J.C. Penney (NYSE:JCP) stock has been noticeably weaker going into December comps and has been weak ever since Kyle Bass announced his sale and the SEC announced their investigation. The prices of the bonds and the bank debt are all basically on their recent highs - where they used to be seemingly chained to the price of the stock. So what does this mean for December and q4 comps which will drive the next leg up or down of the stock? The answer is not exactly crystal clear but I will take a shot at it: The fixed income securities are telling you that December was good enough that sales and margins are not enough to blow a hole in the capital structure which is good news. It probably means that JCP will come close to street expectations of low to mid single digits sales growth in Q4 and some modest amount of EBITDA..
The stock is trading as if that is not enough or on fears that it will be far worse. Given how much information the distressed debt market has access to versus the equity markets - particularly the banks who get monthly numbers if they sign confidentiality agreements, the debt trading is good news. The stock appears to be irrationally pricing in a massive earnings miss. Now the frost hitting the Midwest and Northeast is clearly not good for any retailer so perhaps that is a fear being priced in but other department store stocks appear to be doing just fine, so I doubt that is the reason. JCP also has a national footprint so the frost wouldn't hurt some of their sunbelt stores. Also, cold weather tends to drive sales of high margin winter coats and apparel so its mixed blessing to maybe good for the Company. Bloomberg is out with a research note saying that their retail panel interest in JCP increased to 43% from 12% in the first half of 2013, which indicated that CEO Mike Ullman's sales and promotion strategy is working. Even Imperial, bear on JCP, is out with a note saying the long-dated bonds are one of their best ideas going into 2014. So while I don't like to ignore technical weakness in JCP stock, I believe the strength in the bonds trumps the weakness in the stock and would add to stock positions here.
One of the errors that the bears are making is that they seem oblivious to the impact of a very modest recovery in EBITDA and multiples from their low targets. They anchor around these number to give them and their readers a false sense of security that even if JCP makes it, nothing can really hurt the shorts. I had many comments about recent bearish arguments made against JCP stock so I though I would summarize them in this article just so people can see what risk there is in taking the short side of the trade. As a thought piece, let's assume a 50% recovery using simple math from the $17 billion pre Ron Johnson sales. You get $15 billion of revenue, put GM at the KSS/BONT level of 36-37% range (36.5%). If SGA is $4 billion, EBITDA would he just over $1.5 billion. There are a lot of ways to skin this cat and get to high levels of EBITDA and Free Cash Flow ("FCF"). If you assume $400mm of Capx (guidance for 2014 is $300mm) and $365mm of interest expense. FCF is about $730 mm or $2.40 a share. Put 10x on that number and you have a $24 stock. If you believe that SGA is too low (I don't, but let's be conservative) and increase it to $4.25 billion which is above the Company's run rate and well above where it will be if the Company implements further cost cuts as they have talked about. In this case FCF declines to about $480mm or just under $1.6 per share. At 10x,you get a $16 stock. Bulls and Bears have been debating this same basic data set for months, but I never hear a bear say hey if I am wrong the stock could go up 200% or more.
In the mid $1 billions of EBITDA, you get huge swings in valuation. What I find fascinating is that bears are willing to anchor valuations at very low levels while not acknowledging that very small changes in EBITDA and multiples create huge swings up and down (though you can't get lower than $0, you can get much higher than $6 as one bear suggested as an upside target (never mind that a billion was just raised by smart investors at $9.6). A $100mm swing in EBITDA at 6x is $2 a share or a massive 25% increase over current levels for a very small swing in EBITDA . At $1.5 billion in EBITDA, a 1-turn change in multiple is $5, a 65% increase off the current quote and a level of EBITDA that many bears concede is possible. Last but not least, $2 billion of EBTIDA, which is where EBITDA was before Ron Johnson came in, yields over $4 of free cash per share and a $40 stock at 10x.
I have conceded many times that JCP could go bankrupt if it doesn't execute. I have just shown that very small changes in assumptions could yield fantastic upside to the stock. Are the bears really considering all the possible outcomes? The shorts in Best Buy (NYSE:BBY) sure didn't see $40 coming when the stock was at $8 a year ago. BBY's financials aren't all that different, but the multiple sure is. AMZN's threat is just as real to BBY today as a year ago if not more so.
Additional disclosure: Positions can and do change at anytime without warning or notice.