J C Penney Company Inc (NYSE:JCP) made huge improvements in free cash flow last quarter, from a $752 million cash burn in 1Q13 to $271 million in 1Q14, and management gave the promising guidance of reaching breakeven free cash flow for FY2014. But BMO Capital Markets analyst Wayne Hood just doesn’t see how the retail chain can get there before FY2016 and expects the market to be disappointed when JCP earnings come out August 14.
“Even in the most optimistic of scenarios (a combination of a hockey stick recovery in sales, strong gross margins, and improved working capital efficiency), we believe the company will be hard pressed to achieve management’s breakeven free cash flow target,” writes Hood, who rates J C Penney Company Inc (NYSE:JCP) as Underperform with a $5 price target (currently $9.37).
J C Penney’s breakeven FCF would need incredible comps and gross margin growth
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J C Penney Company Inc (NYSE:JCP) management has guided for $250 million in capex spending for the year, so the company will need to generate net $521 million in cash flow during the period 2Q14 – 4Q14 to breakeven for the year. To do that, Hood estimates that it would have to hit 10% comp-store sales growth, 950bp gross margin growth, with flat year-on-year inventory, and a 270bp increase on its trade payables ratio.
Last quarter’s 6.2% comp sales were a big improvement over 2013, but accelerating that to 10% seems unlikely. Hood actually thinks that J C Penney Company Inc (NYSE:JCP) will beat gross margins expectations, with a forecast 800bp improvement compared to the consensus 470bp, but that only gives more reason to doubt that JCP will reach breakeven this year. He also estimates that 8% comp-store sales growth, while impressive by itself, would leave the company needing to hit 1050bp gross margin growth this year to reach breakeven FCF.
Debt still a concern, even if liquidity isn’t
Even though Hood thinks the market is overvaluing J C Penney Company Inc (NYSE:JCP) on the basis of ‘overly sanguine’ guidance from management, he does expect to see further improvement over the next few years and breakeven FCF by FY2016. He also points out that liquidity is probably not a concern anymore now that JCP has increased its ABL credit facility. But the retailer still has so much debt on its balance sheets that Hood wouldn’t be surprised to see a couple of dilutive equity offerings in the next few years, another downside risk that doesn’t seem to be priced in.