I recommend investors buy protection on JC Penney CDS (short risk) at

14 pts upfront (~890 bps) with a target of ~21 pts upfront (~1,140
bps). For investors that cant transact in CDS, I recommend shorting JC
Penney stock with a target of $8 to $10 per share for a total return of
32%-45%. Under recently fired CEO Ron Johnson, JC Penney has been
potentially irreparably harmed with sales down 25% in 2012 (~$4
billion in lost sales), same store sales down 25% and a cash burn of
$1.3 billion before asset sales. In addition, I project in Q1 (May 18th) a
potential cash burn of up to $908 million and a full year burn of $1.1
billion. As the company burns cash, I expect it to have to draw on its
revolver for the first time in its history. The revolver is secured and will
subordinate all the current debt, which is unsecured. In addition, I
expect the company to look to do a capital raise, priming the bonds
even more (it is rumored the company is looking at a $500 million term
loan backed by the companys inventory).
JC Penney is a department store that has 1,100 stores across America.
The company had been floundering post the financial crisis even as
competitors such as Macys and Dillards recovered. After hitting peak
sales of $19.9 billion and operating margins of 9.7% in 2006, sales
declined to $17.2 billion and an operating margin of 3.1% in 2011, the
year before Ron Johnson was hired (Ron was actually hired in 2011 but
his impact on the company did not begin to be felt until 2012). In
2010, Bill Ackman and Pershing Square took a 26% stake and Vornado
took an 10.6% stake in JC Penney. Ackman & Vornado pushed for a
$900 million share buyback, depleting some of JC Penneys cash
reserves. Under Bill Ackmans direction, then CEO Mike Ullman was
pushed out and in October 2011, Ron Johnson, the genius behind
Apples retail stores and its Genius Bar, was hired as CEO of JC Penney
with a mandate to transform it.
On January 25, 2012, Ron Johnson unveiled his new vision for JC
Penney. First, Ron Johnson decided to end the industry practice of
coupons and promotions. In the prior year, the company had 590
different promotions with very little success. Ron Johnson decided to
change JC Penneys pricing to an everyday low price model. Instead of
pricing say a towel for $15 and marking it down 60% to $6 through
coupons and/or promotions, JC Penney was going to just sell the towel
for $6 with no deals. Ron Johnson went to a 3 tier pricing strategy that
consisted of 1.) Everyday Low Prices, 2.) month long sales (for example
in June, the company might run special sales on outdoor products such
as grills) and 3.) twice monthly clearance sales on the second and last
Friday of each month to get rid of clearance items. The other bedrock
of Ron Johnsons plan was to roll out stores within a store. JC Penney
would create shops that were made to look like separate, different
shops within the JC Penney store and bring in merchants like Joe Fresh,

