a J C Penney (JCP) stock issue post-mortem

More strangeness from JCP.

the final offering price (only mildly strange)

Last Friday, JCP filed a final prospectus with the SEC indicating that it had sold 84 million shares of its common stock to underwriter Goldman Sachs after the close the night before.  JCP received $9.36 for each.  Goldman intended to (and presumably did) sell the shares to the public for $9.65 before the market opened on Friday, netting a fee of $.29/ share.

Goldman retained a 30-day option to purchase another 12.6 million JCP shares on the same terms (the “overallotment” (or “green shoe”)–more about this below).

What’s strange?  The offering price is higher than initially thought–suggesting GS found eager buyers.

the stranger stuff

1.  Mike Ullman, the CEO of JCP was reported by CNBC a couple of days earlier to have assured investors that no fund raising was in the offing.  The stock rallied sharply on this.

Didn’t he know?  If the CNBC news is correct, apparently not.

JCP denies CNBC got the story right, however.

2.  Goldman was the underwriter even though the offering comes right on the heels of a GS report warning investors to be wary of JCP because of declining liquidity and lackluster sales.

Note:  in a separate SEC filing, JCP said its online business was up “double digits,” year over year.  It also stated it expected positive comp store sales for 3Q13 and 4Q13.  If the entire JCP business were growing in double digits, I presume JCP would have said so.  So I take the statement as meaning that the in-store business is up, but not by a lot.  In theory, but highly unlikely in my view, the online business could be going through the roof and in-store sales could be down.

3.  Goldman apparently was able to find institutions willing to buy all those JCP shares.

4.  post-issue trading  

There are two (related) aspects to this:

–hedge fund Perry Corp, which had just recently raised its stake in JCP dumped out 9 million shares on Friday.  Seems to me the issue took them by surprise, too–and they didn’t like it.

–the “overallotment.”  (Even though I stuck this in last place, it’s the real reason I wanted to write this post.)

The way the overallotment works is this:

JCP announced an offering of 84 million shares, with an overallotment of 12.6 million.  The underwriter has the right, but no obligation, to buy an extra 12.6 million shares of JCP within the 30 days following the offering.

In reality, GS sells all 96.6 million shares, including the overallotment, to the public.  In this case, that gets GS an extra $121.6 million.  It does so in order have money at hand to “stabilize” the price of the stock in the initial hours after the offering It does so by standing in the market and offering to buy JCP at $9.65.  Normally, trying to influence the stock price like this is illegal, but there’s an exception for a short post-issue stabilization period.

Stabilization is a no-lose situation for the underwriter, provided he doesn’t get carried away and start using his own money to do this (fat chance of that).  If the stock goes up, he buys nothing in the market.  He exercises his overallotment option with the issuing company and delivers those shares to the client.  If the stock is flat to down, he takes the shares he buys in the market at the issue price or lower and delivers them to the client.  The overallotment option lapses without being used.

Two points:

a.  Unless it’s completely clueless, Perry Corp was well aware of the stabilization period.  Its best exit strategy would have been to sell aggressively while GS was stabilizing the price.

b.  The $9.65 line didn’t hold for a nanosecond in regular trading.  Volume in JCP for the day was a whopping 256.3 million shares.  Yahoo Finance shows an open of $9.53 and a high of $9.67–but I don’t see anything on either Yahoo or Google charts to suggest the price got close to the $9.60s.  In any event, stabilization was a lost cause.

the strangest stuff

Many third-party analysts foresaw JCP’s need for extra cash a long time ago.  Like most things in business, the calculations are relatively simple.  It’s odd the JCP couldn’t make them.

I also find it very odd that JCP generously stepped aside and allowed former large holders Pershing Square and Vornado to sell their shares at much higher prices–and using up potential demand for JCP stock–over the past six weeks before testing the market itself.

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?

