J.C. Penney Company EDF TM CASE STUDY. Default Risk Rises as Venerable Retailer Struggles to Retune its Business Model

Transcription

1 28 OCTOBER 2013 CAPITAL MARKETS RESEARCH EDF TM CASE STUDY Moody s Capital Markets Research, Inc. Authors Irina Makarova +1 (212) irina.makarova@moodys.com David T. Hamilton, PhD +1 (212) david.hamilton@moodys.com About Analyses from Moody s Capital Markets Research, Inc. (CMR) focus on explaining signals from the credit and equity markets. The publications address whether market signals, in the opinion of the group s analysts, accurately reflect the risks and investment opportunities associated with issuers and sectors. CMR research thus complements the fundamentally-oriented research offered by Moody s Investors Service (MIS), the rating agency. J.C. Penney Company Default Risk Rises as Venerable Retailer Struggles to Retune its Business Model Summary Founded over 100 years ago, J.C. Penney is one of America s oldest retailers. Since 2010 J.C. Penney has experienced 9 consecutive quarters of declining sales. In August it reported a 12% decline in YOY revenues, from USD 3.02 billion in 2Q2012 to USD 2.66 billion in 2Q2013. One of the key reasons for J.C. Penney s poor financial performance was a failed attempt to change its business model, one that eliminated frequent discounts and promotions. The result has been sharply lower sales, a high cash burn rate, and job cuts. J.C. Penney s weak operating performance has led to a sharp rise in its probability of default. The firm s one-year probability of default rose from 0.4% in October 2012 to 8.5% as of October 25, 2013, an increase of over 2,000%. Its 8.5% EDF measure is 101 times higher than the median of the US Department Stores industry sector, making J.C. Penney one of the riskiest firms in that group. The increase in J.C. Penney s one-year EDF metric is attributable to a sharp increase in both its market leverage (financial risk) and its asset volatility (business risk). J.C. Penney s market leverage has more than doubled over the past year, to its current 69.2%, placing it among the riskiest companies by that metric in the US. CEO Johnson s strategy to transform the retailer resulted in a sharp increase in business risk. Between July 2012 and April 2013, the firm s asset volatility increased from 19.5% to 24.4%. Figure 1: J.C. Penney s EDF Measure Has Risen at an Accelerating Rate Over the Past Year J.C. Penney s One-Year EDF Measure Since October CMR is part of Moody s Analytics, which is one of the two operating businesses of Moody s Corporation. Moody s Analytics (including CMR) is legally and organizationally separated from Moody s Investors Service and operates on an arm s length basis from the ratings business. CMR does not provide investment advisory services or products. Read the full CMR FAQ capitalmarketsresearch@moodys.com 1-Year EDF (%) Moody's Investors Service cuts J.C. Penney's rating to Ba1 J.C. Penney names Ron Johnson as its new CEO, who introduces a new strategy that eliminated the practice of frequent discounts and promotions. J.C. Penney reports a 20% drop in sales and a $163 million loss in its first quarter. J.C. Penney sells 84 million shares raising about USD 785 million J.C. Penney reports a third quarter loss of $123 million and a 25% decline in sales Oct08 Feb09 Jun09 Oct09 Feb10 Jun10 Oct10 Feb11 Jun11 Oct11 Feb12 Jun12 Oct12 Feb13 Jun13 Oct13 Moody s Analytics markets and distributes all Moody s Capital Markets Research, Inc. materials. Moody s Capital Markets Research, Inc. is a subsidiary of Moody s Corporation. Moody s Analytics does not provide investment advisory services or products. For further detail, please see the last page.

