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.

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.