Pershing Square has sold its entire stake in J C Penney (JCP) overnight

Pershing no longer owns any JCP

Bill Ackman has followed up his departure from the board of JCP by describing his investment in that company as a “failure” and striking a deal with Citigroup (C) to sell his entire 38.08 million share holding (about 18% of the outstanding stock).

Ackman’s investment group will receive $12.90 a share, less fees.  My guess is that they’ll net about $12.25.  We’ll know for sure when the final prospectus comes out.

Contrary to earlier press reports, which said C was going to take this massive position onto its own trading books and gradually dribble the stock out to the market (which would have entailed a huge risk) this is a straightforward underwriting.  The only twist is that there’s no big underwriting/sales group.  C is the sole underwriter.

The underwriting process goes like this:

–Pershing Square asks C to lead an offering to sell its JCP stock

–C assembles the underwriting/sales group, in this case itself

–C calls clients to get indications of interest and to try out possible prices.

–C sets a price (in this case $12.90 a share), distributes a preliminary prospectus, gets firm commitments from clients and buys the stock from Pershing Square.  This last apparently occurred yesterday.

Technically speaking, client commitments aren’t legally binding.  Unless you’re very big and powerful, however, there’s a fat chance you’ll ever get to see a good IPO allocation again if you go back on your word

–C sells the stock to clients.  This is presumably happening  this morning.

As part of the deal, C gives buyers a final prospectus, which– legally speaking, is the only official offering document.  The client has a brief time to review it and return the stock if he doesn’t like what he reads.  In my experience, however, clients seldom read the final prospectus.  I don’t know anyone who’s ever returned stock.

what bothers me

I’m usually a solidly free markets guy.  Laissez faire and all that.  But Pershing-JCP is a case of corporate bungling on an epic scale.

Ackman enters in cape and tights to “save” a company that’s not a world beater but nevertheless is muddling along.  He installs similarly-clad Ron Johnson as CEO.  Johnson promptly alienates customers, loses a third of company sales and burns up a ton of corporate cash.  All the while he’s defended by Ackman.  Both exit the now-smoking wreckage with a few tepid words of apology.

Yes, both lost money and their reputations are tarnished a bit   …but that doesn’t seem to me to be enough.  On the other hand, I’m not sure what other penalties there should be.  Disbarment?

Maybe it’s just the speed at which disaster struck that disturbs me. As I think about it, I can come up with many examples of the same incompetence  in slower-moving corporate train wrecks.  Think:  C. Michael Armstrong at ATT, and then Citigroup (as a board member).  How about Carly Fiorina…or just about any CEO…at Hewlett-Packard?

one other note:  It’s interesting that C was able to find buyers for 18% of the stock at $12.90.  A floor on the stock price?

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.

owning property vs. leasing: investment possibilities

asset heavy to asset light

A generation or two ago, the style in the US was for companies to own the premises their businesses operated in–hotels, department stores, restaurants and the like.  One major disadvantage of this approach, however, is that it takes a huge amount of capital to be able to expand.

About the time I was entering the stock market, American hoteliers had worked out that they could sell their properties to the local doctor, dentist, accountant, or oil sheikh and take back a management contract.  They found the buyers were more interested in the prestige of ownership than in profits.  They were willing to pay very high prices for the properties, while ceding virtually all the hotel cash flow back to the management company.  The “asset light” movement was born.  (Around a decade later, European hotel firms caught on and began to do the same thing.)

Hotels are admittedly an extreme example.  In my experience it rarely has made economic sense to own a hotel.  Better  an office building if you want to own real estate.  Still, asset light is the current style in many industries.

hybrids are potentially interesting

Many hybrids–a mix of leased and owned properties–remain, however.  They can sometimes present interesting investment opportunities.

An example:

At one time a friend pointed out the W Company (not the real name) in Hong Kong.  It was (and still is) a publicly traded, family run department store in Hong Kong, located in the heart of the high-end Central district.  The financials showed that the company was consistently, and highly, profitable.

