J C Penney (JCP) issues stock

the JCP offering

JCP filed a preliminary prospectus with the SEC indicating it is selling 84 million shares of common stock to the public at $9.52 a share through Goldman Sachs.  (In a typical provision of any offering called the “overallotment,” Goldman has permission to sell another 12.8 million shares if it can.)

Let’s say Goldman gets a commission of $.22 a share.  That would mean proceeds to JCP of $781 million – $900 million.

business stabilizing

Just in advance of the red herring, JCP filed an 8-K in which it said it expected comparable store sales to be positive during both 3Q13 and 4Q13.  The reason?  …merchandise that JCP customers want to buy is now in stock, and in the sizes that JCP customers fit.

three aspects of the offering

I hadn’t intended to write so much about JCP, but I think there are three interesting aspects to the offering.

1.  the size

This is a big offering, amounting to over a third of the shares already outstanding.

2.  why a stock offering?

For companies like JCP that want to raise a lot of capital, their first thought is to borrow.  It’s easier to do.  Transaction costs are lower.  Also, Americans firmly believe that debt is a lower-cost form of capital than debt, so borrowing is more beneficial for shareholders.

There comes a point, however, when lenders perceive the capital structure of a firm has become too lopsided.  When that happens, they will refuse to lend any more until the firm demonstrates Wall Street’s confidence in it by raising equity capital.

I assume we’re at that point for JCP.

why not six weeks ago?

After all, the sales projections JCP made in the 8-K are better, I think, than Wall Street had been assuming.  So it’s unlikely that JCP’s need for cash is greater now than it was a few weeks ago.

It’s also hard to think that a big company like JCP would not do continuous financial forecasting of its future cash flows that would indicate when it would need fresh funds, and in what amounts.

I don’t know the answer.

One obvious difference between now and the end of August, however, is that in the meantime two insiders, Pershing Square and Vornado, have unloaded their entire stakes, 52 million shares (!!), at a reported price of about $13 each.  That’s 36% higher than JCP itself is getting today.

I guess you might argue that everyone knew the two activists would be selling, and that this overhang would be enough to scupper a potential offering by JCP.  Seems pretty lame, though.

Me, I’m nonplussed (the first time I’ve used that word in my life).  If I were a JCP shareholder, I’d be stunned.  Maybe we just chalk this up as one of the perils of riding the coattails of latter-day robber barons.  But if I were a shareholder, I’d want to know how the board allowed this to happen.

On September 20th, JCP’s controller left the company.  Is this connected?

two lessons for analysts from JCP

JCP  in the press again over the past two days.

I’ve only seen the headlines, which assert that:

–JCP is trying to sever the 10-year $200 million agreement the previous CEO, Ron Johnson arranged with Martha Stewart.  Why?   …the MS merchandise isn’t selling

–JCP is looking to raise new funds

–a Goldman analyst has used the “B” word (bankruptcy) in warning clients to avoid JCP stock.

I want to make two relatively narrow points:

1.  Analysts are extremely reluctant to speculate on a possible corporate bankruptcy in writing.  They may mention the possibility on the phone or in meetings, but not in print.

A boss of mine years ago at Value Line did this once.  He wrote about a small-cap magazine company that if weak advertising trends continued for the following twelve months, there was a risk the firm would have to close its doors.  Advertising dried up almost immediately on publication of the report.  The company was out of business in three months.

Raising the prospect of bankruptcy is like shouting “Fire!!” in a crowded theater.  It has consequences.

Also, if the firm survives it will never forgive the analyst who made the call.  The Goldman analyst who wrote the report must either be very young or extremely confident that the prediction won’t come back to haunt him/her.

 

2.  In graduate school I spent a year at the university in Tübingen in southwest Germany.  For a while I lived with a family where we all went mushroom hunting on weekends.  What we found made up at least one or two meals the following week.  That’s where I learned about the deaths head mushroom.  Eating it is most often fatal; symptoms only emerge after it’s too late to get treatment.

The obvious course of action–learn what the deaths head looks like, and don’t eat it.

There’s an analogy here.

In the case of JCP, the symptoms we’re seeing now are the direct result of corporate decisions made two or more years ago by ex-CEO Ron Johnson and defended for a long time by Bill Ackman.  Oddly, both seem to have been thinking–contrary to all experience–that falling sales could be remedied by applying a double does of what was causing them.  What’s equally surprising is the the JCP board let the situation go unaddressed until it had reached crisis proportions.

 

My second point:  many times corporate strategies, once put in motion, are difficult or impossible to reverse.  So we, as investors, have to be constantly scanning the horizon for indications of possible weakness. Normally, the early signs of deterioration are found on the balance sheet (rising receivables and inventories) and the cash flow statement.

For JCP, though, there was nothing subtle about its difficulties.  Sales fell apart almost as soon as Ron Johnson took the controls.  Another reason it”s so hard to understand why the board let the situation get so out of control.

 

Bill Ackman, J C Penney (JCP)’s largest shareholder, is leaving the board. What does this mean?

the JCP board and its CEO search

Bill Ackman is the activist investor who initially targeted (no pun intended) JCP as a serial laggard that could be made to perform better.  Recently, he has argued with the rest of that company’s board–at first in private–about the pace of JCP’s search for a new CEO.  Ackman believes the search could/should be done in two months.  The rest of the board seems to be thinking in terms of nine.

Last week he made public a letter he wrote to the board, which he concluded with, “We can’t afford to wait.”

This week, after being criticized by many, he resigned from the JCP board.

Certainly. the spat between the board and its largest shareholder won’t speed the flow of CEO candidates knocking on JCP’s door.  On the other hand, it won’t deter very many, either, in my view.  What it does do is raise the price the new CEO can command.

The media have portrayed Mr. Ackman as a shallow, petulant Ivy-Leaguer having a mini-tantrum because he isn’t getting his way.  Entertaining and gossipy as that may sound, the media assessment is probably not right.  In fact, Mr. Ackman may prefer that people view the affair this way, because is suggests that everything else, save Mr. Ackman’s personality, is all right.

It isn’t.

what’s really going on

Two possibilities, one based on back-of-the envelope calculations, the other pure conjecture.  Both are based on the idea that the fact of the board disagreement has information in it–and that it’s not gossip column fare.

1.  a castle in the air

Let’s say the properties JCP controls are worth $5 billion.  That’s halfway between brokerage house estimates (which may ultimately come from Mr. Ackman) and the recently announced, but incomplete, Cushman and Wakefield assessment of $4.06 billion.

If we think the rental yield on these assets should be 7%, then the annual rental income from them should be $350 million.  That’s the amount a third-party would pay to do business on those properties.

How much does JCP pay?  I don’t know.  Certainly it’s substantially less than $350 million.  Let’s say JCP actually pays $50 million. This means that in a sense JCP real estate subsidizes the department store operations by the difference between what it could get by renting the properties to someone else vs. operating JCP stores on them.  According to what I’ve written so far, that subsidy is $300 million.  After income tax, that amounts to about $200 million.

Why is this important?

In 2010, the last year before Mr. Ackman brought in Ron Johnson to run the company, JCP made $378 million in net income.  If my numbers are anywhere near correct, over half JCP’s profits came from owning real estate.  In 2011, selling stuff lost money.

Strip away real estate gains over a long period and JCP’s retailing profits look very highly cyclical.  That makes sense, because JCP’s traditional market has been less affluent consumers, whose incomes are the most cyclical.  The company may suffer a lot during recession but makes up for that by making a relative killing as recovery gets into year three or four.

In other words, JCP should be cleaning up now.  Instead, it’s piling up enormous losses.  This spells potential trouble as/when the economic cycle turns down, and–if past form runs true–profits evaporate.

Maybe this is the source of Mr. Ackman’s sense of urgency.

2.  pure speculation

Maybe Mr. Ackman’s chief worry isn’t his projected timeline for JCP’s profits but the structure of the fund he put together to invest in the company.  He’s told reporters that his cost basis in JCP stock is $25.  But he may have financial leverage or options or other derivative instruments that make the risk/reward clock tick faster for his fund than for JCP itself.

Whatever the cause of Mr. Ackman’s behavior over the past few weeks, it’s almost certainly not simply pique.

lessons from J C Penney (JCP)

preliminary 1Q13 results

In conjunction with arranging a five-year $1.75 billion loan through Goldman, JCP has filed an 8-k in which it gives preliminary information about the April 2013 quarter.

–Sales were $2.635 billion, down 16.4% year-on-year (comp store sales = -16.6%).  Looking at a two-year comparison, sales are down by 33.2% from (the pre-Ron Johnson) 1Q11.

