1.What do the liquidity ratiosCurrent, Quick, and Cash-to-Salesreveal about JCP's financial position for the eight quarters spanning Q1 2011 to Q4 2012?

2.What do the leverage ratiosDebt-to-Capital, Interest Coverage, and Cash-to-Debtreveal about JCP's financial position for the eight quarters spanning Q1 2011 to Q4 2012?

3.How has JCP managed its working capital accounts over the past eight quarters? Is there an opportunity to squeeze more cash from any of these accounts? (Asset management category ratios)

4.Assume that JCP will experience a $1.5 billion net income loss for 2013 and that a cash balance of $1.0 billion is required for JCP to operate efficiently. Create a pro forma sources and uses statement to estimate JCP's external funding required by year-end 2013. Be prepared to recommend whether the debt or equity issuance is the better choice as the source for external funding. How will the stock price react to the announcement of a debt offering? An equity issuance?

5.What effect did Bill Ackman have on the company? Were his interests appropriately aligned with those of shareholders? How do you assess the board's decisions regarding CEO appointments? Was Ron Johnson the right choice as the CEO?

Page 453 CASE 36 J. C. Penney Company On Friday, February 8, 2013, J. C. Penney (JCP) CEO Ron Johnson was facing the unenviable task of turning around one of America's oldest and most prominent retailers. The past three years had seen variable financial results for the company (Exhibit 36.1 through Exhibit 36.4) and the cash balance had gradually declined. According to Johnson, "as we execute our ambitious transformation plan, we are pleased with the great strides we made to improve J. C. Penney's cost structure, technology platforms and the overall customer experience. We have accomplished so much in the last twelve months. We believe the bold actions taken in 2012 will materially improve the Company's long-term growth and profitability."1 EXHIBIT 36.1 | Income Statements 2010-2012 (in millions of dollars, except per-share data 2012 2011 2010 Total revenue 12,985 17,260 17.759 Cost of revenue 8,919 11,042 10.799 Gross profit 4,066 6.218 6.960 Selling general and adminis 4,535 5.251 5.358 Non recurring 451 255 Others 543 518 515 Total operating expenses 5.376 6.220 6.128 Operating Income or loss (1,310) (2) 832 Income from continuing operations Total other Income/expenses net Earnings before intorost and taxes (1,310) (2) 823 Interest expense 226 227 231 Income before tax (1.536) (229) 592 Income tax expense (551) 203 Net Income (985) (152 ) 389 es for basic EPS-basic 219.2 217.4 236.4 Weighted average shares-diluted 219.2 217.4 238.0 Basic earnings per share ($4.49) ($0.70 $1.64 Diluted earnings per share $4 49) (SO.70) $1.63likely in 1H13. Despite recent actions geared toward capital preservation, JCP will likely require $1B of capital this year to continue its transformation at the pace initially discussed.?2 EXHIBIT 36.6 | Cash Balances: Q1 2010-Q4 2012 (in millions of dollars) $3,000 $2.622 $2.500 62.378- $2.003 $2,000 $1666 $1767 $1.551 $1507 $1.500 $1,085 $1,000 $830-$838 $500 $525 So L 10 2010 The release of the full-year results proved to be worse than expected: JCP lost $985 million for 2012 and Q4 earnings alone were $1.71-per-share below analyst expectations. When compared to prior Q4 cash balances of $2.6 billion in 2010 and $1.5 billion in 2011, JCP's cash balance of $930 million for 2012 confirmed that the analyst community had good reason for concern. An analysis of the sources and uses of cash for 2012 revealed that JCP's large operating losses were draining the company of cash, and were it not for the reduction of inventories and sales of "other assets," JCP's cash could have fallen critically close to zero (Exhibit 36.7). EXHIBIT 36.7 | Sources and Uses of Cash for 2012 (in millions of dollars)SOURCES of Cash USES of Cash: Not profit/Loss + Comprehensive Income/Loss $894 Depreciation Increase/Decrease in net working capital $838 Increase/Decrease in other assets $422 Capital expenditures $720 Decrease/Increase in other and deferred liabilities $701 Net Issuance Retirement of debt $120 Net issuance Retirement of equity Stock compensation $102 Dividends $47 TOTAL sources/Uses $1,90 $2,48 Beginning cash balance $1.507 + Sources of cash $1.905 - Uses of cash ($2.482) Ending cash balance $930 Source: Case writer estimates. Johnson had a variety of actions he could take to meet the