2 Failed Business Strategy Results in High and Rising Risk of Default James Cash Penney founded his dry goods store in 1913, stating Profits must come through public confidence, and public confidence is given to any merchant in proportion to the service which he gives to the public. Both profits and public confidence have been in short supply for the venerable American department store chain over the past twelve months. While the competitive environment for J.C. Penney has been challenging, the company has also been reeling from largely self-inflicted wounds caused by a change in its business model that resulted in lower sales, a high cash burn rate, job cuts, and a slumping equity price. As a result the risk of default for J.C. Penny has risen markedly. As Figure 1 on the cover of this report shows, over the past year J.C. Penney s Expected Default Frequency (EDF TM ) measure has signaled a high and rising probability of default. The firm s one-year probability of default increased from 0.4% in October 2012 to 8.5% as of October 25, 2013, a 2,025% jump. The change in J.C. Penney s EDF measure is in sharp contrast to competitors like Macy s, Sears, Kohl s, and Target (shown in Figure 2 below). As economic growth in the US has sustained its pace, credit risk for Macy s, Kohl s, and Target has fallen. Particularly interesting is the contrast in the evolution of J.C. Penny s EDF measure with that of Sears, another centenarian struggling US retailer. Sears has experienced a similar set of challenges to its traditional business model as J.C. Penney, and between 2010 and 2013 its EDF measure increased to become one of the highest in its industry sector. However, after peaking in 2011 Sears EDF measure, although volatile, has bounced along a nearly flat trend. J.C. Penney s EDF measure shot past Sears in March 2013, and now exceeds Sears probability of default by a wide margin. While J.C. Penney s EDF measure continues to deteriorate, Sears EDF measure improved by 20% from 2.6% in June 2013 to its current level of 2.1% as of October 25, Figure 2: J.C. Penney s Default Risk Has Increased Sharply Relative to its Closest Competitors J.C. Penney s EDF Measure vs. Selected Department Store Competitors (log scale) Source: Moody s Analytics CreditEdge The negative momentum in J.C. Penney s EDF measure and its underperformance relative to its peers now distinguishes J.C. Penney as one of the riskiest firms among its industry competitors. In Figure 3 we show the trend of J.C. Penney s EDF measure versus the median, the 25 th, and 75 th percentile EDF measures for the US Department Stores industry sector. Prior to 2012, J.C. Penney s EDF measure tracked the median for its sector very closely; indeed, in the early part of the graph, during the financial crisis and US recession, J.C. Penney actually outperformed its industry sector peers. However, June 2012 saw a dramatic reversal in the trend of J.C. Penney s EDF measure. In just one year, J.C. Penney s EDF measure went from the median for its industry to the 75 th percentile. J.C. Penney s current 8.5% EDF measure is 101 times higher than the median of its sector. Furthermore, the rapid increase in J.C. Penney s EDF measure since June 2012 was in sharp 2 28 OCTOBER 2013 CAPITAL MARKETS RESEARCH GROUP / EDF CASE STUDY / MOODYS.COM

3 contrast to the changes in the median EDF level for the US Department Stores group, whose EDF metric improved by 70% over the same period. Figure 3: J.C. Penney s EDF Measure vs. EDF Distribution for US Department Stores Group J.C. Penney s EDF measure has risen sharply in both abosulte and relative terms US Department Stores Group J.C. Penney Sears 75% Median Year EDF (%, log scale) % 0.0 Oct08 Feb09 Jun09 Oct09 Feb10 Jun10 Oct10 Feb11 Jun11 Oct11 Feb12 Jun12 Oct12 Feb13 Jun13 Oct13 Source: Moody s Analytics CreditEdge Moody s Analytics research has shown that firms that underperform their industry sectors, regardless of the level of their EDF measure, experience higher default rates. Moreover, based on our analysis of historical defaults, we found that firms whose EDF levels are in the 75 th percentile of their industry sectors or higher are, on average, 4.5 times more likely to default than firms below the 75 th percentile, making J.C. Penney the one to watch closely. One of the key reasons for J.C. Penney s flagging performance has been a considerable drying up of liquidity caused by a steep decline in sales. Like many other brick-and-mortar retail stores, J.C. Penney has faced fierce competition for market share