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J.C. Penney: The Death Spiral Scenario


The connection between Bill Ackman's demand that J.C. Penney (JCP) switch leadership and why it increases the chances of the retailer going out of business comes down to credit risk. The cause and effect are somewhat arcane but the threat is very real. It comes down to fundamentals of the retail business.

In short, most retailers keep a constant line of credit. They borrow money to buy inventory and use the proceeds from selling that inventory to pay off the debt. Lather, rinse, repeat.

Related: J.C. Penney: Why Ackman's Tantrum Will Kill the Company

CIT Group (CIT) is JCP's lender. They pay vendors and charge interest while waiting for JCP to sell the goods and pay off the debt. If the rumors are true (and JCP insists they are not), CIT is refusing to pay higher risk vendors on behalf of J.C. Penney. In other words, CIT doesn't have enough confidence in JCP's ability to move merchandise and make good on the debt.

Firing a CEO during the Christmas buying and shipping period is the type of thing apt to make CIT reluctant to do business with JCP. If there's any truth to the rumors, what Ackman is demanding would be enough to push CIT over the edge.

Related: Without Credit, J.C. Penney Can't Be Saved

JC Penney offers two reasons why CIT refusing to pay a vendor wouldn't be a problem, even if it were true.

1. CIT only provides funding for 4% of their inventory

2. JCP has $1.5 billion in cash on the balance sheet

Both of these arguments are silly even in the context of this willfully oversimplified example.

First, if CIT starts yanking credit for 4% of the vendors, every other vendor's risk grows. No one wants to ship goods or provide funding to a retailer actively losing other vendors.

Second, the balance sheet cash was supposed to be closer to $1.9 billion at the end of the quarter. JCP is burning cash faster than expected and it can't sell anything if they don't pay employees. Half of JCP's stores are stuck in the middle of Ron Johnson's turnaround construction. No one really takes the $1.5 billion seriously.

The End Game

Retailers don't run into "little liquidity problems." Every liquidity problem is a mortal wound for a struggling company.

JCP's condition is such that they can't afford even a hiccup in their credit line. If the company is forced to start paying for inventory upfront they will need to increase turns dramatically (i.e. they'll have to sell inventory faster and use the cash to buy more goods and pay debt).

The markdown cycle of pricing new goods at full price and slowly reducing shifting goods to the discount bin will be gone. JCP will need to price everything to move the second it gets in the door because they need the cash NOW in order to buy inventory for the next quarter, pay employees and pay the whatever funding they somehow get. The rates they'll be charged will be roughly the vig rate you'd get from a thug bookie.

If JCP loses CIT for goods delivered after August, it'll be in a perpetual state of "Everything Must Go" promotions. Margins will fall straight to hell immediately. No customer in their right mind will pay full price because they'll know markdowns are perpetually imminent.

This cycle is why leverage and retail make such horrible bed fellows. Levered up merchants can't afford even a single bad quarter. It's an immutable fact of retail nature.

It'll be game over for JCP if they lose financing.

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