Michael Graves, Bodum, Tourneau, Levis, IZOD and others. Over 4

years, JC Penney would build out 100 shops. Ron Johnson hoped to
bring in more upscale merchandise and attract a younger, more
affluent customer. In addition, free WiFi would be build out and things
such as lego tables for kids, sofas & ipads so people could buy some
coffee or some food and just hang out and surf the web.
Unfortunately, Ron Johnson violated one of the first rules of retail and
did not test these concepts in small, out of the way stores to see what
results would look like. He decided to roll out everything to the whole
company at once. In addition, only 700 stores were going to receive
the store within a store concept raising the question of what the
remaining 400 JC Penney stores would look like. Would they just be left
alone and left to look like they always have? Ron Johnson did not
understand just how much consumers loved to feel like they were
getting a deal. Even if the right price was $6 for a towel, he or she
always felt like they were getting a deal if the towel was priced at $15,
but marked down to $6. As a result of these changes, customers
began to flee JC Penney in droves. Same store sales declined by 18.9%
in Q1 12, 21.7% in Q2, 26.1% in Q3 and 31.7% in Q4. Traffic declined
by 10%, 12%, 12% and 17% in Q1, Q2, Q3 and Q4 respectively. In
another blunder, Ron Johnson seemed to completely disregard the
internet channel of JC Penney sales. While competitors such as Macys,
Kohls and Nordstroms saw internet sales rise by 30, 40 or even 50%
in 2012, JC Penney saw internet sales plummet by 33%, including a
34% drop in the all important holiday Q4. After Q4s disasterous
results, Vornado sold 10 million shares, reducing its stake to 6.1%.
Given their familiarity with JC Penney and its real estate, I dont think
this was a ringing endorsement of one of the bulls major arguments,
that JC Penney has significant real estate value. JC Penneys
management team also seemed to forget that retail changes dont
happen in a vacuum. Competitors such as Stage Stores, Macys,
Kohls, etc all still ran promotions and in some cases promoted even
more to steal customers away from Penneys. In the end, Ron Johnson
drove away his core customer who loved deals and failed to attract a
younger, more affluent customer.
Q2 2012 results were worse than Q1 and as a result, JC Penney
revamped its pricing strategy. The company admitted its customers
were confused and eliminated its 2x monthly clearance prices and just
moved to two different pricing strategies, 1.) Everyday Low Prices and
2.) Full time clearance prices. In a bid to stimulate traffic, JCP tried to
offer free haircuts every Sunday in the fall and free family portraits
during the holidays. In addition, Ron Johnson & Company brought back
limited promotions for the holiday season. Still things only got worse
and Q4 was the worst quarter to date with same store sales plunging

32%. Even with promotions in Q4, the decline in traffic accelerate to

-17% from a 12% drop in Q3. All year long JC Penney had promised it
would end the year with $1 billion in cash. The company failed, ending
the year with $930 million in cash. However, to even meet this goal,
the company had to push out payables. Payables as a percentage of
inventories rose to 49% from ~35% in the previous 2 years, and
payable days spiked to 35 days from ~26 days on average in the
previous two years. JC Penney even admitted it deferred paying $85
million to vendors until Q1. If payables were normalized, JC Penneys
cash balances would have been approximately $343 million less to
$587 million.
Looking deeper into JC Penneys results, you can see that Ron
Johnsons strategy was not working. Sales in higher margin, everyday
low price items (49.6% selling margin) declined YoY by 23% in Q1, 25%
in Q2, 34% in Q3 and 37% in Q4. Sales of clearance items (-5.5%
selling margins) increased by 13% and 23% in Q3 and Q4. Note that in
Q1 and Q2, the updated store concept was only rolled out to 2% of JC
Penneys square footage, while in quarters 3 and 4, this was increased
to 11% of total square footage. So despite better and better products
introduced to JC Penney, sales of these products plummeted and sales
of clearance products increased dramatically despite an increase in the
rollout of the shop within a shop concept. On JC Penneys Q3
conference call, management said that the new shop within a shop
stores were seeing sales uplifts of ~33% and that similar uplifts were
seen in Q4. Based on this, we can ascertain that sales in the old JC
Penney, core JC Penney declined by 33% in Q3 and 40% in Q4. So
lets reiterate that despite better products being rolled out to more of JC
Penneys square footage, consumers bought less of the higher margin
products, and more of the lower margin products and sales within the
core JC Penneys saw their rate of decline increase. Hardly a winning
strategy.
Recently JC Penny fired Ron Johnson and replaced him with Mike
Ullman, the former CEO that was pushed out by Bill Ackman. JC
Penney doesnt have the luxury of time and a new CEO would probably
need 6 months to get to know the company. Ullman is familiar with JC
Penney and doesnt need a lot of time to get up to speed. As a familiar
face he can help in soothing some of the companys vendors fears
about a bankruptcy (especially in light of the fact the company is
stretching payables). However, if he was not the right man the first
time around for JC Penney (Bill Ackman was very vocal about how
poorly run JC Penney was and how poorly its stock price faired under
Mike Ulmans reign), why is he the right man the second time around?
Wall Street didnt like the choice when Mr. Ullman was named CEO last
Monday night and on Tuesday, JC Penney equity fell 12%.

