ESADE Corporate Finance – 2022 / 2023: 17/10/2022

Case Study Nr 2 - The JC Penney Company

Group C7

ESADE Corporate Finance – 2022 / 2023:

Case Study Nr 2 - The JC Penney Company

Group C7
Sagarika Jindal
Marlene Heiland
Nuno Bras
Florian Kausch
Henri de Sloovere

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ESADE Corporate Finance – 2022 / 2023: 17/10/2022

Case Study Nr 2 - The JC Penney Company

Group C7
1) Analysis of the firm’s liquidity situation and overall capital structure

i) Liquidity ratios from 2011Q1 to 2012Q4

Table 1: Liquidity Ratios from 2011Q1 to 2012Q4

Source: Information provided by JC Penney Case Study.

Overall, J.C. Penney’s (JCP) current ratio is above 1 in all quarters, which indicates that it is
able to meet its short-term obligations. The quick ratio excludes inventory from current assets
and is therefore quite low, as the retail industry´s current assets are mostly composed by
inventory and are directly affected by consumer demand.
The current ratio, the quick ratio and cash to sales have constantly decreased from Q1 2011
to Q4 2012, indicating that JCP is losing its ability to pay current liabilities with its current
assets. The decline of cash to sales shows that sales are generating a smaller amount of cash
due to the decrease of sales. Typical for a retail company, JCP collects its revenues in cash
or credit card receipts and has no accounts receivable. Additionally, the company funds its
stock buy-back programme in Q1 2011 with cash and short-term investments and hired costly
executives in 2011. In the period of Q3 2011 to Q1 2012, the observed ratios increased,
indicating that JCP was more stable during these periods, due to the decrease of merchandise
accounts payable related to the sales drop from Q1 2012. On the other hand, JCP enlarged
its short-term and current long-term debt in this period.

ii) Leverage ratios from 2011Q1 to 2012Q4

Table 2: Leverage Ratios from 2011Q1 to 2012Q4

Source: Information provided by JC Penney Case Study.

Looking at the interest coverage ratio, we can clearly observe a sharp decline over the 8-
quarter period. This decline is a result of the business’ deteriorating operating profitability.
While interest expenses remain constant, EBIT has declined by over 360% from Q1 2011 to
Q4 2012. Further, JCP’s Cash-to-Debt ratio experienced a decline, mainly due to a sharp drop
in cash and cash equivalents from Q3 & Q4 2011 to Q1 2012. Sales took a large hit in Q1
2012, (-20% YoY) due to the unsuccessful implementation of new pricing strategy. Stock buy-
backs and expensive executive hires added to the lower cash position as no significant new
long-term debt was issued over the period.

As for the Debt-to-Total Assets ratio, the portion of short-term and long-term debt to JCP’s
total assets increased. Counterintuitively, an increase in debt is not the reason for the
movement, but the decline in total assets. While the disposal of non-core assets and

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ESADE Corporate Finance – 2022 / 2023: 17/10/2022

Case Study Nr 2 - The JC Penney Company

Group C7
discontinuation of non-core operations, in line with new management’s strategy, should
increase the overall cash position, lack of customer demand weighs stronger and thus, the
decrease in cash & inventory affected the decrease in total assets significantly. Overall, the
three ratios showcase an increase of JPC’s liquidity risk and thus, imply similar findings to i).
Five out of six ratios include cash, therefore it is logical, that decreases in cash show similar
results regarding liquidity risk.

2) JCP’s working capital management

Working capital is a financial metric that helps to assess the financial health of the company
and aids in determining whether the company would be able to meet its short-term obligations.
It is calculated as net of current asset and current liabilities. Hence, it is desirable to have a
positive working capital as it can fund short-term business growth without incurring debt and
can provide leeway for contingencies and cover short-term liabilities. However, an excessively
high working capital can indicate operational inefficiency.

In JC Penny’s case, we observed the following about working capital:

1. Declining cash & cash equivalents: Even though we see a positive working capital over
the 8 quarters from 2011-2012, the working capital is declining with an increasing trend
(from USD 2,963m in Q1 2011 to USD 1,115m in Q4 2012). The major contributor to
the declining trend in the working capital is the reduction in cash and cash equivalents
which was caused by both the fall in the sales revenue and gross margin.
2. Fluctuating inventory: Inventory declined by 20% from 2011 to 2012. Moreover, a high
fluctuation was observed in days sales inventory outstanding.
Henceforth, our recommendation to squeeze out cash from working capital are the following:
1. Improve inventory turnover ratio: Since we observed a fluctuating trend in the days
sales inventory outstanding, it shows a potential for the company to improve its cash
position by reducing its inventory level towards the lower end of the fluctuating
inventory turnover ratio which is shown in Fig. 1
2. Stretching the days of accounts payable: Generally having a high days payable means
that the company has extra cash on hand. Even though in the case of JC Penny, the
number of days payable has been quite high, the same can be stretched further as it
can help the company to improve its cash holding.
Figure 1: Days inventory turnover

Source: Group calculations based on information provided by JC Penney Case Study.

