations or worst-performing stores. That would not only give it ready cash, but would also allow it to focus on turning around its better locations.

Meanwhile, some debtholders have already proved themselves to be a restive bunch as they wait for the cash to show up. Not only is the company debt load just south of $3 billion, but there are covenants tied to a chunk of that debt.

In February, law firm Brown Rudnick LLP, claiming to represent more than 50% of the $325 million of 7.4% debentures due in 2037, notified J.C. Penney that the company had breached covenants by drawing down its asset-backed lending revolver. This time, J.C. Penney went on offense and asked a judge to declare that no covenants had been tripped. Shortly afterward, the debtholders, who had never been identified, dropped their claim without explanation, although one person with knowledge of the dispute said it was "because they were just plain wrong."

J.C. Penney said in its 10-K filing that its tangible assets to senior funded debt was 304% at the end of 2012. The company also has an indenture covering its $255 million of notes due in 2023 requiring it to have a minimum of 200% net tangible assets to senior funded indebtedness. This means that the company might not be able to fully withdraw its ABL revolver without dropping below the 200% number.

Carol Levenson, director of research at Gimme Credit LLC, said that with the current tangible asset-to-debt ratio, J.C. Penney should have as much as $1.2 billion in additional headroom before it tripped any covenants.

One thing the company does have going for it when it comes to debt is that its maturity profile is somewhat manageable. While the amount is sizable, no debt is due until October 2015 when $200 million of 6.875% senior notes mature. An additional $200 million of 7.65% debentures are due in August 2016.

In addition to the company's bonds, J.C. Penney has $1.85 billion in borrowing capacity through the revolver over which the debenture holders were allegedly upset. The revolver was originally arranged with a size of $1.25 billion and increased to $1.75 billion in January and then to $1.85 billion in February.

Written by Richard Collings in New York. Jamie Mason and Jonathan Schwarzberg contributed to this report.

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