–Cash on hand at the end of 4Q12 was $930 million.  During 1Q13, JCP borrowed an additional $850 million, by drawing half its beefed-up bank credit line.  As of May 4th, the company had cash of $821 million.  In other words, JCP has blown through the entire $850 million, plus another $109 million in three months.

lessons

1.  When things go wrong, they often have a runaway train character.  Ron Johnson joined JCP in late 2011.  Almost immediately, sales went into a tailspin.  By mid-2012 it was clear that something was desperately wrong and needed to be fixed.

But no one acts right away.  There’s always the temptation to wait just a little while longer in hopes the tide will change.

In addition, a company’s plans may be set in stone months in advance.  There are advertising campaigns, construction plans, and billions of dollars of (the wrong) merchandise in the stores–with more of the same on order.

In this case, nine months after starting to back away from the Johnson strategy, JCP is still losing cash at the rate of over $250 million a month.

2.  Cash tells the story, in a trouble company.  That’s cash flow, cash on hand and cash the company can borrow.

In the JCP case:

–cash flow is -$250 a month,

–cash on hand is $821 million, and

–borrowing power is $2.6 billion (the $1.75 billion loan arranged by Goldman plus the remaining $850 million in JCP’s bank credit line).

Assuming its banks don’t get cold feet and withdraw the credit line, JCP has total cash available of $3.4 billion.  That’s enough to sustain a cash drain at the 1Q13 rate for another 13 months.

3.  Riding coattails is a risky business.  The Financial Times website posted an article last evening titled “Tips from Wall Street gurus fail to reward faithful.”  In it, the FT looks at the performance of the hedge fund “best ideas” presented at last year’s Ira Sohn conference in New York.  In the aggregate, the tips underperformed the S&P 500.  Some, like JCP, were unbelievable clunkers.

Two factors:

–even the best equity managers are wrong 40% of the time, and

–some managers become celebrities mostly through their own aggressive marketing efforts rather than by having stellar performance.  Or they parlay a one- or two-year hot streak into an entire career.  Caveat emptor.

J C Penney (JCP) just borrowed $850 million…why?

the 8-k

Yesterday, JCP announced in an 8-K filed with the SEC that it has borrowed $850 million on its newly expanded $1.8 billion bank credit line   …even though it doesn’t really need the money right now.  It also said it’s looking for other sources of new finance, which I interpret as meaning finding someone to purchase new bonds or stock.

My guess is that as the company needs seasonal working capital finance it will borrow more on the credit line rather than deplete its cash balances, which should now amount to around $1.8 billion.  This despite the fact that paying the current 5.25% interest rate on the $850 million will cost the company $44.6 million a year.

Why do this?

We know that the Ackman/Johnson regime inflicted terrible damage on JCP.  Part of this is actual–the stuff about lost sales and profits that we can read in the company’s financial statements.  Part of it is psychological–we don’t know how deeply JCP is wounded, how long it will take for the company to heal, nor even how much healing is possible.

a psychological plus

By borrowing the money now, JCP is in a sense buying itself an insurance policy on the psychological/confidence front by establishing several things:

— it now has enough cash to be able to weather two more ugly years like 2012, rather than one.  This gives it much more breathing room to negotiate any asset disposals, to say nothing of getting customers back into the stores.

–it has lessened the possibility that its banks will withdraw or reduce the credit line if sales continue to deteriorate.  After all, they now have their $850 million that’s in JCP’s hands to protect.

–it demonstrates to suppliers that the company has ample cash to pay for merchandise.  JCP will likely get better payment terms with the money on the balance sheet than without it, although it’s not clear to me that payables still won’t shrink this year.   More important, in my view, is that suppliers won’t restrict either the quantity or selection of merchandise they deliver to JCP for fear they won’t be paid.

–it avoids the negative publicity (see my 2011 post on Eastman Kodak) that would likely have been generated were JCP to wait until it genuinely needed the funds, or until its banks might be getting cold feet.

so far, so good

So far, Wall Street is taking the move in stride.  The stock showed no adverse effect from the announcement.  And in pre-market trading today, it’s up.

more about JCP

I’ve been thinking about Bill Ackman and JCP over the past few days, enough to have looked at the most recent financials for the company.  Why am I writing about this again?   You can usually a learn a lot from a situation where the wheels are starting to come off, and JCP’s 4Q12 financials give a good example of why the cash flow statement is an important document to study.

