NEW YORK--(BUSINESS WIRE)--Spreads on five-year credit default swaps (CDS) on J.C. Penney have tightened 31% and are currently quoted at 1,149 basis points after reaching a high of 1,665 basis points on Oct. 25, 2013, according to Fitch Solutions. The CDS move outperformed a 5% firming for the broader North America Retail CDS Index over the same time period.
The tightening reflects the 0.9% improvement in comparative store sales in October, marking the first positive comp report since December 2011. JCP said that trends are expected to improve into the fourth quarter, supported by a 10% comp increase in November. The company also expects that gross margin should improve from third quarter depressed levels of 29.5%.
A widening of over 700 bps from September to October had reflected market concerns about the need for additional liquidity over the next 6-12 months. This follows an $800 million equity infusion to offset the significant cash burn during the first three quarters and weak prospects for top line and gross margin improvement.
However, JCP credit protection continues to price at distressed levels given the significant execution risk and concerns regarding the heightened promotions needed to drive sales. The CDS maturity curve remains partially inverted. However, Fitch notes the 6 month CDS is no longer the most expensive tenor. This is now the 3 year, currently 32 basis points above the 5-year CDS.
CDS liquidity for JCP remains high but has decreased slightly, from trading in the second global percentile rank to the fifth.
After third-quarter results and reported November comps, Fitch expects JCP's EBITDA to be in the range of negative $800 million-negative $900 million and its cash burn to be $2.8 billion-$2.9 billion in 2013. With the liquidity injection of approximately $800 million from the equity offering in October on top of the $2.25 billion secured term loan issued in May, Fitch expects total year-end liquidity to be in excess of $2.0 billion (which includes $550 million currently available on its credit facility).
Beyond 2013, Fitch estimates that the company will have to generate a minimum of $650 million-$675 million in EBITDA to fund ongoing capex of $300 million and cash interest expense of $360 million-$375 million. This would require JCP to return sales of approximately $13 billion, up 10% from 2013 projected levels of approximately $12 billion, and realize gross margins in the 39%-40% range, assuming a relatively flat cost structure.
This still appears highly ambitious given the significant execution risk.
Fitch expects EBITDA to be more in the range of $250 million-$300 million on positive mid-single-digit comps. Therefore, free cash flow could remain materially negative in 2014. Peak seasonal working capital funding needs (from year-end levels, which are typically used as a gauge of trough working capital levels) are estimated to be $850 million-$1 billion. The speed and ability of the company to return to positive comps growth and sell at more normalized gross margins (in the 38%-40% range, assuming inventory buys are aligned with sales expectations) will ultimately determine any additional funding requirements in 2014 and beyond.
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