Whenever a stock is in the middle of a short squeeze, you can hop on board for quick gains.

It’s certainly unwise to short such a stock while in this trading phase. But once the dust settles, and shorts have bought back a lot of stock, fresh opportunities may emerge to capture renewed downside.

That appears to be the very straightforward setup for struggling retailer J.C. Penney (NYSE: JCP). Back in February, while shares were halfway through a rebound move from $5 to $9, I suggested you could profit from the short squeeze. 

Three months later, this trading window has now closed. The size of the short position has shrunk from 128.5 million shares back then, to 91 million by the end of April, to 78 million by the middle of May — but don’t look for the short position to fall much further. A fresh view of quarterly results suggests there are ample reasons to suspect that the remaining shorts will stand their ground. Downside exists toward the all-time low of $4.90 a share.

To see why that is, I should first make clear that J.C. Penney is no longer a candidate for bankruptcy, as many had only recently assumed. The company has been able to shore up its balance sheet — led by a recent $2.3 billion in bank funds — to the point where enough cash on hand exists to help management complete its turnaround.

And what I wrote back in February still applies: The company’s back-to-basics merchandising strategies, are likely to fuel moderately positive same-store sales trends. Sales are expected to rise nearly 5% in each of the next two years, thanks in part to the fact sales were so horrid a year ago. 

The trouble for this stock lies in what management will still need to do to address the still-weak balance sheet, and what that means for this stock’s current and eventual valuation.

Investment Catch-Up
Much ink has been spilled about the sorry state of rival Sears Holdings (Nasdaq: SHLD). 

The retailer has been so mismanaged that weak traffic and cash flow led to a cycle of underinvestment in the stores that became quite obvious to consumers, who have been abandoning this retailer in ever larger numbers. Other department store retailers, such as Macy’s (NYSE: M), have done a much better job of staying on top of their store base through ongoing capital spending initiatives.

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	Flickr/JeepersMedia
	J.C. Penney is no longer a candidate for bankruptcy, as many had only recently assumed. The company has been able to shore up its balance sheet to the point where enough cash on hand exists to help management complete its turnaround.

Meanwhile, J.C. Penney has been following the Sears playbook. JCP spent more than $1 billion annually on capital spending a decade ago, which coincides with the retailer’s heyday as a winning investment. That figure slumped to $500 million in fiscal 2011, which led to steadily falling sales as consumers noticed a more stale selling environment, which led to a slumping stock price and a new CEO, Ron Johnson (Apple’s (Nasdaq: AAPL) former senior vice president of retail operations). 

Johnson famously ripped up the business model, boosting capital spending in fiscal 2012 to more than $1 billion to create an Apple-like sales environment. That effort failed miserably.

Current management — which was the former management — is trying to reverse the damage by restoring the previous layouts, but they are doing it on the cheap. Capital spending will be just $250 million this year, according to analysts at Wells Fargo.

The key takeaway: JCP will need to restore capital expenditures to industry norms over the next few years, eating into any cash flow the company may garner. Management suggests that JCP may be able to reach break-even this year on a free cash flow basis, but the higher capital spending in coming years likely represents a return to negative free cash flow in the future. 

And JCP’s inability to generate robust free cash flow means that it will be hard-pressed to make a huge dent in its now-considerable net debt load, which currently stands at around $4.1 billion. Such a burden means that net debt, as a multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA), “is still an eye-popping 14.2  at the end of fiscal 2015,” according to analysts at BMO Capital. Most other department store chains trade for 6 to 8 times 2016 EBITDA on an enterprise value basis, according to these analysts. 

Management now has two choices: endure a very long period of high debt and low capital spending and hope that sales eventually grow high enough to accelerate debt reductions and capital spending hikes. Or they can move much more quickly by simply issuing a lot of new stock to raise cash to both pay down debt and boost capital spending. BMO’s analysts predict a $950 million equity offering is coming in the next 12 months, which would dilute current shareholders by a round 30%. When the market digests such a likely event, these analysts predict shares will fall to just $5, or right near this stock’s all-time low. 

Analysts at Wells Fargo see shares sliding to the $5 to $6 range. “JCP’s high level of debt likely leaves very little value left for equity holders,” they write, adding that the stock’s current valuation implies that JCP will generate $1.1 billion in EBITDA by fiscal 2016. “The last time JCP achieved that level of EBITDA was before they gave up $5.4 billion in sales.” These analysts strongly doubt that J.C. Penney can generate strong enough sales so quickly to make up for all of the lost ground of recent years. 

Risks to Consider: Two clear upside risks exist: A sharp snapback in consumer spending, or a suddenly stronger hand when it comes to merchandising.

Action to Take –> J.C. Penney’s management has done a great job of stabilizing a sinking ship. But this ship still carries too much water, and a dilutive equity raise is the only clear option to help the ship start moving forward. If you’ve captured gains (shares are up 67% since early February) then it’s wise to book profits. And now that many short sellers have covered their positions, it’s a lot safer to short this stock once again.   

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