After a Massive Short Squeeze, Is This Stock Headed Even Higher?

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After the market closed for trading on Wednesday, Feb. 26, short sellers quickly scanned the latest short interest data (which had just been released for the two weeks ended Feb. 15). These shorts know that if a company they are targeting is also being targeted by many others as well, they can get badly burned in a short squeeze ensues.

#-ad_banner-#The fact that the short interest in struggling retailer J.C. Penney (NYSE: JCP ) had just spiked another 10 million shares in just two weeks (to 128.5 million shares, representing 43% of the trading float) was a cause for concern.

The morning after the fresh short interest data came out, shares were squeezed a stunning 25% higher. Management's prediction that J.C. Penney would not run out of money any time soon was not wanted short sellers were hoping to hear.

At this point, both the shorts -- as well as the company's bulls -- are wondering: What's next for this stock? Let's take a closer look at each argument.

Going Terminal?

Short sellers love to target stocks that they believe will eventually fall to zero, known as a "terminal short." And at first glance, J.C. Penney sure looks like a worthy candidate.

The retailer bled $900 million in free cash flow in fiscal 2013 and a whopping $2.7 billion in fiscal 2014. When the ink is dry for the fiscal year that ended in January, a few more billion in free cash flow will have vanished.

Just to keep the doors open, J.C. Penney has had to borrow so much that total debt has ballooned to more than $5.5 billion. It would take many years of positive free cash flow to make a sizable dent in that debt load. With most of its assets already pledged as collateral to lenders, J.C. Penney's ability to further tap debt markets is limited. Which in a nutshell is why short sellers think that J.C. Penney will run out of cash before cash flow turns positive.

Rapid Fixes

J.C. Penney's Mike Ullman (who had a prior track record of success before leaving the company a few years ago), deserves a huge amount of credit for stabilizing operations. He's pared overhead to the bone while restoring the retailer's former approaches to merchandising and pricing.

No one would argue that J.C. Penney's stores are any more appealing than peers. Then again, a typical J.C. Penney store is no less appealing than stores operated by Macy's (NYSE: M ) , Kohl's (NYSE: KSS ) and others. The unfortunate reality in retail is that all of the major operators lack differentiation.

Flickr/JeepersMediaJust to keep the doors open, J.C. Penney has had to borrow so much that total debt has ballooned to more than .5 billion.

The fortunate part: It remains a very profitable industry, even as consumer spending remains sluggish. Macy's and Kohl's, for example, each generated roughly $1 billion in free cash flow in fiscal 2014.

Not only did J.C. Penney manage to stabilize operations during a very difficult season for retailers (with same store sales actually rising 2%), but the stage is now set for even better year-over-year comparisons in coming quarters.

Back in early January, Piper Jaffray's Neely Tamminga bucked the tide by boosting her rating from "neutral" to "overweight," believing that JCP's dismal results last spring were the result of a perfect storm of bad merchandising, negative corporate publicity, and dampened consumer spending due to the resumption of a higher payroll tax.

Those headwinds should be tailwinds this spring, Tamminga predicts: "This year, with an improved home assortment (merchandised by classification, not brand), a redesigned floor better allocating supply and demand of core JCP brands, and continued improvement in product markups from the prior administration's failed (everyday low prices) strategy, we like JCP's prospects of continued positive comps and margin gains in 2014."

J.C. Penney's Ullman confirms the view that same store sales will rebound in the coming year. It's not a bold prediction: Sales were so bad last year, as Tamminga noted, that even lackluster sales will look great by comparison.

Back in January, Tamminga predicted shares would rebound to $11, though to be sure, they fell further in the past seven weeks before the recent sharp rebound. Still, shares have 45% upside to her price target.

To be sure, it will be several years before J.C. Penney has a shot at looking like a normal retailer. Rivals such as Kohl's and Macy's typically sport gross margins above 35%. J.C. Penney's gross margins remain below 30%, even after a recent rebound. At current margins, the balance sheet is no longer hemorrhaging cash, but nor is it building cash either.

Here's why bullish investors suddenly have a much stronger case than bearish investors: Assuming a very modest rise in same-store sales again in fiscal 2016 (which starts next February), J.C. Penney is expected to start generating positive free cash flow again, which means it will be able to refinance its debt load and eventually whittle down that debt. Even dubious analysts, such as Merrill's Hutchinson, which rates shares as "neutral," predict that free cash flow could exceed $600 million by fiscal 2017. The company's current market value stands at around $2.3 billion, implying a free cash flow yield in excess of 25% for investors that have the patience to watch this turnaround unfold.

Risks to Consider: Even with the sharp drop in overhead expenses and the rebound in gross margins, J.C. Penney is still on track to lose nearly $3 a share this year, according to Merrill Lynch's Lorraine Hutchinson. She also anticipates negative $350 million in free cash flow this year.

Action to Take --> Even with the sudden bounceback for this stock, it still likely remains heavily shorted. Most short sellers are likely unconvinced that J.C. Penney will be able to survive, but if the company can deliver decent same store sales results this spring, as appears increasingly likely, then short sellers may lose heart. Simply covering their positions, which still likely represents more than 355 of the trading float, will create a powerful buying stimulus.

If you missed out on the stunning share price gain in recent days, you still have time to hop on, as further upside, perhaps beyond the $10 or $11 mark, still appears quite feasible.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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