The drama which continues to unfold inside the Plano, Texas headquarters of J.C. Penney Company (JCP) has wreaked havoc on shareholders. Since CEO Ron Johnson stepped on board and attempted to revamp the retail model (which proved unsuccessful ), major institutional shareholders have drastically reduced their position in the stock. The bad news continues to pour out for this company, whether it be a lawsuit with rival Macy's (M), increased pension expenses, a cash burnout, restructuring charges or higher capital expenditures in the coming year. However savvy value investors love a story like J.C. Penney, and typically the bottom of a stock's decline occurs when the news appears at its worst and the media can't stop talking down about a company.
The focus of this article will not be on finding an appropriate value for shares of JCP. While this is certainly an important process before making any investments, there have been many excellent articles throughout the Seeking Alpha community which highlight possible scenarios, I suggest reading this one. The purpose of this article is to highlight an interesting divergence between the common stock and preferred stock of J.C. Penney.
An overview of the securities
Hidden deep within the every growing capital structure of J.C. Penney in note #11 of the recent 10-k filing lies $500 million of 7.625% notes due 2097. The first question that comes to mind is how in the world was J.C. Penney able to issue 100 year debt? Answer, the wonderful financial alchemy of Wall Street. Suppose J.C. Penney needs to raise capital at the lowest possible cost, three options are available, debt, equity, or preferred stock. Let's suppose investors are demanding preferred stock at the time of issuance. The downside to the issuing company is that dividends paid on preferred stock are not tax deductible. Solution, an investment bank sets up a trust account which J.C. Penney issues bonds to, then the trust account divides up these bonds into $25 increments and sells them a preferred shares. J.C. Penney is now able to indirectly give investors the preferred shares they demand, while receiving all the tax benefit of issuing a bond.
This new security benefits holders of the trust preferred shares in a few ways. First, rather than having J.C. Penney issue preferred shares directly, investors are now higher up in the credit ladder in the case of bankruptcy (they essentially own a J.C. Penney bond). Second, gaining exposure to the debt can be made in much smaller increments, a $25 share price (par value) compared to a $1,000 par value bond. Lastly, the shares trade on the New York Stock Exchange so investors have an active and liquid market in which to trade shares.
There are two types of preferred trust securities that J.C. Penney issued that investors have available to trade. One is the Corts Trust for JC Penney (ticker KTP), the second is the Cabco Trust for J.C. Penney (ticker PFH). Both shares have similar bond indentures and historically trade in tandem with one another. The securities are callable at any time by the issuer no lower than par value ($25) and at a price above par that would make the yield equal to the 30 year treasury bond plus 20 basis points. Given the current cash issues at the company, it does not appear likely that a callable event will occur anytime soon.
Recent Trading Activity
For illustration purposes I will use the Corts Trust (KTP), note however that the Cabco Trust (PFH) has historically traded in a similar fashion. As you can see in the price chart below, other than the recessions our country experienced in 2000-2001 and 2008-2009, the shares of KTP have traded within a few dollar range of their $25 par value. Typically preferred securities will fluctuate within these bands due to upcoming dividend payments, interest rate levels, or company specific issues.
Source: Yahoo! Finance
Beginning in November of last year we began to see a massive divergence from the trading range I mentioned above. Additionally we saw a very similar correlation between shares of JCP, KTP, and PFH (see chart below). Investor sentiment has turned swiftly against J.C. Penney and it appears equity holders are not the only ones feeling pressure. As the chart below shows, common stock holders suffered tremendous volatility in May through November while preferred stock holders were somewhat immune. As more and more bad news kept coming out from management, investors began to grow disgruntled with management's new plan and most all J.C. Penney investments followed suit.
Source: Yahoo! Finance
There are numerous risks associated with owning either KTP or PFH, I urge investors to read the bond indentures for both securities to fully understand all risk pertaining to the securities. I will briefly highlight some of the risks I feel are worth noting.
Since you are essentially buying debt of J.C. Penney Company, any change to the credit rating of JCP will have an effect on the preferred shares. Just because they are in a separate trust does not automatically seal them off from the original issuer. If bankruptcy or liquidation became a reality for J.C. Penney, you would stand in line behind other bond holders (although not at the bottom of the pack) and before equity holders.
Both KTP and PFH shares are very thinly traded. Average three month volume is roughly 23,000 shares, and given the selling pressure we have seen in the past few weeks, that average may be artificially inflated. It may be wise for investors to use limit orders when making a decision to buy or sell.
There is also no guarantee that the correlation between the common stock and trust preferred shares will remain intact. Although one would assume that if the company becomes financially healthy again, investors will re-price the preferred stock in a similar fashion to other going-concern companies or back towards par value, there is no guarantee this will occur. Investors should be aware that we may see the common stock rebound while the preferred stay at depressed levels for an uncertain period of time.
In the event that J.C. Penney is able to turnaround the company and re-brand itself, the upside potential remains attractive in the preferred trust securities. Given the recent volatility in any investment associated with J.C. Penney, I will assume both PFH and KTP currently trade at $17 for illustration purposes only. The semi-annual distribution of 7.625% equates to a current distribution rate of 11.21% based upon currently depressed prices. Assuming we are able to get back to par value, investors who purchased shares at $17 would realize a 32% gain in the share price alone.
Considering the fact that you have the potential for equity like returns and are higher up on the capital structure than equity holders, in my opinion the trust preferreds offer a compelling case over the common stock. If you are a believer in J.C. Penney for the long term it may be worth further investigation in the Corts and Cabco Trusts.
As new headlines come out from J.C. Penney almost daily, investors in any JCP linked security are likely to experience continued volatility. However if you are a believer that the company will exist for the long term, the debt side currently appears to offer a more attractive risk-to-reward scenario for investors.
Consider your investment goals and objectives before initiating a position in any J.C. Penney security, and please remember that the value of investments in equity securities, like JCP, KTP, and PFH will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.