With J.C. Penney Company, Inc. (NYSE:JCP)’s management setting the comps/margin bar arguably at high level and with execution risk elevated, Sterne Agee analysts prefer to stay sidelined on the prospects of the retailer.

J.C. Penney Company JCP

Charles Grom and team at Sterne Agee in their June 25, 2014 report note the biggest risk facing the retailer is their ability to recover the shopper that it lost during the Ron Johnson 2012 experiment.

J.C. Penney’s improved traffic

After conducting a series of store checks, the Sterne Agee analysts note the J.C. Penney Company, Inc. (NYSE:JCP)’ box has undergone much change over the past 12 months. They note that despite their store check sample is relatively small, walking J.C. Penney stores today feels different as compared to year-ago. They noticed shoppers perusing racks and talking to associates at jewelry counters. The analysts’ fieldwork leads them to believe that the retailer had a constructive Father’s Day and hence conclude that traffic is gradually improving.

However, the analysts prefer to watch whether the retailer can reverse the unfavorable traffic trend, though their recent store visits make them incrementally comfortable with their 5.0% SSS estimate for the second quarter.

Free cash flow analysis

The analysts note running the math implied by ‘break-even FCF guidance’ suggests the retailer believes the business will improve markedly in coming quarters. The Sterne Agee analysts point out that the retailer anticipates working capital to be a source of funds which means the implied net loss as wells as the implied comps/GPM would be lower.

The Sterne Agee analysts highlight their view through the following sensitivity table:

Sensitivity table

As can be deduced from the above table, the analysts displayed various working capital assumptions, the more likely scenario (4.0 to 7% comps, $200 to $300 million working capital source of cash), fall in cases where implied 2Q-4Q gross margins are about 36% to 38% range. Hence the analysts believe despite gross margins could witness benefits, a substantial improvement in the business may or may not materialize.

The analysts note by taking a different top-down approach would yield several scenarios to consider while analyzing the retailer’s potential cash positioning at FY14 end. They have also run several 2Q-4Q comp and GPM scenarios by using their other key modeled FY14 assumptions such as SG&A of $4.04 billion, D&A of $630 million.

The following table captures J.C. Penney Company, Inc. (NYSE:JCP)’s FY14 Free Cash Flow under various 2Q-4Q Comp and GPM scenarios:

JCP's FCF

J.C. Penney’s GPM assumptions

The analysts point out that flexing those comp/GPM assumptions up yields many FCF scenarios. However, for now they note their assumptions fall in the northwest corner of the above matrix and hence much room required before they get to the FCF neutral / positive territory.

Keeping in view the execution risk, the Sterne Agee analysts prefer to take a more conservative stance for now.

Accordingly the analysts have assigned ‘neutral’ rating on J.C. Penney Company, Inc. (NYSE:JCP) and pegged the target price at $8.55.