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ESADE Corporate Finance – 2022 / 2023: 17/10/2022

Case Study Nr 2 - The JC Penney Company

Group C7

3) JCP’s management analysis

When Bill Ackman announced his USD 900m share purchase of JCP in 2010, optimism spread
across the company and its investors. Having a track record of successful turnarounds as
activist investor in the Consumer & Retail space, investors had increased confidence when
Ackman stated his conviction about the potential of JCP. Following his appointment on the
board of directors and restructuring of operations, the company posted strong FY 2010 results
under CEO Ullman, deciding for a USD 900m buyback program. With the appointment of
highly reputed industry veteran Ron Johnson as new CEO, the stock soared by 17.00%, while
the former Apple Executive received a pay package including a base salary of USD 357,000,
a performance-based bonus of USD 236,000 and a significant USD 50m in RSU. Expensive
senior hires followed while a shift in strategy was put forward. Ackman, sought to increase
EBITDA-margins to boost his ROE and maximise the exit value of his investment.
However, the strategy did not end up in success. Despite the short-term success, the stock
decreased by around 59.00%, creating a loss of over USD 500m for Ackman during his holding
period and sending JCP into severe liquidity pressure. The main issue was that Ackman blindly
trusted in Johnson’s management approach and strategy while it was clear that Apple’s
business model and JCP’s heavily differed from each other. Having relied on discounts and
promotion on its products to boost sales, JCP now concluded to put in place a similar Apple
strategy of fair and full pricing while overhauling the mall concept. This led to reduced sales
and increased capex. In short, Ackman hired and blindly trusted a CEO that was ill-suited to
the customers and strategy of JCP. Little to no testing of the concept was undertaken.
Additionally, pay packages for newly hired senior industry stars included significant sign-on
bonuses and base salaries, that ate into JCP’s operating expenses. While stock-based
compensation increases management and shareholder alignment, managers destroyed
shareholder value as their past track record of success did not deliver future results.

4) Stock and index returns for JC Penney and S&P 500

i) Abnormal return of stock on Feb 25th, 2011 – day of announcement of $900 Mio
stock buy-back
On 25/02/2021, on the day of the announcement of the USD 900m stock buy-back, JCP’s
stock had an abnormal return of –6.91%, based on an expected price of USD 36.60 per share
and an actual price of USD 34.16.
We calculated JCP’s beta based on the relation of its returns to S&P 500 returns of the past
90 days1, because the short period reflects best the firm-specific events, especially since Bill
Ackman started buying JCP´s shares and had a stake of 16.80% in Q3 of 2010. He was
famous for having a significant impact on management decisions and had mentioned that he
planned to change the company´s operations and join the board. The expected share price
should therefore be based on the company´s returns since Ackmans investments in JCP.
Stock buybacks usually support the stock prices. As the company is investing in its own
shares, it signals that the company believes the market is undervaluing is shares and the
buyback therefore increases shareholder value. However, JCP´s stock declined after the
announcement because they used cash and short investments to fund the buyback, reducing
their working capital in a time of economic crisis.

1 Source used for historical S&P 500 returns (closing prices) – Yahoo Finance.

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ESADE Corporate Finance – 2022 / 2023: 17/10/2022