and pricing pressure from online retailers such as Amazon.com. In addition, at the end of 2010 the retail industry was affected by rising cotton prices following a chain of events among major Asian cotton producers that has decreased global supply. Cotton prices hit a 15-year high that year. For companies like J.C. Penney, Sears, Wal-Mart and Gap Inc., this meant that the higher costs had to be passed on to customers. In an effort to overhaul the aged retailers business model, Ron Johnson, former head of Apple s stores became CEO in November 2011 and introduced a new strategy that eliminated the practice of frequent discounts and promotions. The new strategy proved nothing short of a catastrophe for J.C. Penney. The approach, which attempted to transform J.C. Penney into an upscale boutique shop, drove customers away and by May 2012, J.C. Penney reported a 20% drop in sales and a USD 163 million loss in its first quarter. Since then, J.C. Penney has suffered from deep declines in comparable-store sales, even as many of its peers have seen increases (see Figure 4). Former CEO Mike Ullman replaced Ron Johnson in April Ullman began the process of undoing Johnson s failed strategy, reintroducing popular merchandizing and promotional strategies. Although the YOY change in sales continues to be negative, the trajectory of sales has reversed and is now positive, as shown in Figure 4 below. Ullman also quickly moved to shore up J.C. Penney s liquidity by selling 84 million equity shares valued at approximately USD 785 million in September. The share sale followed a USD 859 million revolving credit line from Goldman Sachs. J.C. Penney claims that it will end the year with over USD 2 billion in liquidity, which should help stabilize the company s credit picture in the short run as it attempts to address its fundamental business model challenges OCTOBER 2013 CAPITAL MARKETS RESEARCH GROUP / EDF CASE STUDY / MOODYS.COM

4 Figure 4: Although Recovering, J.C. Penney s Sales Are Still Down from the Previous Year Year-Over-Year Percentage Change in Comparable-Store Sales 10.0 Macy's Target Kohls J.C. Penney Sears Source: Company filing J.C. Penney s Default Risk Driven by Increases in Financial and Business Risk Expected Default Frequency measures are probabilities of default that incorporate the two primary fundamental drivers of credit risk: financial risk and business risk. In this section we will look into these drivers of J.C. Penney s EDF measure in greater detail. Moody s Analytics public firm EDF model belongs to a class of credit risk models referred to as structural or asset value models. The basic assumption of asset value models is that there is a causal, economically motivated reason that default occurs. Default is highly likely to occur when the market value of the firm (the sum of the value of its market capitalization and debt) is insufficient to cover its liabilities due at some future date i.e. firms tend to default when they are insolvent. This follows from the fact that equity holders are residual claimants on the value of the firm. If the market value of the firm is negative, equity holders can and often will put the residual value of the firm to creditors. The above economic intuition can be translated into three quantifiable variables: the expected value of a firm s assets (A), the volatility of its assets (denonted by σ), and its default point, X, which is determined by a firm s liabilities. The interaction of the three variables is encapsulated by the firm s distance-to-default (DD) which, under some largely innocuous assumptions, can be expressed as: DD ( ln(a)-ln(x) ) / σ This simple equation essentially states that a firm s relative credit risk (measured by DD) is a function of its financial risk and its business risk, two factors that are core concepts of fundamental credit analysis. The numerator of the above equation measures market leverage i.e. financial risk. All else equal, higher leverage decreases DD and hence increases the probability of default. The denominator of the DD equation can be viewed as business risk. Firms in industries with high asset volatility tend to exhibit higher risk of default, all else equal. Once we have calculated a firm s DD, we can derive its probability of default (its EDF measure) by looking at the historical average default rate consistent with each DD level. The increase in J.C. Penney s probability of default is attributable to a sharp increase in both financial and business risk. Figure 6 shows the time series of J.C. Penney s market value of assets, its default point, and its market leverage. Market leverage summarizes a firm s financial risk, and is simply the ratio of a firm s default point to its market value of assets (expressed in percent). Unlike book leverage, market leverage reflects the forward-looking views of investors. Market leverage goes up when a firm s liabilities increase and/or when 4 28 OCTOBER 2013 CAPITAL MARKETS RESEARCH GROUP / EDF CASE STUDY / MOODYS.COM