demand for cash flow. First, he could manage cash flow by stretching payables and reducing inventories. Both of these working-capital components were significant cash flow determinants for most large retailers. If the internally generated cash flow proved inadequate, he could turn to JCP's credit facility, which had $1.5 billion of available credit. By design, however, the revolver was a short-term source of funds that the banks could choose to not renew if they perceived that JCP was using the revolver as permanent financing. If JCP had to seek permanent financing, Johnson could access either the debt market or the equity market. The prospect, however, of issuing debt was no more appealing than issuing equity. The debt would likely carry a non- investment-grade credit rating with a coupon rate of approximately 6.0% (Exhibit 36.8). Given that the stock was currently selling at $19.80 per share, a much larger share issuance would be required than if it had occurred just one year earlier, when the stock was selling at $42 per share (Exhibit 36.9). EXHIBIT 36.8 | Credit Rating History and Debt Yields J. C. Penney Long- Term Unsecured Senior DebtMoody's SSP 4/1/2009 Bat 4/16/2009 5/18/2010 4/7/2010 BB + 8/10/2012 7/1 1/2012 Moody's and Standard & Poor's (S&P) were the two largest credit rating agencies. Credit ratings were based on the ssment of the likelihood that the issuer would meet its financial obligation. The rating of a company's long-term unsecured senior debt was a key measure because such debt represented an Important source of financing. The debt rating symbols for Moody's and S&P wore as follows: Moody's S&P Aa AAA Exterely strong capacity to meet financial obligations Very strong capacity to meet financial obligations Strong capacity to meet financial obligations estment Grade Baa capacity to meet financial obligation peculative Grado Substantial crodit risk Caa High credit risk CCC Very high credit risk Ca cc Near default some prospect of recovery of principal and interest Near default little prospect of recovery of principal and interest Default S&P ratings could be modified by the addition of a plus (+) or minus () sign to show relatives major rating categories. Similarly, Moody's used nun ers: 1 represented a plus, 2 was neutral, and 3 represented a minus. For example. Moody's "Baal" was analo ous to SAP's "BBB+." Examples of interest rates as of December 31, 2012, for 10-year corporate bonds were 3.44 for BBB-rated debt. for BB-rated debt and 5.88 Data sources: Bloomberg. Moodys.com, StandardandPoors.com. EXHIBIT 36.9 | Stock Price Performance: January 2011-February 2013 S&P Up 18% JCP Down 34% ..... S&P500 Jan-11 ADe-11 Jut-11 Oct.11 Jan-12 App - 12 Jul - 12 Oct. 12 Jan- 13 Data source: Yahoo! Finance.Data source: All exhibits, unless otherwise specified, include data sourced from J. C. Penney annual reports. EXHIBIT 36.2 | Balance Sheets 2010-2012 (in millions of dollars) 2012 2011 2010 Assets Current assets Cash and cash equivalents 930 1.507 2.622 Inventory 2.341 2.916 3,213 Prepaid and other 412 658 535 Total current assets 3,683 5.081 6,370 Property. plant, and equipment 5.353 5.176 5.231 Other assets 745 1.167 1.467 Total assets 9,781 11,424 13,068 Liabilities Current liabilities Merchandise accounts payable 1.162 1,022 1.133 Other accounts payable 1.380 1.503 1.514 Short-term and current long-term debt 26 231 Total current liabilities 2,568 2.756 2,647 Long-term debt 2.956 2.871 3,099 Other liabilities 698 899 670 Deferred long-term liability charges 38B 888 1,192 Total liabilities 6,610 7.414 7,608 Stockholders' equity Common stock 110 108 118 Retained earnings 380 1.412 2,222 Capital surplus 3.799 3.699 3.925 Other stockholder equity (1.118 (1.209) (805) Total stockholder equity 3,171 4,010 5,460 Total liabilities and stockholders' equity 9,781 1,424 13,068 EXHIBIT 36.3 | Quarterly Income Statements, 2011 and 2012 (in millions of dollars, except per-share data) 04 2012 Q3 2012 02 2012 Q1 2012 04 2011 Q3 2011 02 2011 01 2011 Total revenue 3,884 2,927 3,022 3,152 5,425 3.986 3.906 3,943 Cost of revenue 2.960 1.975 2,018 1,966 3,788 2.497 2.409 2.348 Gross profit 924 952 1,004 1,186 1,637 1.489 1.497 1.595 Operating expenses Selling. general and administrative 1.209 1.087 1.050 1.160 1.343 1.242 1.243 1.281 Depreciation and amortization 157 133 128 125 135 127 128 128 Other 303 (112) 127 232 291 45 25 Total operating expenses 1.669 1.108 1,187 1,412 1,710 1.660 1.416 1.434 