NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed the Issuer Default Ratings (IDRs) of J.C. Penney Co., Inc. and J.C. Penney Corporation, Inc. at 'CCC' and assigned a Positive Outlook. A full list of rating actions follows at the end of this press release.
KEY RATING DRIVERS
The ratings continue to reflect the material deterioration in J.C. Penney's business over the past two years with revenue down over 30% to $11.9 billion and operating EBITDA loss of $630 million versus a revenue base of $17.3 billion and positive EBITDA of $1.3 billion in 2011. While the business is beginning to show some positive traction, the road to recovery remains highly uncertain and it is too early to ascertain whether the company will see a sustainable improvement in its business over the next 24 months to 36 months to a level where it can internally fund its operations and debt maturities.
The Positive Outlook reflects J.C. Penney's recently improved liquidity profile following a number of actions it has taken over the past few months. On May 15, 2014, J.C. Penney announced it is upsizing its credit facility from $1,850 million to $2,350 million during 2Q'14, providing another $0.5 billion liquidity cushion during peak seasonal needs.
In addition, the company reduced SG&A expenses by almost $300 million in the fourth quarter of 2013 (4Q'13) versus Fitch's expectation that expenses would be flat. Overall expenses are expected to be flat in 2014 relative to the lower 2013 expense structure. Finally, capex is projected at $250 million in 2014. While the $250 million level is not sustainable over the long term, Fitch views the projected level of $250 million to $300 million level as adequate for the next two to three years given the uplift of the entire store base from the major remodels conducted in 2012/2013.
First-quarter comps came in at +6.2%, providing early indications that J.C. Penney's business is beginning to turn the corner with the reintroduction of promotions, key private brands and other remerchandising initiatives such as beefing up the basics offering and revamping the home department. However, the recovery is expected to remain slow given the overall weak sales and pricing environment. Gross margin at 33.1% improved sequentially and was up over 220 basis points (bps) versus the year ago period but remains well below pre-2012 levels of 40%-41%.
For 2014, Fitch expects mid-single digit comps and gross margin in the mid-30%. Given the lower expense structure, Fitch expects J.C. Penney to generate EBITDA in the $250 million to $300 million range. With EBITDA expected to be negative the first three quarters, the ability to generate projected EBITDA will be dependent on sustaining mid-single digit comps and 35% to 36% gross margin during the important holiday season in 4Q.
Free cash flow (FCF) is expected to be in the range of negative $200 million to $250 million in 2014 assuming a working capital benefit of approximately $100 million. However, worse-than-expected comps and/or high inventory levels could result in a lower-than-expected gross margin and working capital being a use of funds.
Trough liquidity (between cash on hand and availability on the revolver) in late October to mid-November is expected to be around $1.3 billion with year-end liquidity of approximately $1.9 billion to $2.1 billion.
This should provide sufficient liquidity to fund the 2015 holiday season on Fitch's expectations of 2015 EBITDA of approximately $550 million to $600 million on low single digit comps and mid-single EBITDA margins. However, J.C. Penney would need to generate EBITDA of about $800 million in 2015 and 2016 to cover interest expense of $330 million to $350 million, capex of $250 million to $300 million, and debt maturities of $200 million annually. This implies that J.C. Penney would still need to draw down on its revolver to fund a portion of its ongoing obligations.
Achieving a run rate of $800 million in EBITDA would require J.C. Penney to produce a combination of 3% to 5% comps growth and gross margin in the 37% to 38% range assuming a relatively flat expense structure. Achieving this is likely to remain challenging given the overall secular decline in department store sales.
ISSUE RATINGS BASED ON RECOVERY ANALYSIS
For issuers with IDRs at 'B+' and below, Fitch performs a recovery analysis for each class of obligations of the issuer. The issue ratings are derived from the IDR and the relevant Recovery Rating and notching, based on Fitch's recovery analysis, that places a liquidation value under a distressed scenario of approximately $5.7 billion as of May 3, 2014 for J.C. Penney.
J.C. Penney's $1.85 billion senior secured asset-based credit facility (ABL) that matures in April 2016 is expected to be replaced with a $2.35 billion facility in the second quarter and is rated 'B/RR1', which indicates outstanding recovery prospects (91%-100%) in a distressed scenario. The new $2.35 billion facility will comprise a revolving component estimated at $1.7 billion to $1.8 billion and is expected to have a five-year maturity and a fixed $550 million to $650 million term loan facility. The facility is secured by first lien priority on inventory and receivables with borrowings subject to a borrowing base; therefore, J.C. Penney should have access the full revolver during peak seasonal needs.
The current facility is subject to a springing covenant of maintaining fixed-charge coverage of 1.0x if the availability falls below the greater of (i) 10% of line cap (the lesser of total commitment or borrowing base) and (ii) $125 million. As of the end of 1Q'14, the company had approximately $690 million available for future borrowings (after taking into account $650 million in borrowings and approximately $500 million in LOCs), of which $500 million is currently accessible due to the limitation of the fixed charge coverage ratio.
The $2.25 billion term loan facility due May 2018 is also rated 'B/RR1'. The term loan facility is secured by (a) first lien mortgages on owned and ground leased stores (subject to certain restrictions primarily related to Principal Property owned by J.C. Penney Corporation, Inc.), the company's headquarters and related land, and nine owned distribution centers; (b) a first lien on intellectual property (trademarks including J.C. Penney, Liz Claiborne, St. John's Bay, and Arizona), machinery, and equipment; (c) a stock pledge of J.C. Penney Corporation and all of its material subsidiaries and all intercompany debt; and (d) second lien on inventory and accounts receivable that back the $1.85 billion ABL facility.
The $2.6 billion of senior unsecured notes are rated 'CCC/RR4', indicating average recovery prospects (31%-50%).
A Negative Rating action could occur if the recovery in comps and margin trends stalls, indicating J.C. Penney is not stabilizing its business, and leading to concerns around the company's liquidity position.
A Positive Rating action could occur if the company generates sufficient EBITDA to cover its projected capex and interest expense at a total of $600 million to $650 million and has enough liquidity to manage debt maturities of $200 million annually in 2015 and 2016.
Fitch has affirmed J.C. Penney's ratings as follows:
J.C. Penney Co., Inc.
--IDR at 'CCC'.
J.C. Penney Corporation, Inc.
--IDR at 'CCC';
--Senior secured bank credit facility at 'B/RR1';
--Senior secured term loan at 'B/RR1'; and
--Senior unsecured notes and debentures at 'CCC/RR4'.
The Rating Outlook is Positive.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology' (Aug. 8, 2013);
--'Recovery Ratings and Notching Criteria for Nonfinancial Corporate Issuers' (Nov. 20, 2013).
Applicable Criteria and Related Research:
Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage
Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers