Goldman Sachs Sees More Bad Times Ahead for J.C. Penney


If you're a CEO, you know you're in trouble when investment bankers start advising clients to bet on your company going bankrupt. That's essentially what Goldman Sachs credit analysts did on Wednesday by recommending that clients buy J.C. Penney credit default swaps.

Wall Street is increasingly coming around to the idea that J.C. Penney may not survive its recent tailspin. I couldn't agree more. Back in June, I highlighted J.C. Penney as a long-term bankruptcy candidate, and the company has done nothing since then to show that it can recover.

While J.C. Penney may see some improvement in sales starting next quarter, it probably needs to grow comparable store sales by 25% just to break even. Even in a best-case scenario, it will take several years to engineer a recovery on that scale. As a result, investors should continue to avoid J.C. Penney stock: It's more likely to be a value trap than a bargain.

Reading the tea leaves
In a report released on Wednesday, Goldman Sachs bond analyst Kristen McDuffy stated that J.C. Penney could burn $800 million in cash during the third quarter due to pre-holiday inventory investments. That would be a small improvement compared to last quarter, when J.C. Penney burned more than $1.1 billion of cash.

Holiday sales that live up to expectations would provide a little bit of breathing room. However, McDuffy believes J.C. Penney could still run short of cash as soon as the third quarter of 2014, when the company would normally be building up inventory for next year's holiday season.

Based on that analysis, the Goldman Sachs team recommended buying J.C. Penney credit default swaps. Credit default swaps are hedging instruments that pay off if a company defaults on its debt. In other words, people buying J.C. Penney credit default swaps today are betting the company will not be able to pay off the underlying debt in full. Goldman's advice is essentially a bet that the prospect of bankruptcy will loom large for J.C. Penney within the next few years.

Penney strikes back, with a wet noodle
On Thursday, J.C. Penney responded with a brief press release stating that it is pleased with its turnaround progress so far and that business trends are improving. The company also projected that it will achieve positive comparable store sales trends coming out of the third quarter, and that comparable store sales will rise in the fourth quarter. Later, CEO Myron Ullman stated that he doesn't expect J.C. Penney will need to raise more liquidity this year.

However, none of these statements are very reassuring for J.C. Penney investors. If comparable store sales trends had already turned positive, the company could have -- and presumably would have -- stated that clearly. Instead, the company's guidance seems to imply that comparable store sales are still declining year over year, but that the trend is expected to reverse by the end of next month.

Yet analysts already expect fairly healthy sales growth later this year and beyond. The average estimate calls for a 1.6% sales gain in the fourth quarter (despite the fact that last year's corresponding quarter had an extra week) and 7.4% sales growth next year. The problem for investors is that even 7% growth leaves J.C. Penney far short of profitability.

Additionally, while it's good that J.C. Penney will not need more liquidity this year, Ullman did not say anything about liquidity needs for 2014. Recent speculation that J.C. Penney may be looking to raise more capital has been premised on the idea that the company should raise capital now to give itself a cushion, rather than waiting until next year when it may be even more desperate.

Stock might have further to fall
As far as J.C. Penney stock has fallen in the past two years, it can fall even further if the retailer hits any bumps during its current turnaround attempt. Wall Street analysts have been slow to recognize the scale of J.C. Penney's problems, but they are finally starting to recognize that it will take a miracle to keep the company going without some kind of restructuring. Investors shouldn't wait around in the hope that things will get better soon.

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