Operating Income (745 (156) (183) (226) (73) (171) 81 161 Interest expense 57 55 58 56 57 55 57 Income before tax (302) (211) (241) (282) (130) (226) 24 103 Income tax expense (250) (88) 194) (119) (43) (83) 10 Not income (552) (123) (147) (163) (87) (143) 14 Wi. avg shares for basic EPS-basic 219.5 219.4 219.3 218.3 217.4 213.3 216 229.2 Weighted average shares-diluted 219.5 2194 219.3 2183 217.4 213.3 216 231.7 Basic earnings per share $2.51) ($0.56) $0.67) ($0.75) (30.40 ($0.67 30,06 $0.28 Diluted earnings per share $2.51) ($0.56) $0.67) ($0.75 ($0.40 ($0.67) $0.06 50.28EXHIBIT 36.4 | Quarterly Balance Sheets 2011-2012 (in millions of dollars) Q4 2012 03 2012 02 2012 2 01 2012 04 2011 03 2011 02 2011 01 2011 arrant assots Cash and cash equivalents Other current assets Total Current Assets Property, plant. 5.353 Other as 745 Total assets 9.781 Liabilities Current labilities Merchandise accounts payable Other accounts payable Short term and current long-term debt Long-term debt forred long-term lability charges Total Babilities Stockholders' equity Common stock Other stockholder equry (1.118) Total stockholder equity Despite Johnson's plans, there were rumors among Wall Street analysts that the company was facing significant liquidity issues and perhaps the possibility of bankruptcy. Sales and profits were continuing to decline and the dividend had been eliminated. Just two days earlier, a Wall Street equity analyst had recommended investors sell their JCP stock by stating, "Cash flow is weak and could become critical. At current burn rates-and absent any further asset sales-we estimate that J. C. Penney will be virtually out of cash by fiscal year-end 2013."- On top of that, JCP was dealing with allegations that the company was defaulting on its 7.4% debentures, which were due in 2037. Although JCP management had responded that the default allegations were invalid, the rumors of the company's liquidity problems continued to circulate and analysts wanted assurance that JCP had a financing plan in place in the event that an injection of cash became critical to the company's survival. Page 454History of J. C. Penney In 1902, an ambitious 26-year-old man named James Cash Penney used his $500 savings account to open "The Golden Rule Store" in a one-room wooden building in Kemmerer, Wyoming. The store appealed to mining and farming families and was well known for its assortment of merchandise and exceptional customer service. By 1914, Penney had changed the company name to J. C. Penney and relocated headquarters to New York City. Penney was using private-label brands as a means to ensure a distinct level in quality, and the ability to control pricing and margins, which was not often the case when handling brand names. By 1929, JCP had expanded to more than 1,000 stores and the company was listed on the New York Stock Exchange. The week after the company went public, however, the stock market crashed and the Great Depression began. Despite its dubious beginnings as a public company, JCP was able to prosper during the ensuing years by managing inventory levels and passing low prices on to consumers. By 1951, the company achieved the unprecedented sales level of $1 billion due partly to having eliminated the company's cash-only policy and introducing its first credit card. By 1968, sales exceeded $3 billion and the company had begun to see increased competition from small specialty stores that carried a specific range of merchandise. Nonetheless, with the help of its $1 billion catalog service and the launch of a women's fashion program, sales reached $11 billion by 1978. In an effort to stay current with continued shifts in consumer trends and to solidify its identity, JCP launched a restructuring initiative in the early 1980s with the objective of transforming the company from a mass merchant to a national department store. JCP spent $1 billion to remodel its stores and announced in 1983 that it would begin to phase out its auto-service, appliance, hardware, and fabrics merchandising in favor of emphasizingapparel, home furnishings, and leisure lines. Despite these changes, JCP continued to face challenges of being perceived as being a middle-ground retailer; consumers were favoring either luxury merchants or discounters. As part of the effort to revamp JCP's image, the company named a new CEO, Allen Questrom, in 2000. Questrom was known as a "retailing turnaround artist," and had made his name leading famous department stores-including Federated Department Stores, Macy's, and Barneys-out of bankruptcy.3 Questrom competed a second round of restructuring that included store closings, layoffs, a conversion to a centralized merchandising system, and large divestitures of noncore units (insurance and Eckerd Drug). The results for 2004 were promising: the company reported $584 million in net profits. Having succeeded in his turnaround efforts, Questrom stepped down and was replaced by Mike Ullman. Considered a branding expert, Ullman ushered in a new era of higher-end fashion as JCP signed large exclusive deals with big brands such as Liz Claiborne and makeup retailer Sephora. Ullman successfully grew online sales and, in 2007, instituted an aggressive expansion plan for new store openings and to expand the net Page 455 income margin to 15%. Despite these efforts, the credit crisis and economic downturn of 2008 to 2011 provided an extra set of challenges as growing consumer frugality allowed "off-price" competitors such as Kohl's to further erode JCP's sales and margins. Bill Ackman Takes a Stake After each of the first two quarters of 2010, Ullman lowered sales and earnings guidance. After a disappointing Q2 earnings report, JCP's stock price dropped to a low for the year of $19.82 per share. In the days following, activist investor Bill Ackman, founder of Pershing Square Management, began buying JCP shares. Ackman was well known for his activism tacticswith companies such as Wendy's, Target, and Barnes & Noble, wherein he had successfully pressured management into making decisions that he believed benefited shareholder interests. For example, in 2006, Ackman managed to convince Wendy's management to sell its subsidiary Tim Hortons doughnut chain through an IPO." In 2012, Ackman persuaded Burger King's private equity owners to postpone a planned IPO in order to begin merger negotiations with a publicly traded shell company. By early October 2010, Ackman's position in JCP was close to 40 million shares, which represented a 16.8% stake in the company and was worth approximately $900 million.- By February 2011, when asked about his investment in JCP, Ackman responded that it had "the most potential of any company in his portfolio." Furthermore, he believed that the stock was being valued cheaply at only five times EBITDA and that the company's 110 million square feet of property was "some of the best real estate in the world." Ackman also disclosed that he was interested in changing the operations of the company and that he would be joining the board of directors. Later in February, when JCP released its results for 2010, it appeared that Ackman had once again picked a winner. Not only had earnings beaten expectations, but based on the company's strong Page 456 cash position of $2.6 billion, Ullman announced that JCP would commence a $900 million buyback program: Our performance in 2010 reflects the strides we have made to deliver on our operating goals and position J. C. Penney as a retail industry leader. This was particularly evident in the fourth quarter when the actions we took during the year -including new growth initiatives and improvements across our merchandise assortments, redefining the jep.com experience and driving efficiencies across our company-enabled us to achieve sales, market share and profitability growth that surpassed our expectations, and to establish a share buyback plan which will return value to our shareholders.Management Changes Despite Ullman's successful 2010 and Q1 2011 results, he announced he would be stepping down as CEO. Although Ullman retained his position as executive chairman, Ron Johnson of Apple Inc.'s retail stores was hired as the new CEO. Johnson's success at Apple had been well documented. The New York Times described him as the man at Apple who had "turned the boring computer sales floor into a sleek playroom filled with gadgets."12 In an interview following the announcement, Johnson stated, "My lifetime dream has been to lead one of the large great retailers, to reimagine what it could be. In the U.S., the department store has a chance to regain its status as the leader in style, the leader in excitement. It will be a period of true innovation for this company." Ackman conveyed confidence in the management change by saying, "Ron Johnson is the Steve Jobs of the retail industry."13 JCP investors echoed Ackman's optimism as the stock rallied 17% upon the