5 the market value of its assets declines. One can view changes in the market value of a firm s assets as investors collective view on the future profitability of a company: when the market value of assets goes up, investors expect future cash flows to increase. The opposite is true when the market value of assets goes down as in the current case. Figure 5 shows that J.C. Penney s market leverage increased sharply over the past two years. After J.C. Penney s year-over-year decline in FY 2012 net income, from a loss of USD 152 million to a larger loss of USD 985 million, along with USD 577 million decline in the cash reserves, the company s market value of assets dropped from USD 11.5 billion in October 2012 to USD 9.1 billion in October 2013 a 20% decline. Since October 2012 alone, J.C. Penney s market leverage has increased by 80%, from 38.4% to 69.2% as of October 25, Currently, its market leverage is in the 99 th percentile of its industry group. The increase in market leverage came from both a fall in the company s market value of assets and an increase in its default point. Since January 2012, J.C. Penney s market value of assets has fallen by a third, while its default point has increased by 37%. Figure 5: J.C. Penney s Market Leverage, Default Point and Market Value of Assets J.C. Penney s market value of assets has eroded sharply while liabilities have increased, driving market leverage and EDF higher Source: Moody s Analytics CreditEdge Another contributing factor to the rise in J.C. Penney s probability of default has been its worsening operating performance, which is measured by the firm s asset volatility. Over the past year J.C. Penney has spent enormous amount of resources in efforts to turn around nine consecutive declines in sales. Between July 2012 and April 2013, the firm s asset volatility increased from 19.5% to 24.4%. The combination of higher leverage and higher asset volatility led to a sharp drop in its distance to default and a material rise in its EDF measure. As Figure 6 clearly shows, CEO Johnson s strategy to transform the retailer resulted in a sharp increase in business risk. Almost immediately after his replacement by Ullman, business risk began to decline. As of October 2013, J.C. Penney s asset volatility stands at 23.3% OCTOBER 2013 CAPITAL MARKETS RESEARCH GROUP / EDF CASE STUDY / MOODYS.COM

6 Figure 6: J.C. Penney s Business Risk Increased Until CEO Johnson Was Replaced J.C. Penney s Asset Volatility (Annualized) Source: Moody s Analytics CreditEdge EDF Measures Versus Credit Ratings and Other Market Signals of Risk One of the advantages of the public EDF measure is that it uses equity market information as one of its inputs to estimate probabilities of default. The liquidity of the public equity market relative to the bond or credit default swap market enables EDF credit measures to signal sudden changes in default risk. Credit spreads (both bond and CDS) are often used as early warning of credit risk. However, J.C. Penney s EDF measure has shown a significant and rapid rise over the past year, while the bond market has shown a more gradual deterioration in its spread level. Figure 7: J.C. Penney s EDF Measure Showed a Rapid Deterioration Compared to its Bond Spread Percent Change in J.C. Penney s EDF Measure and its Bond Spread Over US Treasury Since October % 2000% EDF Measure 1500% % Change 1000% 500% 0% OAS Spread -500% Oct11 Jan12 Apr12 Jul12 Oct12 Jan13 Apr13 Jul13 Oct13 Source: Moody s Analytics CreditEdge, Bloomberg Figure 7 shows the percent change in the public EDF measure for J.C. Penney together with the percent change in the spread over 10-year Treasuries on its 7.125% bonds maturing in Each line shows the percent change on a given date vs. October 2011 (the first date shown on the graph). Since J.C. Penney 6 28 OCTOBER 2013 CAPITAL MARKETS RESEARCH GROUP / EDF CASE STUDY / MOODYS.COM

