Seeking Alpha
Macro, contrarian, bonds
Profile| Send Message|
( followers)  

Summary

  • Determine which portion of the capital structure provided the better return to investors. Did the common stock or bond outperform?
  • Explore decisions that may have contributed to the poor financial performance. And the tough management decision that helped aid the turnaround.
  • A few catalysts that might improve investor sentiment and move the stock and or bonds..

Stock and Bond Performance

The table below highlights the change in price of the J.C. Penney (NYSE:JCP) bonds and common stock from the March 5, 2013 article to July 9, 2014.

March 5, 2013

July 9, 2014

Price Change $

Price Change %

Common Stock

14.96

8.94

(6.02)

(40.24%)

6.375 of 2036

72.75

83.50

10.75

14.77%

5.750 of 2018

80.25

95.24

14.99

18.68%

5.650 of 2020

79.50

88.81

9.31

11.71%

From the prior article:

"An equity raise that improves the financial position of the firm, might see the credit rating stabilize or improve. This might result in an improvement in prices and or credit quality."

J.C. Penney did an equity raise but the credit rating has dropped a notch. However, the bond prices have improved.

"At times the best investment for total return (income + capital gain/loss) can be the less risk instrument in the capital structure. This appears fit the description."

The table above illustrates that the less risky bonds have handily outperformed the more risky common stock performance without taking into account the interest income from the bonds. The common stock paid no income.

Is it time to consider an equity investment in J.C. Penney, given the negative sentiment? It is worthwhile to review how J.C. Penney arrived at the situation it faces today.

Board of Directors Risky Trade:

During the first half of 2011, the board of J.C. Penney approved the purchase of roughly 24.4 million shares for $900 million, or $36.98 per share. During September 2013, it sold roughly 84 million shares at $9.65 per share that raised less than $900 million. The net effect of the 2011 share repurchase program was to increase the loss per share, increase the leverage of the firm, increase the cost of capital, and limit financial flexibility. The financial engineering did not work unless you were a former shareholder that exchanged shares for corporate cash.

Shareholder might wish to pressure the board of directors for a prohibition on any future share repurchase plan. Unless it is a Dutch tender permitting all shareholders the opportunity to exchange shares for corporate cash. However, bondholders may wish to see a total ban on share repurchases.

Board Members Exit:

It is baffling why the board would wait until two large shareholders and former board member disposed of their entire equity stakes at roughly $13 per share before they decided to tap the equity market for capital at $9.65 per share.

The equity capital raised should provide some comfort for bondholders as the financial leverage has been reduced. This should increase the odds that interest and principal shall be paid in a timely manner.

More surprisingly is that Wall Street permitted two large investors to exit at what turned out to be attractive levels. Economics would have suggested large and quick sale of concentrated holdings to a new diverse ownership base might have required a discount, or haircut.

What is done is water over the bridge. The tough decision to raise equity capital resulted in some unhappy shareholders. However, the move to increase equity is seen as a positive.

Bonds versus Stock:

In this article from February, I argued that the bonds offered a better risk-reward situation over the common stock.

For those with a high tolerance of risk,the common stock may now offer attractive risk-reward trade for the following reasons.

  1. Two large insiders and former board members have sold their stock.
  2. Roughly, $800 million is being raised with the sale of 84 million shares.
  3. Most of the news has been negative, with high negative sediment.
  4. Short interest of 82.7 million shares, as of June 13, 2014. Down from 130.9 millions shares on February 28, 2014.
  5. The poison pill is set to expire in August 2014

Alternatively, build your own convertible bond by pairing a bond with some common stock. This way you are paid to wait with the bond interest. In addition, should J.C. Penney stage a turnaround then the common stock may provide for great upside appreciation than the bonds.

After the exit of the two former board members and large shareholders, a position was established in the common stock for the following reasons.

  1. Did not expect the "Street" to permit two large shareholders to exit via block trades at a premium price. Boy was I wrong! Citigroup got them great a price at roughly $13. The board then sold stock at what is being reported at $9.65. Double ouch.
  2. The charts looked attractive with the filling of the $12.90 breakout gap.
  3. The bonds were acting well given the turmoil in the common stock and the general increase to interest rates.

What could go wrong?

  1. Retail sales could continue to stagnate or decline.
  2. J.C. Penney could lose knowledgeable sales staff making the customer experience less than ideal.
  3. Management may make merchandising errors that cost sales and profits.
  4. Gross margin fails to improve.

What could go right?

  1. Customers give J.C. Penney a second chance.
  2. Management strikes the perfect merchandising mix
  3. Gross margin expands faster than expected
  4. Sales improve faster than expected as the remodeled stores attract customers.
  5. Management decides to reward all employees for a turn-a-round success. This might encourage all to work together to improve sales, profits and the customer experience.

The over whelming sediment is negative on the chances of J.C. Penney. This is good news and bad news. The bad news is in the stock price, and most news coverage will focus upon the negative. The question I ask. How much worse can the news get? I do not see anything on the horizon that would be a surprise. In fact, should a surprise occur it could be favorable. Say better than expected sales, and or gross margin.

There are major headwinds facing the employees of J.C. Penney. However, this is America, and it is not wise to under estimate the American worker. A mild favorable breeze may see JCP experience retail turnaround like Team Oracle with the America's Cup. Not many believed that Team Oracle could or would win eight must win races in a row but they did. Is Team Penney up to the challenge? I have placed my bet on it.

Source: J.C. Penney Stock Versus Bond Update