With Sears (SHLD) basically circling the drain, I view J.C. Penney (JCP) as the next bet for shorts. There is the potential for an upswing as the downfall of Sears means some new market share for J.C. Penney to grab. Long term, however, I don't think that will pan out.
It's clear that new market share is ending up with better names i.e. Amazon (AMZN) , Macy's (M) , etc. The store closures have been vast, but the company still retains the debt of a much larger enterprise. To that end, I don't think they'll be able to make their payments over the long run. The stock has climbed recently; despite the overall market downturn. I suspect it is the direct result of Sears' big fallout. Long term, I don't see the rally as being meaningful and think hype going into the holiday season will present opportunities for better premiums on put options, or straight forward short positions.
By now everyone's heard the news that Sears is indeed filing for bankruptcy. How this could be a surprise to anyone is beyond me. Nevertheless, with arguably the weakest retailer in the industry biting the bullet, the restructuring (if they can manage it) will leave gaps in the marketplace.
Still, I think it would be a foolish notion to think that JCP will be the one benefiting. The retailer has shed store locations in a comparable pace to Sears, and lacks the backing of a big hedge fund like Eddie Lampert's ESL investments. I don't see J.C. Penney having that option. Their executives, whom change frequently, will not be able to provide financing to the company to keep it alive. With the capital constraints already facing the JCP, I think they'll struggle to innovate or drive new business. Their cash is going to be needed to pay bills.
No real correlation between the share price and reality
In the most recent quarter, J.C. Penney reported a loss of $101 million. Despite reporting positive comparable store sales of 0.3%, the company's net losses doubled year over year. The quarter was blamed on ineffective inventory procurement. As the quarterly release basically explained, they couldn't clear their inventory and had to mark down prices to move merchandise. Whatever way you slice it, this essentially means that JCP is having trouble selling. Even if they lower their inventory purchases to match sales demand, that means less overall revenue potential. Revenue growth is already a problem for the company as they shutter unreliable store locations. Total revenues were down 6% in the first half of the year to $5.5 billion.
I can credit the company on decreasing its overall losses for the first six months to $179 million; a 23.8% improvement over 2017. Unfortunately, that is $0.57 per diluted share more than JCP can afford to lose. Thanks to the fallout in total revenues, JCP dealt with negative operating income of $33 million in the first half of 2018. That's bad news. All of the losses make the current stock price rather unrealistic. JCP does not have the cash on hand to manage the burning that is taking place. I question whether new CEO Jill Soltau really has the means to fix the situation. I think she's come into a scenario that's too far along to solve.
The cash situation will lead to more debt
Guidance offered in the second quarter alluded to losses per share of $0.80 to $1.00 for the full year. The company had $182 million in cash/equivalents at the beginning of August. They maintained that cash position by taking on more long term debt to cover the quarter's losses; $124 million to be precise. It seems doubtful that the third quarter will offer positive gains on the scale that would be needed to alter this situation.
Estimates for the third quarter imply analysts expect losses of around $0.56 per share. Barring capital acquired from sales of assets, a Q3 loss like that will force to JCP to borrow even higher sums of cash in order to cover its loss. Otherwise they'd risk operating with not nearly enough cash on hand. In the end, I predict the debts are what will do the company in. As they keep shrinking to find a profitable business, they keep incurring losses. On top of that, the lower overall revenue potential limits JCP's ability to create income that will cover its expenses. The retailer has accumulated nearly $4 billion in long-term debt. That's not sustainable for a company with shrinking sales.
The new short
Make no mistake, further financing and losses will lead to further pressure on the shares. That's where the shorts come in. If we can learn anything from Sears, it's that volatility played a major factor in the retailer as its stock collapsed. I expect the same from JCP. The shares will very likely overreact to any and all good or bad news. If the company reports losses that are less than expected, it's not out of the question for this thing to run to $2. Conversely, weak sales trends will continue to topple the stock.
Within the chaos, I think there will be a lot of opportunities to take advantage of premiums on put options. I was too greedy with Sears; and bought $1 put contracts for September 28. The stock did fall into the money, but I panicked and got out early. If I had bought myself more time, I really could have made a killing.
For JCP, I like the January 2020 $2 puts. The premiums are currently $0.80, but any sort of rally into the holidays could yield better prices. Of course there are many different ways to play this. Those with real cash power can simply short the stock altogether. Pick your poison, but I think JCP is next on the chopping block.
-- This article was originally published Oct. 12 on Real Money.