I haven’t (yet, at least, and I may never) done a real analysis and come up with an investment conclusion.  But I do have a reasonable hypothesis about what’s going on.  By way of its stores’ physical locations, JCP controls a lot of real estate, either through long-term lease or by owning it.  Given Mr. Ackman’s interest in real estate and his prior experience with Target, I imagine his plan has been to ultimately separate JCP into two parts, a real estate entity and a department store and thereby hopefully getting a much higher stock market valuation for each.  I’m sure he also saw some low-hanging operational fruit:  costs were too high, inventories were bloated, some non-essential assets could be sold.  Addressing these issues could raise a ton of cash.

In addition, the real estate value is connected in a strong way to the viability and profitability of JCP stores.  If the department store business is booming, the value of the real estate–in the sense of the ability to raise the rent–rises (and vice versa).  So a Ron Johnson-led makeover of JCP could have a big positive effect on both the value of the stores and the real estate on which they lie.

So much for the concept.  Where does JCP stand now?

Let’s take a look at the 4Q12 earnings report presentation:

recurring items

–during 2012, JCP cut SG&A (Sales, General & Administrative) expense by $603 million, even after  boosting marketing by $25 million and IT spending by $25 million.  That’s tremendous.

–at the same time, 2012’s same store sales comparisons fell by 25.2%.  Worse, comparisons deteriorated steadily as the year progressed, reaching -31.7% during 4Q12.  The number pf people going into JCP stores was off by 13% for the year, with, again, the low point of -17% happening during 4Q.  Conversion, meaning the percentage of people visiting the store who actually bought something, showed the same pattern:  -9% for the year, -10% for 4Q12.  To state the obvious, something went horribly wrong with department store operations.

–the cash flow statement (I’ve rearranged the order of the items JCP lists to give what I think is a more coherent story)…

Under GAAP (the accounting conventions used for financial reporting), JCP lost $985 million during 2012.

GAAP allows a company to reduce the reported loss by the extent it can shelter future profits from income tax (called deferred tax).  For JCP, this was $350 million.  Correcting for this, the pre-possible-future-tax-benefit loss was $1.335 billion.

Part of any company’s expenses are provisions for wear and tear on plant and equipment (the buildings, display counters and other fixtures).  This is called depreciation and isn’t cash out the door.  For JCP, this was $543 million.  Adding that back in gives a sense of whether the company took in money or had an outflow during the year.  In JCP’s case, the “cash flow” number is a loss of $792 million.

one-time items

JCP sold non-core assets during the year.  It wrote down others and took an employee benefit charge.  The gain on the sale and the charges pretty much offset one another, although the asset sales brought in $526 million in cash.

The company got rid of a lot of excess inventory, generating $575 million in cash in the process.  It also got better payment terms from suppliers that saved it, at least temporarily, from paying $140 million for merchandise.  Together, the two working capital actions generated $710 million in cash.  

The net of all this–and a couple of items I didn’t mention–is that operations pretty much broke even.

What’s important to note is that breakeven happened, in my view, only because the inventory and payables adjustments generated $710 million.  I doubt this can happen again in 2013.

investing/financing

JCP spent $810 million last year overhauling its stores and repaid $250 million in debt.  That’s an outflow of $1.060 billion.  It got $526 million in from asset sales.  There were a couple of other small items, leading to a net outflow of $$567 million from investing/financing.

the bottom line

For full-year 2012, JCP had a net outflow of cash of $577 million.  What jumps out at me, though, is that the figure is only this low because of asset sales and working capital adjustments totaling $1.236 billion.  Without them, the outflow is $1.8 billion+.

Of course, JCP would never have embarked on its aggressive store remake had it not figured the $1.236 billion would be available.  What it didn’t anticipate was the drain on cash from the collapse in sales.

where to from here?

In February, JCP announced it has negotiated an increase in its bank credit line to $1.85 billion.  I read this as as much a psychological event as a financial one–to reinforce the idea that JCP has plenty of money to carry out its transformation.

In the 4Q12 earnings call transcript I read, I was struck by the fact that many analysts wished the company good luck after they asked questions.  I can’t remember ever having seen this before.  Putting on my fortune-teller’s hat, I think analysts believe JCP is on the right track but are not yet 100% convinced that this story will have a happy ending.

As far as cash goes, the company now has about $800 million on the balance sheet.  It says it has non-core assets worth several hundred million dollars that it can sell.  And it has it bank credit line.  Absent a repeat of the horrible operating performance of 2012, that should be enough.

On the other hand, Vornado Realty Trust, an ally of Pershing Square Capital, recently sold 40% of its holding in JCP–hardly an act that inspires confidence.

