Once a bull, yet not quite a bear.
It's been a rough two weeks, harrowing for bulls and bears alike. A 10.1% same-store sales increase year over year in November left bears uneasy. Bass' equity flight, Wells Fargo's stake slamming, and an SEC inquisition left bulls questioning themselves. I'm now wondering if a bullish stance on J.C. Penney's (JCP) equity is still justified.
As some of you know, I've been bullish in the past. My original thesis of ample sales capacity, favorable forward cash flow environment, and a potentially undervalued balance sheet received some favorable bipartisan commentary. More recently, my piece on accounting math, cash flow, and dilution delirium -- as well as gross margin and interest rate risk -- received incredibly insightful commentary, again from both sides of the aisle (albeit over some heads).
However, am I now a converted bear? Let's dig deeper into the recent headlines and the foregone conclusions.
Kyle Bass' Catch-22
From what I can gather, the standing perspective is if he's in or out, I'm in or out, respectively. However, is his thesis parallel enough to yours to trade not only with him, but behind him? We should look to his trade history, original investment, and commentary to understand.
First, Bass has a capital structure trade in place consisting of multiple tiers of the companies' securities. Second, the equity side of Hayman Capital's trade revolved around the turnaround. Third, the more recent sale consisted of half his original equity position. Fourth, he is still long other tiers of unsecured bonds. Fifth -- and most importantly -- he underestimated the power of trade creditors.
Time to look at those points a little closer. Capital structure arbitrage is a complicated strategy, most likely one that the Talking Heads just don't get -- so please excuse their naiveté. As I should've noted in my first article we should not be following hedge fund titans, but questioning their motives. A good example of this point is to look at another hedge fund with a JCP equity stake: Magnetar. Some will remember this fund of great recessionary infamy. Summarily, ex-Citadel supernova Alex Litowitz longed the "equity" portion of the period's worst structured credit deals, enabling a positive carry short position on the "safer" garbage. They are known for this interspatial strategy, and they're straight ex-Jedi. I would be interested if anyone knows more about their intentions or thesis.
Next, we go to the timing of Hayman's acquisition and expulsion of JCP equity. Bass' 13-F disclosed his 11.4 million share stake on the third of September. By the end of September, he had sold half of that stake. In between those two dates, JCP sold equity to the public, adding cash to JCP's balance sheet and removing immediate liquidity concerns. Bass did not expect this; however, the equity offering did have a stabilizing effect on the company. Between October and his most recent pronouncement on CNBC (Oct. 1-Dec. 5), Kyle exited his remaining 5.7 million shares. In that time, JCP announced positive October year-over-year sales, an increase in revenue growth momentum, and expectations beating same-store revenue numbers for November. His equity thesis played out, he sold out. Extrapolating, Bass has seen the beginning of the turnaround, but isn't betting on its magnitude.
Now, on to the most important insight, the power of JCP trade creditors. For a quick recap, trade credit is a term used to describe timing of trade payments. Company A buys Company B's widget and they agree that Company A will pay for their purchase within 30 days. Here is where the aforementioned risk comes into play. Although Company B cannot make Company A pay without court order, B can refuse to sell A additional widgets. In the context of JCP we can see that the company has no overnight liquidity risk, resulting from multiple suppliers with differing terms and purchasing periods. However, they do have short-term liquidity (roughly, days payable outstanding), gross margin, and inventory risk. Let's look at days payable outstanding first.
Click to enlarge images.
A few things stand out from this table. For one, DPO this year has been historically high, and trade creditors are most likely not pleased. However, third-quarter DPO is at its historical average, meaning DPO has stabilized. DPO in the fourth quarter is historically lower, meaning the company pays off many of its purchases in this time. This is something to look at going forward.
Now let's move on to gross margin and inventory risk. If we can assume from DPO that JCP's trade credit has not been pulled, we should be looking at other ways in which JCP will feel the burn. As many of you have noted, inventory is higher than it has been in eight quarters, so I haven't seen evidence of suppliers pulling sales. However, the same cannot be said for gross margin. Recent creditor annoyance will only be reflected in next quarter's gross margin, and this is a risk we have yet to see play out. So in conclusion to Bass' trade credit realization, gross margin is the likeliest of places JCP will be hit.
The SEC Inquisition
This is not a good thing, but have we already witnessed the entirety of the repercussion?
