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Summary

  • JCP is still a risky stock; a long position doesn't make sense at $8 or $9.
  • Stagnation is a real possibility as the company shores up its cash reserves and plays it safe.
  • Buying the bonds and shorting the stock in the right proportion will allow you to take advantage of the high coupon yield without significant exposure.

Over the last few months, the future of J.C. Penney (NYSE:JCP) has been the subject of hot debate and endless commentary, with almost every possible scenario being played out to its logical conclusion. Since the Q4 earning report last week announced earnings $.12 above analysts' expectations, the bears have been quite subdued and the previously incessant cries of bankruptcy are all but gone. And while the Market apparently thinks that JCP is worth 50% more than it was a month ago, caution should not be abandoned. There are still a few ways in which JCP could fail the bulls.

First, I don't believe that the threat of bankruptcy or dilution is totally off the table. Optimistic guidance supplied by management notwithstanding, JCP is still close to the edge and will dry up a substantial amount of its liquidity buying up inventory going into the 3rd Quarter holiday season. The company's failure to perform at any time during the next year (especially during Q3) could lead it to the edge of the same cliff from which it just now backing away. Furthermore, if management sees trouble on the horizon, they may try to leverage the higher stock price into a more favorable dilution scenario. While dilution at $5/ share is devastating, dilution at $9/share is not much better.

The second way that JCP could disappoint is by conservatively building up its cash reserves, slowly strengthening its financial position and then failing to innovate or grow. In short stagnating. As has been pointed out many times by SA contributors of all stripes, and other commentators, retail is not an easy market to be in these days, and by all accounts, the competitive atmosphere is only getting more intense. JCP, and anyone in the retail landscape, is at a critical point in their existence, where they will either take bold innovate steps toward redefining their role in the marketplace, or be destined to become cash cows with dwindling margins and diminishing revenues. The main traits that will separate the growth companies in the retail space from the laggards are vision and resources.

JCP has neither.

Resources

To say that JCP has no real resources is to say nothing at all. It is barely maintaining minimum liquidity, it is already levered to the hilt and there is no way it is getting any more debt financing for a long time to come. Safety is the name of their game. On the conference call, management touted their decrease in SG&A and CapEx, with the implication that they are in the mindset of cutting expenses at every opportunity. They simply don't have the cash to innovate and grow. They are hanging on for dear life. Even after they get back on their feet, I believe they will continue to build up their cash reserves until all fears of bankruptcy are allayed. A brush with death like this leaves its mark.

Vision

As far as vision goes, JCP already had its shot. They installed as CEO a rising star from arguably the most visionary company doing business - Apple. Ron Johnson's tenure was by all measures disastrous, and may still end up bankrupting the company. Vision has been tried. It failed. JCP doesn't get another chance. The board's decision to bring back Ullman signals its return to the tried and true. The move means more than just going back to being a discount store, it means conservatism is on the agenda. I'm not arguing that this is the wrong strategy, indeed it probably saved the company, I'm simply saying that it does not engender long-term growth. It's hard to summon the courage to try anything new when the last attempt ended so badly.

Conclusion

The stock does not have a lot of upside left in it. It may have been a buy at $5/share, but at $8 or $9, I don't see the growth to make it worth the risk. That being said, there is a way to bet on JCP's slow recovery and stagnation. The 2097 maturity bonds are trading with an effective annual yield of 11.75%, a number that will likely get pushed to 12% as the prices calm down after the Q4 earnings excitement subsides.

These bonds would be the perfect assets to be invested in if JCP ends up doing well enough to avoid bankruptcy, but not well enough to create significant future growth.

The same conservative approach that will hamper stock will be perfect for the debt, and 12% is a nice yield for a bond that will last till 2097 and is still trading at a fraction of face value. I used the last year of data from JCP and a JCP bond trust fund, PFH (basically an exchange-traded bond fund with a face value of $25), to see how the two prices moved relative to each other, and found that while they are obviously positively correlated, the stock is about three times as noisy as the bond.

(click to enlarge)

I calculated the Beta of the PFH vs. JCP, just like you would calculate the Beta of a stock vs. the market, and found that PFH has a beta of .31, meaning that for every 10% change in the return of JCP, the return in PFH will generally change about 3%. By using only the last year of data, I have effectively eliminated interest rate risk that bonds can be subject to and zeroed in on the change that is due to default risk.

Using this data, it would not be difficult to construct a hedged portfolio by buying the bonds and shorting the stock, effectively hedging out everything but the coupon payments.

Suddenly stagnation isn't looking so bad.

Source: Betting On J.C. Penney's Stagnation