For me, at this point JCP is an interesting case study and nothing more.  I have no special edge here.  I have no idea whether sales will begin to rebound quickly–in which case JCP shares would skyrocket–or not. And I don’t need to have an opinion.   So I’ll just watch from the sidelines.

Bill Ackman’s investment philosophy?

A couple of weeks ago, I heard a conference call held by noted hedge fund manager Bill Ackman (Pershing Square Capital) and broadcast over Bloomberg radio.  I didn’t listen to the entire call, but two things I heard have been rolling around in my mind since then.

a fifty year investment horizon…

1.  Mr. Ackman said that what distinguished him from other investors was that he takes a longer view than most in analyzing his potential investments.   His time horizon?   …the coming 50 years.  

Virtually every investment manager seeking clients will say that two factors differentiate him from rivals:  that he does more meticulous research; and that he has a longer investment horizon, which makes him more resistant to the periodic panics that beset the stock market.  So in one sense, Ackman’s assertion is right out of Marketing 101.  In addition, it certainly sets him apart from the crowd.  And it’s possible that he sincerely believes what he’s saying–although I think that, if so, there’s a wide disconnect between what he thinks he does and how he actually makes money.

But does a fifty-year time horizon make any sense?

I don’t think so.

For one thing, all the available evidence shows that professional securities analysts can’t accurately forecast company financials even one year ahead, let alone fifty.

…when everything is in flux

For another, let’s consider what the world of fifty years ago was like:

–there was no Internet.  So, no Google, no Amazon

–there were no cellphones

–there were no video games (Nintendo was making decks of playing cards); there was also almost no color TVs to play them on

–there were no personal computers, and not that many corporate mainframes, either

–there were no microwaves, no copiers, no fax machines (people used manual typewriters, carbon paper and the post office.  They warmed stuff on the stove)

–there was no Civil Rights Act.  Women and minority group members could do little more than menial labor

–air travel was in its infancy and the interstates were still being built. People traveled by boat and train.

I could go on, but the point is that life fifty years ago was mind-bogglingly different from life today.  It’s almost impossible for us to imagine what it must have been like, even though we have all the historical data, as well as access to people who experienced it first-hand.  It’s also hard to find companies that have survived during the entire period, and even more difficult to locate within that small group ones that haven’t had to change radically to do so.

How much harder, then, to project fifty years into the future, where we will likely continue to see equally surprising twists and turns?

Mr. Ackman’s reply, apparently, is that he invests in real estate, and buildings and land can easily stay around for a half-century.  I guess the argument is that the practice of entering into long-term leases means that real estate only responds slowly to changes in economic circumstances.  Still, it seems to me that real estate remains subject to the same forces of flux that anything else in the economy is.  Cities or states may move in and out of favor (think:  Detroit, the Motor City in 1960 vs. now), as do neighborhoods and sections of cities as circumstances change.  Real estate still needs to be traded, depending on changing economic fortunes.

2.  Mr. Ackman also described the first time he entered the Apple Store on Fifth Avenue in Manhattan (no date given, but the store opened in mid-2006.  Even with its recent swoon, AAPL shares are up 6x since then).  He was deeply impressed and knew there must be an investment idea based on his experience.

Others might have bought AAPL stock.

Not Mr. Ackman, who knew it ‘s impossible to predicts  fifty-year timeline  for the company.  Instead, Ackman decided to hire away fellow Harvard MBA, Ron Johnson, the head of the Apple Store division, and put him in charge of turning around J C Penney, where Pershing Square and allies had a controlling ownership position.

In moving from the store visit to hiring Johnson, Ackman must have made several other judgments that connect the dots:

–that Steve Jobs, one of the biggest micro-managers of all time, had no role in the location, design or layout of the Apple Stores.  It was all, or mostly, Johnson

–that the the fabulous success of the Apple Stores was due to Johnson, not to the quality of the Apple merchandise or the company’s truly immense marketing budget, and

–that the skills needed to run a chain of specialty boutiques selling very upscale consumer electronics products are the same ones needed to run a mid- to down-market clothing-oriented department store.

How has this worked out so far?

…a string of mammoth same-store sales declines by JCP, a large net loss and a decision by insider Vornado Realty Trust to dump 40% of its shares.  JCP stock has lost over half its market value since Mr. Johnson took over, a period when the S&P is up almost 30%.

I’m sure Mr. Ackman would tell you that you can’t judge a 50-year plan based on a mere 2% of that time.  Still, for me the whole conversation had a certain through-the-looking-glass air about it.