announcement of Johnson's appointment. JCP's board had created a compensation package to incentivize Johnson's performance that included a base salary of $375,000 and a performance-based bonus of $236,000. The board also awarded Johnson $50 million of restricted stock to offset the Apple stock options Johnson had forfeited when he accepted the JCP position. Through the rest of 2011, Johnson continued to make headlines by recruiting high-profile executives for his management team. The most noteworthy was the CMO, Michael Francis, who had held the same position at Target. Francis received a base salary of $1.2 million and $12 million as a 'sign-on cash bonus."15 In addition to Francis, Johnson hired Daniel Walker as his chief talent officer for $8 million and Michael Kramer as COO for $4 million in cash and $29 million in restricted stock. Results for Q3 2011 were disappointing: sales declined 4.8% Page 457compared to Q3 2010 and earnings fell to a $143 million loss. 16 As JCP entered 2012 in a tenuous financial position, Johnson responded by announcing a "fair-and-square" pricing strategy that eliminated all promotions in favor of "everyday, regular prices."17 Having run 590 separate promotions in 2011, Johnson argued, "We want customers to shop on their terms, not ours. By setting our store monthly and maintaining our best prices for an entire month, we feel confident that customers will love shopping when it is convenient for them, rather than when it is expedient for us."18 The new pricing strategy was met with skepticism. Pricing consultant Rafi Mohammed wrote in the Harvard Business Review that "J. C. Penney lacks the differentiation to make this pricing strategy successful. J. C. Penney's products are fairly homogenous. When selling a relatively undifferentiated product, the only lever to generate higher sales is discounts. Even worse, if competitors drop prices on comparable products, J. C. Penney's hands are tied-it is a sitting duck that can't respond."19 By Q1 2012, JCP's financial condition was showing signs of rapid deterioration as sales dropped 20% relative to Q1 2011 and losses hit 75 cents per share.Johnson announced a 10% reduction of the work force and that the dividend that had been paid since 1987 would be discontinued. The dividend cut was a clear signal to Wall Street that the company was experiencing significant liquidity concerns. As retail equities analyst Brian Sozzi observed, "The dividend cut makes you lose shareholder support. And it also makes you wonder, [does JCP] have the balance sheet to fund this massive transformation of the business over the next two to three years?"21 In June 2012, with sales declining and the share price sliding toward $20 a share, Johnson's key hire, CMO Francis, resigned. After only nine months at the company, Francis left with a $12 million bonus in his pocket. Liquidity IssuesAt the end of Q2 2012, JCP's capital structure was relatively strong. With $3.1 billion in debt and a market capitalization of $6.5 billion, JCP had a debt-to-capital ratio of 33%, only slightly higher than the average of 30% for its competitors (Exhibit 36.5). The company's debt included Page 458 secured and unsecured bonds and a short-term credit facility (revolver) that was secured by JCP's credit card receivables, accounts receivable, and inventory. JPC had traditionally made limited use of the revolver and had not drawn upon it during 2012. As was true for most short- term credit facilities, JCP's was designed primarily to finance seasonal inventories and receivables around the holiday season. The credit limit of the revolver was $1.5 billion. EXHIBIT 36.5 | Capital Structure of J. C. Penney and Competitors (in millions of dollars as of June 30, 2012) 14,000 12.000 33% $10,744 10.000 8.000 6,000 4,000 - $3. 2,000 Jog Macy's Debt Debt includes all short-term and long-term interest-bearing debt. Operating leases are included in debt as six times the reported rental expense for the year. Equity is computed on a mar outstanding) By Q3 2012, the company's diminishing cash balance had become evident (Exhibit 36.6)-it had only $525 million in cash. Analysts began to question the company's long-term stability. For example, prior to the company's 2012 annual earnings announcement, JPMorgan Chase & Co. equity analysts wrote: We increasingly question JCP's ability to self-fund its transformation on [ free cash flow] generation alone. We view a draw on the revolver as increasingly