Imperial Capital Management analysts Mary Ross-Gilbert and Seweryn Sztalkoper maintain a Buy rating for J.C. Penney Company, Inc. (NYSE:JCP)’s senior notes.

J.C. Penney bonds may continue to trade-up

We are maintaining our BUY ratings on the longer-dated senior notes (maturing in 2020–2097) at the prices shown in Figure 1. We think the bonds may continue to trade-up (for potential returns north of ~20%) on anticipated favorable operating momentum in F1Q14 and F2Q14, benefiting from the restoration of private brand assortments and the “home” department (which was closed for the better part of 2013), and the near elimination of “excess” clearance inventory. Furthermore, at recent prices in the mid-70s, the longer-dated bonds create the company at 33% of revenues (43% excluding excess cash), which compares favorably to other major department store retailers trading in the 43-92% range. We continue to recommend investors to consider hedging a long position by shorting the shares and/or the shorter-dated bonds. While we see significant improvement in financial performance through FY15, debt leverage would be nearly 10x, potentially requiring a restructuring unless J.C. Penney Company, Inc. (NYSE:JCP) raises additional equity, which appears possible this year based on anticipated positive operating momentum.

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We are maintaining our HOLD ratings on the shorter-dated senior notes (maturing 2015–2018) at the prices shown in Figure 1. We think the bonds also trade-up on anticipated favorable operating momentum, but to a lesser degree than the longer-dated bonds and yet, if J.C. Penney Company, Inc. (NYSE:JCP) is forced to restructure in 2015 or 2016, prices on shorter-dated bonds may compress to match prices on longer-dated bonds.

We are also maintaining our HOLD rating on the $2.25bn senior secured term loan due 5/22/18 at a recent price of 97 (6.19% CY; 6.81% YTM) on favorable collateral asset support.

We are maintaining our Underperform rating on the shares and our one-year price target of $2.50, reflecting the leveraged optionality on the shares based on valuation.

Working Capital Cash Generation Supports Free Cash Flow in 2014, Not in 2015

A potential recovery in EBITDA and anticipated reduction in inventory in FY14 may be sufficient to cover cash requirements, based on J.C. Penney Company, Inc. (NYSE:JCP)’s guidance and our estimates. In 2015, we estimate EBITDA to reach $506mn, from an estimated $307mn in FY14, which is not sufficient to cover cash interest and capital expenditures of approximately $643mn combined. Average debt leverage is anticipated to be nearly 10x. We think J.C. Penney should consider issuing additional equity in the next few months to lower its debt.

Home Department Revenues Should Aid Comp Sales in FY14

We believe sales from J.C. Penney Company, Inc. (NYSE:JCP)’s remerchandised “home” department should boost comp sales in FY14 even if comparable sales from the rest of the store increase only 1-2%. “Home” merchandise generated approximately $1.56bn in revenues in FY12 and over $2.5bn in FY11, and we estimate it may have generated approximately $950mn in FY13 (up from our previous estimate of $600mn) since the home department in the majority of the larger stores were closed, and once the departments were reopened, they were poorly merchandised. We estimate F1Q14 comp sales to increase 4.3%, versus our previous estimate of up 8.7%, (with total sales up 0.8%, versus our previous estimate of up 5%) and F2Q14 comps to rise 6.4%, versus our previous estimate of up 7.3% (with total sales up 3.2%, versus our previous estimate of up 4.1%).

Based on our discussions with J.C. Penney Company, Inc. (NYSE:JCP), we believe the incremental revenue opportunity in FY14 could be as high as $400-500mn (versus our previous estimate of $500-700mn), for a total of $1.4-1.5bn, nearly the same level of “home” sales in FY12. In our model, we are assuming the incremental revenue opportunity is $450mn; see Figure 4.

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