Go Private or Go Bankrupt

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After only 17 months on the job, J.C. Penney (NYSE: JCP) CEO Ron Johnson was ousted, with the previous CEO taking his place. This comes after a turnaround effort focused on a store-within-a-store concept and everyday low prices has failed miserably, with JCP posting a $552 million loss in the fourth quarter of 2012. With the company quickly blowing through its remaining cash, is bankruptcy becoming an inevitable reality?

A precarious position

People make all sorts of claims about different companies going bankrupt, but most of them can be easily refuted by glancing at a few numbers. J.C. Penney, however, is truly in a terrible spot. At the end of 2012 the company had just $930 million in cash remaining, down from $3 billion at the end of 2009. The free cash flow in 2013 was -$830 million, and if this doesn't improve the cash balance will be almost completely depleted by the end of 2013. The company's $3 billion in debt, on which it pays $226 million in interest annually, isn't helping the situation either.

There was much hope that Ron Johnson's strategy would work, and the stock rocketed to over $40 per share at the beginning of 2011. It now trades at about $14 per share as Ron Johnson exits and it becomes painfully clear that J.C. Penney is on its last legs.

How likely is it that J.C. Penney goes bankrupt? One useful metric to look at is the Altman z-score. This number, developed by Edward Altman in 1968, has a fairly high level of accuracy in predicting whether or not a company will go bankrupt within two years. The z-score is made up of five different components:

<img alt="" src="http://g.fool.com/editorial/images/31596/altman_large.png" />

Combining these components according to the following equation yields the z-score:

<img alt="" src="http://g.fool.com/editorial/images/31596/altman-2_large.png" />

When the z-score is above 2.99 the company is considered safe. Between 1.81 and 2.99 is the so-called "grey zone," where the company is not in immediate danger of bankruptcy but could be heading that way. And a z-score of below 1.81 means that the company is likely to go bankrupt within the next two years.

I'll calculate the z-score for the last 5 years so that any trends become apparent. I'll also compare the results for J.C. Penney to two other members of the troubled retailer gang, Sears Holdings (NASDAQ: SHLD) and Best Buy (NYSE: BBY). Here's the z-score calculation for J.C. Penney.

J.C. Penney

<img alt="" src="http://g.fool.com/editorial/images/31596/jcp-altman_1_large.png" />

From 2008 to 2011 J.C. Penney was squarely in the "grey zone." But after a disastrous 2012 the z-score plummeted to just 1.48, which means that J.C. Penney has a significant chance of going bankrupt in the next two years.

The results for Sears tells a slightly rosier story:

Sears Holdings

<img alt="" src="http://g.fool.com/editorial/images/31596/shld-altman_large.png" />

Sears saw its EBIT turn negative in 2011, resulting in a large decline in the z-score. However, the 2011 z-score of 2.05 is still in the "grey zone," and in 2012 Sears reduced its losses and increased the z-score by about 10%. Sears and J.C. Penney are similar, in that both large retail stores which have a long history and are currently struggling for relevance. But it appears that Sears is in a better financial position than Penney, albeit still not a great one. The company is losing money, and if the loses continue in 2013 and beyond the z-score will drop and Sears will be at real risk of bankruptcy.

Although there was much talk last year of a possible bankruptcy, Best Buy is in by far the best financial position of the three companies, as is evidenced by its z-score:

Best Buy

<img alt="" src="http://g.fool.com/editorial/images/31596/bby-altman_1_large.png" />

Best Buy's z-score has always been in the "safe zone," and although it has dropped in 2011 and 2012 this is largely due to large goodwill write-offs and restructuring charges which lowered the EBIT. All of the talk of a possible bankruptcy last year was clearly presumptuous.

The problem with J.C. Penney

There's nothing special about J.C. Penney. The company sells the same products found in countless other stores and does it with higher costs. The store-within-a-store concept doesn't make much sense for a clothing store. What does separating different brands into sections do for the consumer? Apparently nothing, given the company's financial results. There's just no reason for someone to shop at J.C. Penney when they could go to Kohl's for low prices and Macy's or Nordstrom for a proper department store. Not to mention the stores owned by The Gap.

If J.C. Penney disappeared off the face of earth would anyone care? Would anyone even notice? What does J.C. Penney offer that other stores don't? The answer is nothing.

I visited a J.C. Penney store a while back after the store-within-a-store concept had been implemented, and what I found was a barren wasteland. The dressing rooms were a mess, with clothing thrown on the floor, and the funhouse mirror meant to make people look thinner was not exactly subtle. Obviously, this one experience may not be indicative of the entire company, but I lost all faith in J.C. Penney's turnaround efforts on that day.

Why Best Buy is different

Recently Best Buy announced a partnership with Samsung that will introduce Samsung "stores" within 1,400 Best Buy locations. At first this seems like the same failed strategy adopted by J.C. Penney, but it's actually very different. Clothing is simple and understandable, so having separate areas for different brands doesn't offer much to the consumer or the brand itself. But smart phones and tablets and other tech products are very different. Many people walk into a Best Buy knowing nothing about smart phones and having no idea what they want to buy. Having Samsung representatives there to explain the benefits of its products offers value to both the consumer and Samsung itself, and Best Buy makes a pretty penny for facilitating the whole thing. This also allows Samsung to avoid having to build actual retail stores, saving the company untold sums of money.

It's clear that this strategy makes no sense for a company like J.C. Penney. Does having someone explaining the benefits of Levi's, for example, offer anything to consumer? It really doesn't. Pants are pants--they either fit or they don't. They are either comfortable or they're not.

The bottom line

J.C. Penney has one year left. If the company loses the same amount of money in 2013 as it lost in 2012 then its cash will be almost completely depleted and bankruptcy will be all but inevitable. And given the departure of Ron Johnson and no coherent strategy going forward I don't see the situation improving. The only saving grace would be for the company to go private, but who would want to buy a failing discount department store? The price would have to be rock-bottom, well below the stock price today, for this to be a reasonable option. So it makes little sense to speculate on J.C. Penney, and even less sense to invest in it. I think that the most likely outcome will be a J.C. Penney bankruptcy within a few years. And no one will even notice.

Timothy Green owns shares of Best Buy. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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