Where Does J.C. Penney Go From Here? Six Options for the Company

The Ron Johnson experiment at J.C. Penney JCP is over.

In steps former CEO Mike Ullman as an interim CEO to fill the gap until the board of directors can find a full-time replacement. Shares are tumbling as sales growth stalls and customer traffic plunges. The real question is: Where does J.C. Penney go from here?

Analysts at Credit Suisse commented after the announcement late Monday and said, "The key issues that Mike Ullman, the newly reappointed CEO of JCPenney will need to address in the next 60 days include: liquidity, merchandising in general (and the fourth quarter in particular), and rebuilding the management team.

"Mike Ullman was certainly not the top-of-mind candidate to replace Ron Johnson, but he does come with certain attributes. He knows his way around all JCP constituents and has a passion for the business. But he must be viewed as an interim appointment, meant to stabilize the situation. His immediate task in our opinion is to gain additional long term liquidity, something he ensured during his previous tenure at JCP."

Thus, the liquidity issue comes back to light. J.C. Penney is a heavily indebted company with over $2 billion in net debt as of January, compared to an enterprise value of $5.5 billion. With negative earnings and EBITDA and some analysts forecasting negative operating free cash flow for 2014, the liquidity issue could transform into one of solvency, risking bankruptcy or worse, liquidation.

Therefore, the new management team needs to quickly, efficiently and prudently analyze any and all means to raise the company's long-term liquidity position. Right now, the company can pay its debts. Looking forward however, the situation gets rosy and the company needs to begin to worry about these issues now. The company can do a few things to bolster its liquidity position over the next few years both internally and externally and both as either a public or private entity.

Option 1: Cost-Cutting

The age-old strategy of troubled companies is to cut costs to boost the bottom line and protect cash flows. Thus, J.C. Penney could look to close stores, lay off workers and shrink the size of its operations to make the company leaner and more able to withstand changes in its customers preferences. A key negative for the company has been the reduced foot traffic due to the flip-flopping in discount policies at the stores.

The Credit Suisse analysts noted that much of the senior management are proteges of Johnson, brought in to the company during his tenure. "We would expect turnover in these positions followed by the need to fill them rapidly with individuals that have experience in the middle markets of America," Credit Suisse wrote. Thus, layoffs could actually start from the top down.

A revamped marketing campaign that better targets J.C. Penney's customers could also help to boost the top-line.

Tom Keene, the famed anchor of Bloomberg Surveillance, said Tuesday morning that Ron Johnson was amazing at marketing a product that everyone wanted at Apple AAPL in the iPhone; however, J.C. Penney is selling an entirely different product to an entirely different consumer. Better targeting this consumer could bring traffic back to stores and keep the company afloat.

Option 2: REIT Spin-Off

Another option for J.C. Penney would be to spin off some of its stores into a REIT, as mentioned by analysts over the past few weeks. In this scenario, J.C. Penney would spin off some of the company's key stores into a new Real Estate Investment Trust, raising cash quickly for the company. However, raising cash in a quick accounting move such as this creates its own set of problems.

First of all, owning your stores can be beneficial because it shields you from rent inflation. Assuming that the key properties that will be spun out are in strong real estate markets in urban areas such as New York City, J.C. Penney would now expose itself to the inflationary nature of rents as well as regulation such as rent control. In sum, this is a great way to raise cash quickly but can also have negative side affects in the long run.

Option 3: Leveraged Buyout

Bill Ackman, who runs Pershing Square Capital, is notoriously the largest shareholder in J.C. Penney, owning over 18 percent of the shares. Also, he has a very close relationship to the board of Vornado VNO, the REIT that also owns a large stake in J.C. Penney. Since the companies already own a large portion of J.C. Penney stock, the LBO would require less equity in the deal than comparable deals done in the buyout boom of 2005-2006.

However, the leveraged buyout has its own drawbacks. As mentioned, a key issue of J.C. Penney is its liquidity position and its debt load. An LBO requires the investment firm launching the deal to load the company's balance sheet with lots of debt, as stated in the name. Thus, an LBO will be difficult due to the company's already large debt pile. Therefore, investors can pretty much write an LBO off of the table.

Option 4: Un-Leveraged/Management Buyout

Due to the debt loads, an LBO is off the table, however a pure cash buyout is not off of the table. Ackman and Vornado own about 24 percent of the shares in the company already. They would only need about $2.65 billion in cash to make the deal happen given the current market capitalization of the company. This scenario would also serve as a way for the investors to wipe out the company's debt, though that would increase the purchase price.

Even if the deal does not wipe out all of the debt of the company, taking the company private serves multiple beneficial purposes. Most of all, the owners and management do not have the pressure of the market to force decision and turnaround results to happen as quickly. Generally, investors in the stock market can force the hand of management earlier than what management would like, so being private would give the company more time to turnaround.

Option 5: Restructuring

Selective default: even investors not familiar with the credit markets recall this term being thrown around during the Greek debt restructuring. Effectively, J.C. Penney could talk with its creditors into restructuring its debt, either through refinancing or technically defaulting in an effort to restructure its debt. By doing so, the company could lower its debt service costs and boost cash flows or even take them to zero. Obviously, this would look negatively on the company in the short term but would help over the longer term. Of course, there are always negatives to defaulting.

Option 6: Liquidation/Bankruptcy

Up until now, investors, analysts, and the media have largely assumed that Bill Ackman and his cohorts can turn this company around. But with the protracted period of losses expected in a slow-growth economy, is it really possible for the company to turn it around? This question will only be answered with time.

Should the answer be a big, fat 'no' then there is only one solution that the company can take: A quick trip to bankruptcy court. Liquidation is obviously no one's first choice solution nor is it beneficial to anybody except for J.C. Penney's competitors, however it feels as though it is too soon to completely distrust this as a plausible outcome. Until improvement can be seen, the shadow of bankruptcy will creep closer.

Conclusion

The analysts at Credit Suisse pointed out that the month of May will be crucial to J.C. Penney's survival fight. "May will be a critical month for JCP when it releases results for 1Q'13. This in turn will have an impact on vendor perception and receptivity to new orders and strategies.

"Specifically, by the end of May, most of the orders for the key fourth quarter will need to be written. Both the terms and the quantities that JCP will order will be significantly impacted. From a merchandising front, JCP needs to find a better balance between the former administration's focus on item merchandising and 'tonnage' items like basic denim, pillows, and towels that have been lacking and were a large part of the drop in volume that occurred in '12."

This story is still yet to be written; the denouement yet to play out; nevertheless, several events in the not-so-distant future could determine the fate of J.C. Penney as a public company or even as a company that remains in existence.

Over the next few months, look for management changes, guidance from this new management and a new strategy, comments from large investors, earnings for the second quarter, and channel checks on the fourth quarter ordering.

Credit Suisse has an JUnderperform rating on J.C. Penney stock with a $15.00 price target, $0.87 below Monday's closing price but about $0.35 below where the stock was trading pre-market Tuesday.