Case Study Nr 2 - The JC Penney Company

Group C7
The expected share price for February 25th 2011 is based on JCP´s average daily returns of
0.17% and its beta of 1.09 of the past 90 days. Therefore, it is expected that JCP´s share price
would react in the same direction as the market, which had daily returns of 0.14% (S&P 500)
in this period. We estimated JCP’s expected share price based on the CAPM model, with a
daily risk-free rate of 0.01%2, based on the annual Treasury Yield 10 years as of February 14th
2011 (3.43%), and a daily risk premium of 0.13%. For this work we considered the risk
premium as the difference between the average of S&P 500 daily returns of the observed
period and the daily risk-free rate.
JCP´s share price was expected to rise by 0.17% from USD 36.56 on February 24th to USD
36.60 on February 25th. However, the actual share price was lower due to the announcement
of the stock buy-back programme and the negative impact associated, especially regarding
JCP´s working capital.
ii) Abnormal return of stock after May 15th, 2012 – announcement of dividend
suspension
On May 16th, 2012, one day after the announcement of the dividend suspension, JCP´s
abnormal return was –22.00%. The expected share price based on historical returns was USD
33.32, whereas the actual price was only USD 26.75.
To estimate the company´s beta, we chose the time horizon since 15th of June 2011, one day
after the announcement of the new CEO Ron Johnson on 14th of June 2011. We did not take
into account the returns of the day of his appointment, because the share price increased by
17.5% on that day, characterizing an outlier. This unusual share price increase reflects
shareholders expectations that Johnson would turnaround JCP´s business strategy, based on
his prior success at Apple Inc´s retail stores. However, the returns in the following periods
reflect the company´s disappointing results in 2011 and are more adequate for forecasting the
company´s future returns.
Dividend suspensions occur mainly when the company either needs to use the proceeds to
fund growth or when it is in financial strain. Considering that J.C.P. had continuously paid a
dividend since 1987 it signals the latter to investors. As a result, one expects a decrease in
the share price valuation. Furthermore, suspending the dividend implies that management has
not achieved its minimum performance target, therefore, it is expected that a change in senior
management is imminent.
The difference between the expected and actual share price can be explained by the heavy
impact of the dividend suspension announcement. It led to a drastic decrease of the share
price, as market expectations towards JCP´s performance worsened. Nevertheless, JCP
already had negative share price returns since the new CEO´s appointment (average daily
returns of -0.026%), in comparison to S&P 500 which presented average daily returns of
0.014% in the observed period. JCP´s beta was 1.08, which shows the company´s sensitivity
to changes in market, but its share price is mostly impacted by the company´s performance
and negative results. For the estimation of the expected return we considered a daily risk-free
rate of 0.01% (Annual Treasury Yield 10 Years of 1.79%) and a daily risk premium of 0.01%.
iii) Development of the quarterly dividends in the 5y period prior the abrupt
suspension
As JCP´s gross profit declined steadily in from Q4 2011 to Q4 20212, shareholders could
already foresee the eventual suspension of dividend payments. Moreover, the cash flow
statement shows that common dividend payments decreased from USD 189m in 2010 to USD
178m in 2011 and USD 86m in 2012, indicating the suspension.

2
Source: Annual Treasury Yield 10 Years, Yahoo Finance.

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ESADE Corporate Finance – 2022 / 2023: 17/10/2022

Case Study Nr 2 - The JC Penney Company

Group C7
iv) Abnormal return of JCP on Nov 22nd, 2013 – exclusion from Dow Jones Indices
On Nov 22nd, 2013, JCP´s abnormal return was –3.43%, as the expected share price was
USD 9.18 in comparison to the actual share price of USD 8.87.
We chose a period of one year for the estimation of JCP´s beta, because analysts publicly
started to question the company´s liquidity just before the release of its 2012 annual earnings
and therefore, the period of financial distress should be reflected in the company´s beta.
The expected share price is related to JCP´s average daily returns of -0.25% of the observed
period and its beta of 1.01, which shows that the company´s stocks generally move in the
same direction with the market. S&P 500 average historical daily returns represented 0.10%
in this period. For the calculation of the expected return we considered a daily risk-free rate of
0.01%, based on the annual Treasury Yield of 10 years as of Nov 21st, 2013 (2.78%)3, and a
daily risk premium of 0.09%. Therefore, JCP´s share price as of Nov 22nd is expected to rise
by 0.10% from USD 9.17 to USD 9.18.
On the day of the exclusion from the Dow Jones Indices, JCP´s share price fell because
investors sell the stock. However, on Nov 25nd, 2013, one trading day later, JCP´s share price
rose again from USD 8.87 to USD 9.19. This can be explained by the fact that index funds or
ETFs need to sell the stock as it is not listed in the index anymore, which causes the prices to
fall. However, as the value of the company and its performance has not changed, investors
buy the now undervalued stock and as a consequence the stock price stabilizes again. This
can also be observed in Figure 2 below.
Figure 2: JC Penney and S&P 500 Closing Prices in USD

4.000 GSPC JPC 100

3.500 90
80
3.000
70
2.500 60
Announcement of
2.000 stock buy-back 50

1.500 40
Announcement of 30
1.000 exclusion from index
20
500 10
Announcement of
- dividend suspension -

Source: Data from Case Study and Yahoo Finance.

3 Source: Yahoo Finance.