I expect JC Penney to continue to report poor results. As JCP brings

back coupons and promotions, traffic may come back but I feel it will
be at the expense of margins. This will effect Q1. For Q1, I expect
same store sales to fall 18% (despite lapping easy comps of -18.9% in
Q1 of last year), EBITDA of -$200 million and a cash burn of $908
million. For full year 2013, I expect a cash burn of $1.1 billion. As the
company continues to build out its shops within a shop, capex will be
elevated. One of Mr. Ullmans first tasks will be to see what capex is
committed and what capex can be cut as cash is now precious to JC
Penney. The new CEO has some hard choices to make. Will he
continue with the shop rollouts (~20% of total square footage in May)?
Will he stop the rollouts and have the stores look half incomplete with
part of the store looking like the old JC Penney and the other half
having some of the shop within a shop concept? Will he dismantle the
shops? All the choices will be costly and involve wasting a lot of
money.
For 2014, I expect same store sales to rise 3.3%, sales of $12.5 billion
and EBITDA of $215 million. On a lease adjusted basis, JC Penney will
have lease and net adjusted leverage of 11.8x and 11.2x. Based on
where certain retailers trade, I believe that JC Penney CDS should trade
for about 21 pts or ~1,140 bps.

CDS Valuation
Company

5Y CDS
198
260
315
305
742
1,453
707
397

Net Lease Adj

Lev
4.8x
3.8x
4.4x
4.7x
5.6x
7.5x
7.1x
2.8x

Spread/turn of
lev
41
68
72
65
133
194
100
142

Neiman Marcus
Levi Strauss
Jones Group
Office Depot
Toys R Us
RadioShack
Sears
Best Buy
Average

547

5.1x

102

Using 2014s estimated net lease adjusted leverage of 11.2x for JC

Penney and a 102 average spread per turn of leverage, I believe JC
Penney CDS should trade at ~1,140 bps or 21 pts upfront.
Equity Valuation
Because I expect JC Penney to be unprofitable over the next few years I
have used an EV/Sales valuation. JC Penneys past 5 year average
EV/Sales ratio has been 37%. Using a slight premium of 41% to 44%
gets a valuation of $8-$10 per share for JCP equity. Bulls will argue
that there is significant real estate value to JC Penney and its owned
store base of ~426 stores and its below market rents (~$4/sq ft).
However, Vornado bailed on their investment and valuations of JC
Penneys real estate values are all over the map. One cannot easily
evaluate JC Penneys store value without going through a detailed store
by store valuation, which is nearly impossible. Valuations of over $1
billion to between $2-$5 billion dollars have been thrown about. I think
the clearest statement yet about just how low the valuation of JC
Penneys real estate might be is from the fact that Vornado has hit the
eject button on most of its investment and will probably look to get out
of the remainder.
JC Penney faces real bankruptcy risk. I just dont see how the company
survives and that credit spreads dont go wider and equity prices go
lower. I think JC Penney is doomed because:
1.) US marketplace is very crowded
2.) JC Penney was trying to reposition itself to begin with because
the old way wasnt working. Think now going back to it will
work?
3.) Difficult to reposition a dinosaur- no loyalty, people can go and
shop elsewhere
4.) Kind of have to continue with Ron Johnsons plan in some form
because what are you going to do, leave 80% of the store as old
JC Penney and 20% as new JC Penney? Stores will look really
weird.
5.) Assume you continue and go through with the Ron Johnson
strategy and get to new JC Penney, you still dont know that it is
a viable model to compete in the marketplace.
Ultimate, JC Penney will continue to bleed cash. I think that the
company will look to do a secured capital raise, which will subordinate
the bonds and push down recoveries. In the long run, it is a business
model problem and throwing liquidity at it will not help. It will only
prolong the day of reckoning. As a result, I recommend buying
protection on CDS with a target of 21 points upfront or shorting the
equity with a price target of $8-$10 per share. However, investors

should initially buy protection/short equity on about 30-50% of their full

position so that there is dry powder in case the company successfully
raises additional capital.
In addition, I have a very detailed model on JC Penney that I am happy
to share with anyone if they want to private message me.