Special Situation Investing - What J.C. Penney Can Teach

| About: J.C. Penney (JCP)

I promised not to write anymore about J.C. Penney (NYSE:JCP) unless something dramatic changed. Yesterday, something dramatic did happen, yet nothing really changed. The stock was hit for 10% on massive volume (25% of the float traded) on rumors that the Company had hired bankruptcy counsel and that factors had tightened terms. The Company was forced to come out with a public denial of these rumors, but the damage was done and the stock still languishes on 30-year lows today. Even news that it has lost out to Apple (NASDAQ:AAPL) for the Burberry (OTCPK:BURBY) CEO was treated as bad news even though I thought it was good that the company was even trying to get someone of that caliber and that Mike Ullman or the board really was trying to get a fulltime CEO.

On some level none of these rumors are surprising, when a stock is in free fall and has financial leverage - these are stock in trade rumors and virtually impossible to disprove. No one even believes the Company's denial. While I am sure JCP hasn't retained bankruptcy counsel after raising $800 million in equity, I would be surprised if it hadn't used some kind of legal advice about the pluses and minuses of rejecting leases and other contracts in Chapter 11. Most of its owned real estate is currently mortgaged so it is not clear to me that the company would be better off in Chapter 11 as those properties would presumably go to the lenders first though I have not done a lease by lease analysis that would be required to fully know the answer. As for factors tightening terms, that is also a good and hard to disprove rumor for a leveraged retailer going into Christmas. My factoring sources are not seeing that alleged tightening, but the factoring community is so diverse that it is hard to lump them all together which is why it is such a good rumor to spread - it is virtually impossible to disprove and could be true of only one small ones (read: inconsequential) do it.

This "news" had gotten enough traction that Buffett was asked by CNBC to comment. His answer was comforting but not really news, "He believes that JCP will survive and that he is not worried about shipping to them." The comments are worth reading for those who believe JCP is on path to liquidation.

What special situation investors need to do in these cases is put their logic hats on. Would a company really file for bankruptcy weeks after a massive equity raise? Would vendors or factor really need to tighten terms given the massive liquidity at the Company? Whose interests are being served by spreading these rumors?

The company has been unfairly rumor mongered, but that is what happens in distressed situations. I still maintain that nothing has changed since the offering and that this too shall pass. Christmas should be fine but not great (more given the retail environment than anything JCP specific), and the real test is the coming year. The company's goal is to recapture $4 billion in top line and get back to 39% gross margins and make further SGA cuts. I still believe that they will get about $2-3 billion in sales back get back to former EBITDA margins. My scenario produces close to $20 in value. The company's scenario will get you to scenarios I outlined in my article about how JCP can be a $50+ stock.

For now the company is in special situation purgatory - getting rumor mongered daily. The tell will be in the bonds as they firm up. What is worth noting is that once a company gets out of this form of hell, a vicious media cycle can turn virtuous - positive comp. sales, higher bond prices, new vendors coming on board, cheaper financing, plain vanilla long only funds buying. The stock starts to gap up inexplicably on no new news and you start to read of hedge fund losses from staying too long at the JCP short party.

Disclosure: I am long JCP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Positions can and do change at any time with no notice.