I recommend investors buy protection on JC Penney CDS (short risk) at 14 pts upfront (~890 bps) with a target of ~21 pts upfront (~1,140 bps). For investors that can’t transact in CDS, I recommend shorting JC Penney stock with a target of $8 to $10 per share for a total return of 32%-45%. Under recently fired CEO Ron Johnson, JC Penney has been potentially irreparably harmed with sales down 25% in 2012 (~$4 billion in lost sales), same store sales down 25% and a cash burn of $1.3 billion before asset sales. In addition, I project in Q1 (May 18th) a potential cash burn of up to $908 million and a full year burn of $1.1 billion. As the company burns cash, I expect it to have to draw on its revolver for the first time in its history. The revolver is secured and will subordinate all the current debt, which is unsecured. In addition, I expect the company to look to do a capital raise, priming the bonds even more (it is rumored the company is looking at a $500 million term loan backed by the company’s inventory).

JC Penney is a department store that has 1,100 stores across America. The company had been floundering post the financial crisis even as competitors such as Macy’s and Dillards recovered. After hitting peak sales of $19.9 billion and operating margins of 9.7% in 2006, sales declined to $17.2 billion and an operating margin of 3.1% in 2011, the year before Ron Johnson was hired (Ron was actually hired in 2011 but his impact on the company did not begin to be felt until 2012). In 2010, Bill Ackman and Pershing Square took a 26% stake and Vornado took an 10.6% stake in JC Penney. Ackman & Vornado pushed for a $900 million share buyback, depleting some of JC Penney’s cash reserves. Under Bill Ackman’s direction, then CEO Mike Ullman was pushed out and in October 2011, Ron Johnson, the genius behind Apple’s retail stores and its Genius Bar, was hired as CEO of JC Penney with a mandate to transform it.

On January 25, 2012, Ron Johnson unveiled his new vision for JC Penney. First, Ron Johnson decided to end the industry practice of coupons and promotions. In the prior year, the company had 590 different promotions with very little success. Ron Johnson decided to change JC Penney’s pricing to an everyday low price model. Instead of pricing say a towel for $15 and marking it down 60% to $6 through coupons and/or promotions, JC Penney was going to just sell the towel for $6 with no deals. Ron Johnson went to a 3 tier pricing strategy that consisted of 1.) Everyday Low Prices, 2.) month long sales (for example in June, the company might run special sales on outdoor products such as grills) and 3.) twice monthly clearance sales on the second and last Friday of each month to get rid of clearance items. The other bedrock of Ron Johnson’s plan was to roll out stores within a store. JC Penney would create shops that were made to look like separate, different shops within the JC Penney store and bring in merchants like Joe Fresh, Michael Graves, Bodum, Tourneau, Levi’s, IZOD and others. Over 4 years, JC Penney would build out 100 shops. Ron Johnson hoped to bring in more upscale merchandise and attract a younger, more affluent customer. In addition, free WiFi would be build out and things such as lego tables for kids, sofas & ipads so people could buy some coffee or some food and just hang out and surf the web.

Unfortunately, Ron Johnson violated one of the first rules of retail and did not test these concepts in small, out of the way stores to see what results would look like. He decided to roll out everything to the whole company at once. In addition, only 700 stores were going to receive the store within a store concept raising the question of what the remaining 400 JC Penney stores would look like. Would they just be left alone and left to look like they always have? Ron Johnson did not understand just how much consumers loved to feel like they were getting a deal. Even if the right price was $6 for a towel, he or she always felt like they were getting a deal if the towel was priced at $15, but marked down to $6. As a result of these changes, customers began to flee JC Penney in droves. Same store sales declined by 18.9% in Q1 ’12, 21.7% in Q2, 26.1% in Q3 and 31.7% in Q4. Traffic declined by 10%, 12%, 12% and 17% in Q1, Q2, Q3 and Q4 respectively. In another blunder, Ron Johnson seemed to completely disregard the internet channel of JC Penney sales. While competitors such as Macy’s, Kohl’s and Nordstrom’s saw internet sales rise by 30, 40 or even 50% in 2012, JC Penney saw internet sales plummet by 33%, including a 34% drop in the all important holiday Q4. After Q4’s disasterous results, Vornado sold 10 million shares, reducing its stake to 6.1%. Given their familiarity with JC Penney and its real estate, I don’t think this was a ringing endorsement of one of the bulls major arguments, that JC Penney has significant real estate value. JC Penney’s management team also seemed to forget that retail changes don’t happen in a vacuum. Competitors such as Stage Stores, Macy’s, Kohl’s, etc all still ran promotions and in some cases promoted even more to steal customers away from Penneys. In the end, Ron Johnson drove away his core customer who loved deals and failed to attract a younger, more affluent customer.

