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.

Quantum Partners, the George Soros investment vehicle, has acquired 7.9% of JCP

the filing

Yesterday, Soros Investment Management LLC, the manager of the Cayman Islands-based Quantum Partners, filed a Schedule 13-g with the SEC.  It declares Quantum now owns 17.4 million shares, or 7.9% of the outstanding shares, of J. C. Penney (JCP) common stock.

What does this mean?

the basics

An institutional investor is required to file a Schedule 13-g within 10 days after having acquired 5% of a company’s common stock.  Soros IM crossed that threshold on April 15th.  It must make follow-up filings whenever it brings its stake up or down by .5% of the outstanding.  The disclosure requirement ends when the holding falls below 5.0%.  Mutual funds do this all the time.

The 13-g differs from Schedule 13-d, which is filed by basically anyone other than a portfolio investor.  That schedule requires the filer to state his intentions–for example, to obtain control of the company, or to take an active part in its management.  The 13-g requires no such declaration, because the presumption is that the portfolio manager has no such intentions.

Assuming his contracts with his clients permit, the filer can always change his mind, however.  He signals this by filing a 13-d.

what we can conclude

I think the conclusion the financial press has drawn that Soros IM is a purely passive investor is unjustified.  The firm is that for now, but it can always alter its stance simply by filing a 13-d.

The stake represents and investment of about $250 million.

It’s unclear whether Soros is finished buying.  Usually, investors amassing a large stake in a publicly-traded company accumulate as much as they can without attracting attention during the ten days of anonymity they have after they hit the 5% mark.  Presumably the 17.4 million shares represents the Soros IM holding as of yesterday.  If so, we won’t know for about two weeks whether he’s continuing to purchase shares in significant amounts.

Importantly, if–as the filing states–the Soros stake represents 7.9% of JCP’s shares, this means the total outstanding must be 219.8 million shares, more or less.  This is the same number listed in the 10-k as outstanding on February 2nd, the end of the latest fiscal year.  In other words, Soros has bought its stake on the open market, not from JCP.  Therefore, JCP is not getting a cash infusion from Soros IM.  The money went to existing shareholders who are cashing out.  JCP still needs to raise money from outside sources.

does the move help JCP?

Arguably, JCP would have been best off if Soros IM had bought new shares from JCP, instead of already existing shares on Wall Street.  That way the quarter-billion dollars would have gone into Penney’s bank account.

Maybe Soros IM tried to buy shares from the company and was rebuffed.  More likely, in my view, Soros IM concluded it should seize the moment and buy while the stock price was weak.  Soros IM may well also be willing to be a buyer in any future securities offering JCP may make.  On the other hand, Soros IM has a very useful block of stock that could be sold to a new activist eager to enter the picture.

The Soros IM move consolidates the ownership of JCP further.  On the one hand, the probably makes it easier to obtain a majority vote.  On the other, it could end up adding another big ego to the boardroom.

the Soros record?

Are the Soros IM portfolio managers good stock pickers?  Is their purchase of JCP a sign that the company is a significant bargain.

I don’t know.

Most of what I know about George Soros comes from his 1987 book, The Alchemy of Finance. It’s a combination of a statement of his general investing principle (which he calls reflexivity) and a long account of his day-by-day musings about the financial markets.   I could only make it about halfway through.

Two things struck me, though:

–Mr. Soros included on the inside covers a multi-year performance record.  It consists of short periods of daring and brilliantly successful currency speculation–and long periods of continuing equity underperformance.

–the second is a petty point, but apparently not one that’s beneath me.  In the book Soros outlines his principle of reflexivity.  He calls it his original contribution to Western philosophical thought, which he put to use in financial markets after developing it as an abstract philosophical concept.  I was stunned when I read this.  Reflexivity is actually the dialectical method Hegel put forth in the early nineteenth century (take the famous description of the  evolving and reversing relationship between master and slave in the Phenomenology of Mind, for example).  These ideas were later applied to economics by Hegel’s follower Karl Marx.  Is it possible that, although he calls himself a philosopher and was educated in Europe, Soros just wasn’t aware of the most influential European thinker of the nineteenth century?  Or is he the master salesman, who figures no one will know?