But when I went to visit the department store itself, it looked more like K-Mart than Neiman Marcus.  The merchandise was undistinguished, the premises dowdy, customers few and far between (observing this last on a company visit is seldom a reliable indicator, though).  The store was surrounded by more modern, glitzy alternatives.  And Hong Kong is all about glitz.

How could this straw-into-gold story be true?  Looking a little closer, I noticed that the department store showed no rental expense on its income statement.  That’s because the company itself owned the building it operated out of.

I checked rents on nearby retail premises.  It turned out that W would probably be paying HK$100 million to a third party to rent the space it was in.  But the department store was only making HK$30 million in annual operating profit. (I don’t remember the exact numbers so I made these ones up.  But they’re roughly correct.)

The economic reality …

…was that W had two separate businesses:

–property ownership, which should have been generating HK$100 million in income, and

–department store retailing, which should have been adding to that.

The company was actually losing HK$70 million from retailing and subsidizing the department store by forgoing the rent it could have earned.

That was, in theory at least, the investment opportunity.  Either the family elders would wake up one day and realize they could triple their profits by closing down the department store and renting out the premises, or a predator would come along and bid for the firm.  The big question in the second case was whether the family would sell.

not alone

In the case of W when I was looking at it, my impression was that the family had never analyzed its business and was perfectly happy with the status quo.  When potential bidders came calling, the elders just said no.

My first instinct is to say that this behavior is crazy.  On the other hand, except for the location and the family owners blocking a change of control, this is the J C Penney story in a nutshell.

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.

new financing for J C Penney (JCP)?

the news

During New York trading last Friday, CNBC reported that Goldman had lined up $1.75 billion in new debt financing for JCP.  The stock, which had already been rising strongly on news that the Soros-run Quantum Fund had acquired a 7.9% stake in the ailing retailer, jumped sharply.  JCP ended the day at $17 a share, up 11.6% on the day.

According to the Wall Street Journal, which isn’t 100% clear, the new loan to have the following characteristics:

–$1.75 billion in size

–a five-year term, after which repayment in full would be due

–a 6.5% interest rate, implying $113.75 million in annual interest expense

–secured by many/most/all the company’s assets not already acting as collateral for other loans.

Neither JCP nor Goldman have confirmed the press reports.  As of Sunday night, when I’m writing this, there’s no SEC filing about this on the Edgar site, either.

my thoughts

1.  From the WSJ account, this new financing appears to be a bond offering rather than a bank loan.   Two differences:   on the one hand, the loan must be made all at once, starting the clock on interest payments, even though the money might not be needed right away; on the other, the lender has, generally speaking, no right to ask for early repayment.

The cost of the financing–before Goldman’s fees– would be close to $570 million over the next five years.

Unlike a bank loan, which can have an indeterminate term, JCP would have to have $1.75 billion available to repay the loan five years from now.  It’s possible that JCP could negotiate an extension, or borrow from someone else to get the money.  Without one or the other, the loan would seem to put a time limit on how quickly the operational turnaround must occur.

2.  To the extent that any assets of JCP serve as collateral for the loan, they would presumably not be able to be sold without the lender’s permission.  This could prove another, possibly severe, limitation to JCP’s options.

In a related story, the WSJ cites a brokerage report by ISI.  The report, which I haven’t seen, asserts that if the top 300 of the properties JCP controls were rented to third-parties instead of being used by JCP, they would fetch yearly rental income of $1.2 billion.  That’s more money than JCP has made in any of the past five years!

I don’t know whether this figure is correct.  If it is, it suggests that even pre-Ron Johnson the value of Penney’s real estate was being frittered away supporting a retail operation that only turned a profit because of a massive rent subsidy.

I’m sure JCP situation is much more complicated than just shutting down retail and allowing the value of the company’s real estate to be recognized–especially now that JCP stores have absorbed so much damage in the recent past.  Still, the point is that accepting the new loan might close out completely the possibility of forming a separate entity with these properties and rerenting them.

It will be interesting to see what JCP chooses to do.