Q2 2012 results were worse than Q1 and as a result, JC Penney revamped its pricing strategy. The company admitted its customers were confused and eliminated its 2x monthly clearance prices and just moved to two different pricing strategies, 1.) Everyday Low Prices and 2.) Full time clearance prices. In a bid to stimulate traffic, JCP tried to offer free haircuts every Sunday in the fall and free family portraits during the holidays. In addition, Ron Johnson & Company brought back limited promotions for the holiday season. Still things only got worse and Q4 was the worst quarter to date with same store sales plunging 32%. Even with promotions in Q4, the decline in traffic accelerate to -17% from a 12% drop in Q3. All year long JC Penney had promised it would end the year with $1 billion in cash. The company failed, ending the year with $930 million in cash. However, to even meet this goal, the company had to push out payables. Payables as a percentage of inventories rose to 49% from ~35% in the previous 2 years, and payable days spiked to 35 days from ~26 days on average in the previous two years. JC Penney even admitted it deferred paying $85 million to vendors until Q1. If payables were normalized, JC Penney’s cash balances would have been approximately $343 million less to $587 million.

Looking deeper into JC Penney’s results, you can see that Ron Johnson’s strategy was not working. Sales in higher margin, everyday low price items (49.6% selling margin) declined YoY by 23% in Q1, 25% in Q2, 34% in Q3 and 37% in Q4. Sales of

clearance items (-5.5% selling margins) increased by 13% and 23% in Q3 and Q4. Note that in Q1 and Q2, the updated store concept was only rolled out to 2% of JC Penney’s square footage, while in quarters 3 and 4, this was increased to 11% of total square footage. So despite better and better products introduced to JC Penney, sales of these products plummeted and sales of clearance products increased dramatically despite an increase in the rollout of the shop within a shop concept. On JC Penney’s Q3 conference call, management said that the new shop within a shop stores were seeing sales uplifts of ~33% and that similar uplifts were seen in Q4. Based on this, we can ascertain that sales in the old JC Penney, “core” JC Penney declined by 33% in Q3 and 40% in Q4. So lets reiterate that despite better products being rolled out to more of JC Penney’s square footage, consumers bought less of the higher margin products, and more of the lower margin products and sales within the core JC Penney’s saw their rate of decline increase. Hardly a winning strategy.

Recently JC Penny fired Ron Johnson and replaced him with Mike Ullman, the former CEO that was pushed out by Bill Ackman. JC Penney doesn’t have the luxury of time and a new CEO would probably need 6 months to get to know the company. Ullman is familiar with JC Penney and doesn’t need a lot of time to get up to speed. As a familiar face he can help in soothing some of the company’s vendors fears about a bankruptcy (especially in light of the fact the company is stretching payables). However, if he was not the right man the first time around for JC Penney (Bill Ackman was very vocal about how poorly run JC Penney was and how poorly its stock price faired under Mike Ulman’s reign), why is he the right man the second time around? Wall Street didn’t like the choice when Mr. Ullman was named CEO last Monday night and on Tuesday, JC Penney equity fell 12%.

