Good News for J.C. Penney: A Stable Rating From Fitch

9/1/2015
Fitch Ratings has upgraded the Issuer Default Ratings (IDRs) of J.C. Penney Co., Inc. and J.C. Penney Corporation, Inc. to 'B-' from 'CCC'. The Rating Outlook is Stable.

Key rating drivers
A pathway to $1 billion in EBITDA: J.C. Penney has demonstrated a meaningful turnaround in its business over the past seven quarters, and Fitch expects the company to generate EBITDA of approximately $650 million in 2015 (which adds back approximately $40 million in non-cash stock-based compensation) versus $277 million in 2014. Fitch's expectations are based on 4 percent comparable store sales (comps) growth, gross margin of approximately 36 percent, and further selling, general and administrative (SG&A) reduction of approximately $120 million. The upgrade reflects increased confidence in J.C. Penney's ability to improve EBITDA to the $800 million range in 2016 and move towards $1 billion in 2017.

At these EBITDA levels, free cash flow (FCF) is expected to be neutral in 2015, turn to positive $75 million in 2016 and approach almost $200 million in 2017. Fitch expects total liquidity (cash and revolver availability) to range from $1.7 billion at seasonal working capital peak to more than $2 billion at fiscal year-end, which will enable the company to address total unsecured debt maturities of $600 million through 2018. J.C. Penney is currently evaluating its options to amend and extend its $2.2 billion real estate term loan due May 2018 for which the 1 percent no-call provision rolled off in May 2015 with better terms, which could include reducing some of the collateral and/or improving the terms on the loan.

Adjusted debt/EBITDAR is expected to be just over 8x at the end of 2015 versus 9x for the LTM period ended Aug. 1, 2015, and could trend towards 6x by 2017 if EBITDA approaches $1 billion and if J.C. Penney refinances its real estate term loan and pays down approximately $600 million in unsecured debt.

Sustaining positive comps
J.C. Penney comps returned to positive territory in fourth-quarter 2013 (4Q13) and have continued on a positive trajectory through 2Q15, with first-half comps at positive 3.7 percent. Gross margins have improved over 400bps in the LTM to 35.8 percent, through improved clearance and promotional selling margin performance, improved performance in private brands and key value items, and better in-stock positions.

Fitch expects J.C. Penney to sustain comps growth in the 2 percent to 3 percent range in 2016/2017, as it invests in areas such as Sephora home; on building back its private brands and omnichannel; and on modestly improving gross margin beyond 2015. Underlying Fitch's comp assumptions is the expectation that overall apparel, accessories, footwear and home sales grow 2 percent to 3 percent annually, with growth in online sales accounting for more than 50 percent of the growth. Department store traffic trends remain soft and industry sales are expected to continue to decline 2 percent annually as volume continues to shift to off-mall channels, such as online, discount and off-price retailers.

Fitch anticipates J.C. Penney's store traffic to be either flat or up slightly in 2016/2017, with store-level comps increasing 1 percent to 2 percent. Fitch expects online sales to grow 10 percent to 12 percent annually from the 2014 base of $1.2 billion, to $1.6 billion to $1.7 billion in 2017, contributing 1 percent to 1.3 percent annually to overall comps.

The company has been focused on cost-cutting efforts and achieved SG&A reduction of approximately $100 million over the LTM and Fitch expects modest cost reductions in 2016/2017 as the company continues to rightsize its cost structure to a $13 billion to $14 billion top-line level, relative to $17 billion-plus in 2011. Should these SG&A savings materialize, J.C. Penney's SG&A ratio would return to 33 percent to 33.5 percent, in line with the 33.3 percent level in 2011.

Key assumptions
  • Fitch expects J.C. Penney comps to be 4 percent in 2015 and to sustain comps growth in the 2 percent-3 percent range in 2016/2017.
  • Adjusted debt/EBITDAR is expected to be just over 8x at the end of 2015 and could trend towards 6x by 2017 with EBITDA approaching $1 billion and some debt paydown.
  • Fitch expects total liquidity (cash and revolver availability) to range from $1.7 billion at seasonal working capital peak to over $2 billion at fiscal year-end, which will enable the company to address total unsecured debt maturities of $600 million through 2018.
  • FCF is expected to be flat to modestly negative in 2015, and is expected to improve to $75 million in 2016 and potentially to $200 million in 2017.
Rating sensitivities
Positive rating action:
A positive rating action could occur if J.C. Penney continues to generate 2 percent to 3 percent comp growth and EBITDA improves to the $1 billion range, the company pays down upcoming unsecured debt maturities and refinances its $2.25 billion term loan, and leverage moves to around 6x.

Negative rating action: A negative rating action could occur if comps and margin trends stall, indicating J.C. Penney is not stabilizing its core business, leading to concerns about the company's liquidity position.

Liquidity
The company ended 2014 with $2.1 billion in liquidity between cash and cash equivalents of $1.3 billion and $773 million available under its $1.85 billion credit facility. FCF is expected to be flat-to-moderately negative in 2015, assuming cash interest expense of $400 million, capex of $250 million-$300 million and flat-to-moderate working capital use. FCF is expected to improve to $75 million in 2016 and potentially to $200 million in 2017 if EBITDA is close to $1 billion.

J.C. Penney is currently evaluating its options to amend and extend the $2.2 billion real estate term loan due May 2018 for which the 1 percent no-call provision rolled off in May 2015. The company's upcoming unsecured debt maturities include $78 million in August 2016, $220 million in April 2017 and $300 million in February 2018. J.C. Penney has sufficient liquidity to pay down these unsecured debt maturities if required.

Issue ratings based on recovery analysis
For issuers with Issuer Default Ratings (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 (RR) and notching, based on Fitch's recovery analysis which places a liquidation value for J.C. Penney under a distressed scenario of approximately $5.6 billion as of Aug. 1, 2015.

J.C. Penney's $2.35 billion senior secured asset-backed (ABL) facility that matures in June 2019 is rated BB-/RR1, which indicates outstanding recovery prospects (91 percent to 100 percent) in a distressed scenario. The facility comprises a $1.85 billion revolving line of credit and a $500 million first-in, last-out term loan.

The facility is secured by a first lien priority on inventory and receivables with borrowings subject to a borrowing base. Any proceeds of the collateral will be applied first to the satisfaction of all obligations under the revolving facility and second to the satisfaction of the obligations under the term loan facility.

J.C. Penney is required to maintain a minimum excess availability at all times of not less than the greater of 1) 10 percent of line capital (the lesser of total commitment or borrowing base), and 2) $150 million.

The $2.2 billion term loan due May 2018 is also expected to have outstanding recovery prospects of 91 percent to 100 percent, leading to a BB-/RR1 rating. 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 ABL facility.

The $2.6 billion of senior unsecured notes are rated 'B-/RR4', indicating average recovery prospects (31 percent-50 percent).

Full list of ratings actions:

Fitch has upgraded the following ratings:
J.C. Penney Co., Inc.
--IDR to 'B-' from 'CCC'.

J.C. Penney Corporation, Inc.
--IDR to 'B-' from 'CCC'.

--Senior secured bank credit facility to 'BB-/RR1' from 'B/RR1';
--Senior secured term loan to 'BB-/RR1' from 'B/RR1'; and
--Senior unsecured notes and debentures to 'B-/RR4' from 'CCC/RR4'.

The rating outlook is stable.


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