“When the [Stock] Market hates something, understand why the market hates it.”
That is how I introduced a previous article. I also wrote that before getting out the firewood and diesel oil to burn Ron Johnson at the stake, we should make an effort to look at the numbers and see what real performance is.
I’ve followed the company for some time, watching news reports and reading the vapid opinions of writers who know nothing about retail. The more I watched and the shriller the opinions got, the more I started to wonder about the financial fundamentals of JCP. When JCP’s stock price took a tumble after the announcement of the FY 2012 results, it was time to start doing some serious research. My nose smelled a valuable investment opportunity, and the numbers were my first stop.
Many of the stories published after the year-end release contained a great deal of rumor, unattributed vitriol, character assassination, and quotes from supposed retail marketing experts. Digging around, I found little bits of hope and cheer from some of the people and companies that had done business with Ron Johnson in the past, mostly from his days at Target. These hopeful articles avoided the financial picture and focused on the actions Johnson and company took to get the ship turned around. These articles painted a compelling story of counterintuitive approaches, what one would expect from a retail leader who worked at Target when it made its transition.
All the negative articles talked about the $1.3 billion operating loss as though it were real and concrete, never mentioning the balance sheet or the cash flow statement. Long time readers of mine know that you have to consider all three financial statements to understand the health of a company. I always teach that it is important to pay attention first to the top third of the Cash Flow Statement, the home of operating cash flow (OCF). The next step is to look at the top of the Balance Sheet, where the assets live, then look to the middle of the Balance Sheet and ponder the liabilities. Always look at the income statement last, once you know how the company spent its cash and how much cash it still has. Only then can you start to think about the expenses of the enterprise.
What follows below follows that approach, a combination of quickly looking at the three dials on the financial dashboard and a more pointed digging into the JCP FY 2012 10-K Annual Report. The tables here are from Yahoo Finance. Yahoo does some consolidating of the numbers, not providing granular details for some line items, and sometimes substitutes titles, like calling depreciation “other” in the Income Statement tables. I use the Yahoo tables for rapid analysis, but never for deep work. Deep work in this case required looking at EDGAR and the actual 10-K and 10-Q filing of the company.
First, an operating loss of $1.3 billion, the number that just about every negative article has focused on since the YE results came out, is a bad number. “Billions” sounds really bad. But let’s look at this in perspective – the number is 7.5% of 2011 revenue, and 10% of 2012 revenue. This follows a year in which the company turned in a $2 million operating loss. For a retailer in the midst of a massive change in the way it goes to market, in the first of what will be three years, a loss like this goes with the territory.
Unlike 99 percent of the population, we smart folks look at the Cash Flow Statement first. Does Penney have cash? Did they make money or lose it? We should ignore the operating loss, for it paints a twisted picture of the financial health of the company. Why? Because it includes the darn depreciation, the bill for the cash that past waves of management spent on the plant and equipment. Looking at the Statement of Operating Cash Flows, depreciation is over 55 percent of the negative net income. Half of the loss is the accounting for the cash spent in the past.
Now, look at what happened with the funds tied up in assets, like inventory and liabilities. The company reduced inventory by $575 million. Not shabby; I call a 20 percent reduction in inventory a significant improvement. The notes on the financial statements indicate inventory turns of 3.03, a hair lower than turns of 3.09 in 2012 In most cases, if a retailer’s revenue drops by 25 percent, we would see the inventory swell. Not here: we see the turns remain fixed on 3, so the company kept the inventory management eye on the ball. What this tells me is that the company did dump old product at deep discounts, or liquidated really old inventory at a deep discount, and held off on buying new products until much of the old stuff was gone. There are reports that the company shed over 400 suppliers as it dropped product lines and closed them out. Inventory rationalization is a hard process.
When you close out a line you must clear it out, and that requires a serious cut in retail price to blow it out, unload it at a loss, or close to a loss. Yet, you liberate the working capital to spend on other things that can generate revenue. Stronger revenue would have helped that cash flow — or maybe not.
Look at the assets of the balance sheet. Net receivables are way down, a reduction of receivable income taxes and differed taxes. Inventory down, which opened up the OCF number.
Now look at the liabilities side of the balance sheet. The drop of the short/long term debit is a result of the retirement of mature debit last year, so it looks like a benefit this year. Liabilities dropped $804 million; looks like a lot of balance-sheet housecleaning going on. As an investor, lowering receivables and inventory is GOOD! Lowering the liabilities associated with the inventory is also GOOD!
The company is burning off cash at a rapid pace. At the close of FY 2010 JCP had over $2.6 billion in cash and short-term investments (close to cash). By the close of FY 2011 the company had burned off $1.1 billion in cash, dropping down to $1.5 billion in combined cash and short-term investments. Come the end of FY 2012, Penney burns off another $600 million, bringing the combined cash on hand to $930 million.
This rapid cash burn-off would not frighten people if there were more cash in the tank, but there isn’t. If we look again at the Cash Flow Statement, along with the Balance Sheet, we can start to construct the story that some people fear. If Penney has another year in which the total cash flow is like FY 2012, when $577 million went out the door, the company has only one more year of cash before the tank runs dry. Now, the total cash burn is not just a Ron Johnson phenomenon. In FY 2010, the company posted $592 million in operating cash flow AND burned off $985 million in capital expenditures, debit repayment, and dividend payouts.
I just mentioned that in FY 2011, the company burned off $1.5 billion in cash. The Cash Flow statement tells us that the company bought back shares of company stock off the open market for $832 million. The board of directors approved the share buyback in February 2011, and by the close of the buying in May 2011 the company had bought 24.4 million shares at an average price of $34.10 per share. The buyback happened before Ron Johnson’s arrival.
We know that the company is spending a ton of money on remodeling the stores. The FCF part of the cash flow statement tells us the company spent over $800 million in capital expenditures. That expense was partially offset by other investing efforts, like selling off non-operating assets, and the notes tell us they closed and sold a call center outside Pittsburgh. The asset sale is not enough to offset the capital spend, but it sets off a significant chunk of the capital outlay. The company paid dividends, and retired over $250 million in debt.
In total, the liabilities are down by $804 million, mostly in the taxes owed (hidden in other liabilities) and the deferred long-term liability charges. Long term debit is up, and is 30 percent of the total asset value of the company. Like most retailers, JCP uses its inventory as collateral for some of the debit it holds, specifically as a revolver. With $2.3 billion of inventory, only a portion of the debit actually covers the inventory, so the rest must be fueling the investments in remodeling the stores.
As I have said in past articles, most amateurs look at the top line of the Income Statement first, but I look at it only after I look at cash flow and the Balance Sheet. Now it is time to look at the top line.
UGLY. A gross profit drop of 35 percent is UGLY, and there is no argument about how ugly a FIVE POINT drop in gross profit is. You’d better be cutting the OPEX percent to sales ratio by as many percentage points if you want to stay in the game, which did not happen. OPEX dropped from $6,220 in 2011, and $5,367 in 2012 — down 13 percent as a cost, but not deep enough. As a percent to sales the 2011 OPEX was 36 percent of revenues; in 2012 the OPEX percent to sales grew to 41 percent. An interesting anomaly that the 10-K mentions about gross margins: all warehousing, transportation, and fulfillment costs are wrapped into the cost of revenue, not SG&A, so the reported gross margin is NET the cost of operating the supply chain, including the cost to deliver to catalogue and e-commerce customers. This is different from many other retailers, which roll the cost of the warehouses and fulfillment centers into SG&A.
The operating expenses titled “others” is the depreciation expense, the accounting for cash spent in past years. Depreciation is about 12 percent of the SG&A, and over 13 percent of the gross profit. From a real cash flow perspective, the company did not lose $1.3 billion from operations, only $10 million. The company chewed through $577 million more in cash that it generated from financing, investments, and operations. JC Penney paid out $86 million in dividends and retired $250 million in debt.
No doubt, the company had a bad year. Considering the massive transformation in marketing, merchandise, and operations, that tough year is not a surprise. An AP reporter covering the story tells of a Credit Suisse study of 17 troubled retailers, including Abercrombie & Fitch, Barnes & Noble, and others. These retailers each suffered revenue drops of 15 percent to 25 percent in a single year between 2000 and 2011. Only four of the retailers, Guess, Ann Taylor, Abercrombie & Fitch, and Barnes & Noble were able to recover. (Interestingly, I have not been able to find the report through research). The ones that recovered took over three years to do so.
Analysis is the art of asking the right questions after looking at the data. So here are my questions:
Does JC Penney have the cash to support a three-year recovery? Not if they repeat their 2012 performance. Frankly, with no change in senior management, and the transformation momentum building, I do not think they will again turn in results like 2012. If there is no change in management, and management only makes corrective changes to tactics and execution, the company will still burn cash, but only to pay down debt. I would expect a positive operating cash flow as the inventory positions rationalize and the remodeled stores start to rebuild revenue.
However, we don’t have the same management team. Johnson is out and Myron Ullman is back. What now?
If you want to change the kind of company JC Penney is — that is, if you want to change the product and change the way it markets — the course that Johnson put JCP on is the right path. If the board had had the spine to keep Johnson in place, and let him continue to work to turn the ship around, the ship would have turned. Revenue would have stopped dropping, and the margins would have improved. OCF would have recovered.
Johnson had the courage to take the mighty risks necessary to redefine the company. If it is successful, the move will create massive value for those investors willing to take the risk and the time to allow the transformation to happen. The main investors, and the board, wussed out.
The real question now is one of leadership, and what that leadership will do. With the return of Myron Ullman to the helm we must speculate where he will spin the wheel. Will he, for the sake of improving revenue, and following his management style, return to the incremental approach to change? Or will Myron decide to follow the path and the vision that led to Ron Johnson’s undoing? Or will the board find a permanent replacement who will take a different approach? For sure, we know that the board does not have the balls to accept responsibility for their lame actions (mostly the share buyback that removed over $800 million of cash from the table). Can we imagine that board of directors growing a set of balls and hiring someone who can see the way through to the other side of a real transition?