I expect JC Penney to continue to report poor results. As JCP brings back coupons and promotions, traffic may come back but I feel it will be at the expense of margins. This will effect Q1. For Q1, I expect same store sales to fall 18% (despite lapping easy comps of -18.9% in Q1 of last year), EBITDA of -$200 million and a cash burn of $908 million. For full year 2013, I expect a cash burn of $1.1 billion. As the company continues to build out its shops within a shop, capex will be elevated. One of Mr. Ullman’s first tasks will be to see what capex is committed and what capex can be cut as cash is now precious to JC Penney. The new CEO has some hard choices to make. Will he continue with the shop rollouts (~20% of total square footage in May)? Will he stop the rollouts and have the stores look half incomplete with part of the store looking like the “old” JC Penney and the other half having some of the shop within a shop concept? Will he dismantle the shops? All the choices will be costly and involve wasting a lot of money.

For 2014, I expect same store sales to rise 3.3%, sales of $12.5 billion and EBITDA of $215 million. On a lease adjusted basis, JC Penney will have lease and net adjusted leverage of 11.8x and 11.2x. Based on where certain retailers trade, I believe that JC Penney CDS should trade for about 21 pts or ~1,140 bps.

CDS Valuation

Company 5Y CDS Net Lease Adj Lev Spread/turn of levNeiman Marcus 198 4.8x 41

Levi Strauss 260 3.8x 68Jones Group 315 4.4x 72Office Depot 305 4.7x 65

Toys R Us 742 5.6x 133RadioShack 1,453 7.5x 194

Sears 707 7.1x 100Best Buy 397 2.8x 142

Average 547 5.1x 102

Using 2014’s estimated net lease adjusted leverage of 11.2x for JC Penney and a 102 average spread per turn of leverage, I believe JC Penney CDS should trade at ~1,140 bps or 21 pts upfront.

Equity Valuation

Because I expect JC Penney to be unprofitable over the next few years I have used an EV/Sales valuation. JC Penney’s past 5 year average EV/Sales ratio has been 37%. Using a slight premium of 41% to 44% gets a valuation of $8-$10 per share for JCP equity. Bulls will argue that there is significant real estate value to JC Penney and its owned store base of ~426 stores and its below market rents (~$4/sq ft). However, Vornado bailed on their investment and valuations of JC Penney’s real estate values are all over the map. One cannot easily evaluate JC Penney’s store value without going through a detailed store by store valuation, which is nearly impossible. Valuations of over $1 billion to between $2-$5 billion dollars have been thrown about. I think the clearest statement yet about just how low the valuation of JC Penney’s real estate might be is from the fact that Vornado has hit the eject button on most of its investment and will probably look to get out of the remainder.

JC Penney faces real bankruptcy risk. I just don’t see how the company survives and that credit spreads don’t go wider and equity prices go lower. I think JC Penney is doomed because:

1.) US marketplace is very crowded2.) JC Penney was trying to reposition itself to begin with because the old way

wasn’t working. Think now going back to it will work?3.) Difficult to reposition a dinosaur- no loyalty, people can go and shop

elsewhere

4.) Kind of have to continue with Ron Johnson’s plan in some form because what are you going to do, leave 80% of the store as old JC Penney and 20% as new JC Penney? Stores will look really weird.

5.) Assume you continue and go through with the Ron Johnson strategy and get to new JC Penney, you still don’t know that it is a viable model to compete in the marketplace.

Ultimate, JC Penney will continue to bleed cash. I think that the company will look to do a secured capital raise, which will subordinate the bonds and push down recoveries. In the long run, it is a business model problem and throwing liquidity at it will not help. It will only prolong the day of reckoning. As a result, I recommend buying protection on CDS with a target of 21 points upfront or shorting the equity with a price target of $8-$10 per share. However, investors should initially buy protection/short equity on about 30-50% of their full position so that there is dry powder in case the company successfully raises additional capital.

In addition, I have a very detailed model on JC Penney that I am happy to share with anyone if they want to private message me.