Shrewd Investors are Buying A&P's Unique Bonds

The regional grocery chain has had a spectacular run-up lately, surging over 100% from $5.97 in early Sept. to nearly $13 last week. The stock’s stunning rally is by no means a result of operational improvement or other change in fundamentals, but rather of a rumor of an impending takeover. The fact is, Billionaire investor Ron Burkle’s Yucaipa Investment company has taken a large, friendly position and has consequently gained board representation.

Further proof of a potential change of ownership was a German newspaper article reporting that GAP’s largest shareholder, the Tengelmann group, is investigating the feasibility of the sale of their entire ownership stake. Interestingly enough, GAP’s corporate bonds have stayed relatively flat in the same timeframe and offer the investor a chance to exploit the inefficiencies of an efficient market by enabling them to buy into a much stronger scenario without having to pay a higher price.

Second quarter earnings: Sales of the regional grocer (who runs both Pathmark and A&P) fell by more than 4% from $2.2 billion to $2.1 billion. While the company’s loss expanded from -$1.97 to -$3.97, its gross profit margin surprisingly improved 30 basis points from 29.8% to 30.1%.

Although the supermarket chain attributed its poor results to a soft economy and its inability to get its Pathmark acquisition up to full potential, it is still cash flow positive. The company announced that it would be seeking a new CEO immediately with the resignation of its current CEO, Eric Claus. Board Chairman Christian Haub will assume interim CEO responsibilities until a successor is named.

The bonds: Gap corporate bonds (GAJ) are very unique. These 9 3/8%, 30 year bonds (aka quibs) were issued ten years ago when the prime rate was 8.25%. They were sold in $25 units (par value) and are traded on the NYSE (8 million shares were issued raising $200 million). Most bonds are sold in $1000 increments and are not traded on the NYSE, that is why these bonds are so unique. Their annual payout of $2.34 equates to a current yield of 10.7% and obviously with a yield so high, they are non investment grade.

The upside: If GAP is eventually acquired, bond holders would have to be paid par value before the acquisition could take place. That would give the holder an immediate 14% gain from the bond’s current price. Another scenario would be GAP calling the bonds at par value so they could reissue new bonds at a lower interest rate (today’s prime rate of 3.25% is more than 60% lower than what the prime rate was (8.5%) when the bonds were originally issued).

Shrewd investors are buying the bonds: Both Gamco Asset Management (managed by Mario Gabelli) and Barclays Global Investors have been aggressively acquiring bond shares. GAMCO who owns 5.4 million shares and recently acquired another 256,000 shares, while Barlcay’s added another 66,000 shares, bringing their total to 2.1 million shares. Further accumulation by these two major bond holders should bode well for GAJ’s price, especially considering its low liquidity status (average trading volume of only 17,000 shares creates substantial volatility).

Bottom line: Buying these bonds is appropriate for those with both short term and long term horizons. Those with a buy and hold approach will be getting a very juicy return, thanks to the dividend. Those wishing to make a fast buck could see a nice 10% pop in the very near term as the bonds are now at about the midpoint of their $20-24 trading range and have been trending higher.

Author's Disclosure: long GAP and GAJ

Comments

[Pondering]

The article contains interesting points, but A&P continues to spew red ink. Further, the road back to profitability is likely to be filled with potholes. Intense price competition and problems in integrating Pathmark will continue to impact results. These bonds are only appropriate for risk-tolerant investors.

2009 Nov 23 12:46 PM

[bear_mkt]

These A&P bonds aren't "very unique." There are plenty of other bond-based trust-preferreds out there in $25 denominations.

I would disagree that these are "appropriate" investments for most investors for long and short term holdings. The GAJ bonds are rated junk, Caa1/CCC. If you search around, you can find better credits.

With all the emphasis take-over rumors and scenarios and quick profits, and the omission of any explicit reference to credit quality, I'd have to rate this article as a "puff piece." Caveat emptor.

A&P operates in a tough competitive environment. IMHO, GAP and GAJ have been rising on take-over rumors, not on sound fundamentals. Just my opinion.

2009 Nov 23 01:16 PM

[Mark Krieger]

of course GAP has been rising on takeover rumor--why else would it be so strong?? ( didn't I mention this tidbit in my story?) its fundamentals are horrible---I indicated the bonds were below investment grade in the piece ( how else would you get a double digit yield?) Yes it is a puff piece--pretty much every artilce on SA is--I'm promoting the positions I own--I am putting my money where my mouth is!!! waht's wrong with that?


On Nov 23 01:16 PM bear_mkt wrote:

> These A&P bonds aren't "very unique." There are plenty of other
> bond-based trust-preferreds out there in $25 denominations.
>
> I would disagree that these are "appropriate" investments for most
> investors for long and short term holdings. The GAJ bonds are rated
> junk, Caa1/CCC. If you search around, you can find better credits.
>
>
> With all the emphasis take-over rumors and scenarios and quick profits,
> and the omission of any explicit reference to credit quality, I'd
> have to rate this article as a "puff piece." Caveat emptor.
>
> A&P operates in a tough competitive environment. IMHO, GAP and
> GAJ have been rising on take-over rumors, not on sound fundamentals.
> Just my opinion.

2009 Nov 23 01:46 PM

[bear_mkt]

I appreciate your enthusiasm, but if there's no merger, like Little Steven says on his radio show every Sunday night, "It's back to ugly reality again."

GAP was highlighted as one of 3 stocks to sell on Smart Money, citing a BMO Capital analyst who dismissed the merger stories in the German press as "comments...likely made 'to keep A&P’s stock price at the current, lofty levels' and that considering a merger is far easier than finding a buyer."

GAP's fundamentals are weak. How weak? Let's put it this way. I'm long GAJ, but I do my shopping at Shop-Rite. Beautiful stores with no customers is not a winning business model.

I like GAJ, but they are speculative at best.

Just my opinion

2009 Nov 23 02:20 PM

[satyr]

I had not considered GAJ before, so I appreciate the idea. The case for GAP to be acquired does not seem compelling, particularly at current valuations. So, I guess the question on my mind is what happens to the debt if the grocer just keeps bumping along as an inferior competitor.

In the short run, the return of around 10% is attractive in of itself. You don't get that kind of clip off a typical investment these days without accepting a reasonable amount of risk (not to say it does not exist here).

Eventually, I see a couple of longer term outcomes that raise some worries. First, if GAP flounders and ultimately goes belly up, I have not crunched and extrapolated the numbers to get a sense of what the holders of this debt might expect to get. Has anyone done the math on this? Second, I am in the camp that says that we will run into inflationary problems before too long, and bond values will drop as rates ratchet up. So, if I were to jump into GAJ, I don't see the case to be holding it for more than about 6 months or a year.

2009 Nov 23 06:19 PM