Either way, not much to inspire confidence.

To the JCP point, my guess is that at the age of 82 Mr. Soros no longer plays the leading role in Soros IM investment decisions.  While I personally would hesitate to ride on Mr. Soros’s coattails, despite his fame, it’s unclear to me who exactly had the inspiration behind the JCP purchase.

My bottom line:  JCP now has what amounts to a celebrity endorsement.  It’s from a party whose stock-picking prowess is unclear and who, at least for the moment, is a passive investor.  Were Soros IM clearly supportive of Mr. Ackman et al–according to the New York Times, the two parties have offices in the same building–it would have bought its shares directly from JCP, in my opinion.

Therefore, the stake is potentially destabilizing, even though the filing of a 13-g implied no present activist intentions on Soros’s part.  One positive scenario for third-party shareholders would be if the Soros presence somehow triggered a struggle for control of JCP that drove the stock price higher.  The worst case would be if JCP depleted its cash in buying Soros out.

Personally, I’m going to watch from the sidelines.

 

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.

Ron Johnson out at J. C. Penney (JCP): implications

Yesterday, only a few weeks after major shareholder Bill Ackman gave Ron Johnson a ringing endorsement as CEO of JCP, Mr. Johnson is out.

Former CEO, Mike Ullman, who was unceremoniously dumped not that long ago to make room for Johnson, is back in.

Wow!

What can we make of this?     …quite a lot, I think.

1.  The change comes right after monthly sales results for JCP in March, the second month of the company’s fiscal year, would have been available.  Presumably they’re really bad (the Wall Street Journal is reporting that quarter-to-date sales are down at least 10% year on year).

This is a big problem.  JCP marks up merchandise by about 50% over what it pays.  It uses the gains from sales, called gross income, to cover the costs of running the store network (like advertising, rent, utilities, salaries…).  What’s left over is profit.

JCP’s sales in fiscal 2010 were $17.6 billion;  its pre-tax profit was $581 million.

In fiscal 2012, sales were $13.0 billion, or 26% lower than in fiscal 2010.  My back of the envelope calculation is that JCP lost just under $800 million from retailing last year–offset by a number of non-recurring gains (see my post).

To my mind, the largest factor in the profit decline is the loss of sales.  The March figures suggests sales may not have bottomed out yet.

2.  Since the company was quick to boot Mr. Ullman not so long ago, he’s probably not the company’s first choice as the new CEO.

I can see two possibilities:

–he may be the only experienced executive willing to take the job, or

–JCP may have been pressured into making the change quickly and Mr. Ullman was available on short notice (I’ve heard he was first contacted last weekend).

Neither possibility is encouraging.

3.  Where would outside pressure come from? The two main sources, as I see it, would be:

–suppliers.  Last year JCP generated $140 million in cash by getting suppliers to agree to wait longer to be paid. As the perceived riskiness of dealing with JCP rises, the standard response by suppliers would be to rethink a decision like this.  In a more extreme situation, suppliers would start to reconsider the amounts and types of merchandise they send to a customer.

–banks.  In its 4Q12 earnings conference call, JCP highlighted the fact that it had negotiated a $500 million increase in its bank credit lines, to just over $2 billion.  The message from this seemed to me to be that JCP had ample funds to weather any problems it might encounter in 2013.  Again, the standard response to continuing deterioration in sales would be for banks to reassess their exposure.  All it would likely take to reduce a credit line–something that would doubtless have adverse effects for JCP–would be one credit committee meeting.

There’s no direct evidence that either suppliers or banks have started down this road.  It’s conceivable, though, that one or both told JCP they’ll have to change their thinking if sales don’t perk up soon.  That might have been the final straw for Mr. Johnson.