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Fitch Downgrades JCP: “Default a Real Possibility”

JC Penney has become an industry leader in bad news. After sacrificing considerable credibility insisting they had no intention to raise new capital, they did exactly that. And now Fitch Ratings has downgraded the hobbled retailer, from “B-Minus” to “CCC.”

A spokesman for Fitch said that the downgrade was issued to reflect “higher than expected cash burn in 2013.” Also, they anticipate that JC Penney, despite its recent share  sell-off, will still have to see additional funds next year.

A “CCC” classification, under Fitch’s ratings system, indicates that “default is a real possibility.”

Fitch also said that “the risk for further inventory markdown remains through the holiday season as inventory buys remain aggressive and sales could continue to disappoint.”

According to Fitch, the principal concern is twofold: a much higher than expected cash burn in 2013 and a projected cash shortfall in 2014, pinching JC Penney’s into straitened circumstances. Even with JC Penney adding an additional $3 billion in liquidity this year (and access to $850 million more) it remains a real possibility that the retailer would have to raise even more funds in 2014, especially after what promises to be a punishing holiday shopping season.

As it stands, Fitch forecasts that JC Penney will conclude 2013 with a cash burn of approximately $3 billion, about a billion more than the projections it released in May. JC Penney suffered this year from much weaker than anticipated comp store sales, a listless home department performance, massive markdowns necessary to move piling excess inventory and a significantly contracting gross margin.

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As Fitch interprets it, the central problem is not immediate liquidity, since the recent equity offering generated more than $800 million. They also still have the $2.25 billion loan they secured, with the oversight of Goldman Sachs, last May. The more pressing problem is that, sometime during 2014, JC Penney is compelled to borrow even more, likely sinking its stock, frightening already anxious investors and vendors, and leaving itself so over-leveraged it has to sell off physical assets to raise the money it needs to survive.

According to Fitch’s analysis, for JC Penney to continue to fund its annual $400 to $500 million in expenses, plus interest expenses of $360 to $375 million, it must earn at least $750 million before interest, depreciation, taxes and amortization. This means the retailer would have to perform between 14% and 16% above its own projections for 2014, a return to sales between $13.4 billion and $13.6 billion.

Moody’s and S&P, Fitch’s two closest competitors, currently rate JC Penney at Ba1 and BB+ respectively. While the news of Fitch’s downgrade pushed JC Penney’s stock down 3.12%, the bond market seemed unstirred by the news, watching impassively. This is likely because JC Penney’s longer dated bonds continue to perform well, experiencing very little vacillation over the last year, largely trading between 95 cent and 100 cents on the dollar.