7 reported a 300% YOY decline in earnings in August 2012, the company s EDF measure and bond spread have both increased. However, despite J.C. Penney s plainly aparent and deepening challenges, the bond market has been slower to re-price the risk of default. Compared to its 0.4% EDF level in October 2011, J.C. Penney s EDF measure increased by over 2,000% by October 2013, while its bond spread increased by 142% over the same period of time. J.C. Penney s bond spread on its 7.125% bonds maturing in 2023 is currently 1,086 bp. EDF credit measures, as well as credit spreads, are granular measures of the level of a firm s default risk. However, for some purposes, investors prefer to analyze credit risk in the language of credit ratings. Figure 8 shows J.C. Penney s EDF measure superimposed on the historical default rates consistent with each rating category (sourced from Moody s Investors Service s annual corporate bond default study). The position of the company s EDF measure on these bands indicates the rating to which the EDF measure maps. J.C. Penney s one-year EDF measure improved from B2 to about Ba1 after the 2008 financial crisis. However, since the middle of 2012, amid declining sales and dwindling cash reserves its EDF measure reached a peak of 9.2% on October 21, 2013, which mapped to a Caa1 rating. Over the past week, J.C. Penney s EDF measure improved slightly to its current 8.5%, still suggesting a relatively high risk of default. In figure 8, we again show the contrast in the evolution of J.C. Penney s EDF measure with that of Sears. Sears EDF measure peaked in 2011, which mapped to a Caa1 rating. However, although Sears EDF measure is volatile, it has bounced along a nearly flat trend in a range consistent with default rates of B1 rated companies for the past two years. Figure 8: While the EDF-Implied Rating for Sears Has Been Lower for Longer, J.C. Penny Has Jumped J.C. Penney s EDF Measure vs. Sears EDF Measure 8 Caa1 7 6 B3 1-Year EDF (%) B2 B1 Ba3 1 Ba2 Ba1 0 Baa3 Oct08 Feb09 Jun09 Oct09 Feb10 Jun10 Oct10 Feb11 Jun11 Oct11 Feb12 Jun12 Oct12 Feb13 Jun13 Oct13 JC Penney Sears Source: Moody s Analytics CreditEdge and Moody s Investors Service 7 28 OCTOBER 2013 CAPITAL MARKETS RESEARCH GROUP / EDF CASE STUDY / MOODYS.COM

8 Summary The trend of J.C. Penney s pubic EDF measure indicates that the company has been experiencing increasing financial strain and rising risk of default. Since the implementation of new marketing and merchandizing strategies introduced by J.C. Penney s former CEO Ron Johnson, the company has suffered large revenue drops and struggled to generate cash flow to finance operations. Mike Ullman, who replaced Johnson in April 2013, quickly began the process of undoing the new strategy and to shore up J.C. Penney s liquidity sold 84 million equity shares valued at approximately USD 785 million in September. The firm s one-year probability of default, which is calculated using information from the firm s balance sheet and its equity valuation, has increased by over 2,000%, from 0.4% in October 2012 to 8.5% as of October 25, Moreover, the company s public EDF measure has been underperforming its industry group over the past year, and its EDF measure currently trends among the 75 th percentile for its industry group, signaling a relatively high risk of default compared to its peers. Based on our analysis of the historical defaults, we found that firms whose EDF levels are in the 75 th percentile or higher of their industry sectors are, on average, 4.5 times more likely to default than firms below the 75 th percentile. The negative momentum in J.C. Penney s EDF measure and its underperformance relative to its peers distinguishes J.C. Penney as the riskiest firm in its industry sector. The deterioration of J.C. Penney s EDF measure has been largely due to high and rising market leverage (financial risk). The increase in financial risk has been compounded by worsening liquidity and poor operating performance, which is measured by the firm s asset volatility. Since reporting a USD 260 million loss in Q2 2012, J.C. Penney s market leverage has increased by about 80%, driven by a decline in the market value of the firm s assets and a jump in its default point. Other market signals, such as bond spreads and credit ratings, show the same pattern of increased risk, reinforcing the signal from the firm s public EDF metric Moreover, contrasting the evolution of J.C. Penney s EDF measure with that of its peer Sears Holdings, we find that not only is it important to monitor the level of a company s EDF measure, but it is also critical to monitor the relative movement of an EDF measure. Over the past two years, although volatile, Sears EDF measure has bounced