These two tables help to illustrate my main point in an admittedly back-of-the-envelope type of way. My rudimentary conclusion is that the expected cash loss attributable to such an inquiry is between $18 million and $20 million. However, this does not include concurrent shareholder suits, or a company size factor, but does seemingly overestimate the effectiveness of each SEC inquiry by taking their internal target numbers. I use this simple analysis less as a final say and more as a conversation starter. I look forward to those of you who are able to give a better expected loss calculation.
Wells Fargo and November Sales
Wells Fargo's note is definitely worth reading, especially their assertion against additive stake analysis instead of multiplicative. Additionally, some have remarked on JCP's move to open 10 hours earlier this year than last. This bumps SG&A up as noted by Elephant Analytics in his excellent piece. Furthermore, November 2012 revenue decline was exacerbated by Hurricane Sandy, making for their worst month as estimated by Wells. However, something is missing.
Other commenters have noted the lesser days after Thanksgiving this year as a way December sales can be augmented. Conversely, as Elephant noted in his last piece, because the National Retail Federation (NRF) reporting calendar has shifted up this year vs. last, the number of days post-Thanksgiving will be roughly the same. But, if JCP is following industry standards and adjusting last year to this year based on NRF guidelines before reporting monthly year-over-year sales increases, the resulting reporting period will reflect the time frame in the table below.
This period reflects not only an extra five to six days after Thanksgiving, but includes an extra Saturday of shopping, Dec. 1, 2012. Which leads to the following argument: Most holiday sales take place following Thanksgiving dinner. Thanksgiving dinner took place a week later in 2013 than in 2012. So November missed out on five to six prime selling days. These sales are pulled into December, and because Christmas is the same day every year, are consolidated into fewer days. We cannot say those sales are lost. One might argue that the 8+24 = 32 days of selling in 2012 became 2.17 + 24 = 26.17 days of selling in 2013. The relationship can be seen in the following table.
Now, if we expect JCP's holiday sales to be slightly up this year relative to last, and we know that relative to last year more holiday sales will fall in December, what does that tell us? December could be a good month despite the November acceleration of only 2.3%. Bears should be cognizant of a post-December Ullman PR bump.
So, I'm not exactly sure what to believe here. NRF standards are like parley to pirates -- merely guidelines instead of law. I would imagine litigation-prone JCP would have more of a do-it-by-the-book type of mentality, but I'm no Disney Imagineer.
Seeking Alpha's Workhorses
Seeking Alpha would not be the same without commenters to keep the contributors in line. One commenter recently noted a seemingly negative scenario: a lessening of Inv + Liquidity quarter over quarter. The additional $300 million in liquidity is a good thing for positive cash flowy reasons. By taking the aggregate of Cash + INV drop as a negative , one could be mistaking A - L = SE. Three hundred more in liquidity comes from selling inventory, which is a cash-positive event. The $550 difference pointed out is balanced on the liabilities side by accounts payable. Both have a pretty good delta correlation.
The unexplained cash shortage line may be confusing, but all it really means is there should be more cash if the model was all-encompassing. This means there are cash leakages elsewhere. So obviously these numbers are back-of-the-envelope, but accounting identities and whatever.
Additionally, the commenter assumes net operating losses(NOLs) are worthless, and I'm interested in that conclusion. In the case of future profitability, and buyout scenarios, they are not worthless. From what I can see, they would only be worthless in a complete liquidation of firm assets with no acquirers of the holding company. Currently, the directly related deferred tax assets aren't reflected to decrease litigation exposure if things don't work out. However, this doesn't mean that these assets will go unaccounted forever.
In my last article I mentioned my future intentions, but life got in the way. I do, however, still plan on delivering a couple more articles as soon as possible. The first may be broken into two because it covers a lot: my cash flow model, Bloomberg forward estimates, volatility estimates within sensitivity tables, Citi's real estate model vs. others, weekly/three-day derivative of revenue growth rates, forward-year capex estimate attainability, and some gross margin tinkering derived from November's earnings call.
The other articles will be trade suggestions based off of multiple tradable securities. Capital structure arbitrage and hedging strategies will be a focus. Below is a quick teaser of what is to come.
In a word: chaos. So to answer my lead in: possibly bearish -- just not yet. The comment section is a perfect place to bash me and/or request additional analysis.