along in a near flat trend, while J.C. Penney s one-year probability of default appears to be increasing exponentially. The company s under-performance versus its peers and industry sector reveals heightened risk that might have been overlooked if we had only been monitoring EDF level alone. Further Reading J.C. Penney Sells Shares to Boost Liquidity, Issuer Comment, Moody s Investors Service, October 2, 2013 JCP's secondary offering offsets a higher than expected cash flow burn, Issuer Comment, Moody s Investors Service, September 27, 2013 J. C. Penney Co., Inc. Market-Based Risk Measures Suggest Time May Be Running Short, Market Signals Review, Moody s Analytics, March 18, OCTOBER 2013 CAPITAL MARKETS RESEARCH GROUP / EDF CASE STUDY / MOODYS.COM

9 Report Number: Authors Irina Makarova David Hamilton Contact Us Americas : Europe: +44 (0) Asia: Copyright 2013, Moody s Capital Markets Research, Inc., and/or its licensors and affiliates (together, "MOODY'S). All rights reserved. ALL INFORMATION CONTAINED HEREIN IS PROTECTED BY COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY S PRIOR WRITTEN CONSENT. All information contained herein is obtained by MOODY S from sources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, such information is provided as is without warranty of any kind and MOODY S, in particular, makes no representation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitness for any particular purpose of any such information. Under no circumstances shall MOODY S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY S or any of its directors, officers, employees or agents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY S is advised in advance of the possibility of such damages, resulting from the use of or inability to use, any such information. The credit ratings and financial reporting analysis observations, if any, constituting part of the information contained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding or selling. MOODY S hereby discloses that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MOODY S have, prior to assignment of any rating, agreed to pay to MOODY S for appraisal and rating services rendered by it fees ranging from $1,500 to approximately $2,400,000. Moody s Corporation (MCO) and its wholly-owned credit rating agency subsidiary, Moody s Investors Service (MIS), also maintain policies and procedures to address the independence of MIS s ratings and rating processes. Information regarding certain affiliations that may exist between directors of MCO and rated entities, and between entities who hold ratings from MIS and have also publicly reported to the SEC an ownership interest in MCO of more than 5%, is posted annually on Moody s website at under the heading Shareholder Relations Corporate Governance Director and Shareholder Affiliation Policy. The statements contained in this research report are based solely upon the opinions of Moody s Capital Markets Research, Inc. and the data and information available to the authors at the time of publication of this report. There is no assurance that any predicted results will actually occur. Past performance is no guarantee of future results. The analysis in this report has not been made available to any issuer prior to publication. When making an investment decision, investors should use additional sources of information and consult with their investment advisor. Investing in securities involves certain risks including possible fluctuations in investment return and loss of principal. Investing in bonds presents additional risks, including changes in interest rates and credit risk. All Capital Markets Research Group information is provided by Moody's Capital Markets Research, Inc., a subsidiary of Moody s Corporation. Please note that Moody s Analytics, Inc., an affiliate of Moody s Capital Markets Research, Inc. and a subsidiary of MCO, provides a wide range of research and analytical products and services to corporations and participants in the financial markets. Customers of Moody s Analytics, Inc. may include companies mentioned in this report. Please be advised that a conflict may exist and that any investment decisions you make are your own responsibility. The Moody s Analytics logo is used on certain Capital Markets Research Group products for marketing purposes only. Moody s Analytics is not a part of the Capital Markets Research Group nor is it a part of Moody s Capital Markets Research, Inc OCTOBER 2013 MOODY S CAPITAL MARKETS RESEARCH, INC. / EDF CASE STUDY / MOODYS.COM