Shrewd Investors are Buying A&P's Unique Bonds

Includes: GAJ, GAP
by: Mark Krieger
The regional grocery chain has had a spectacular run-up lately, surging over 100% from $5.97 in early Sept. to nearly $13 last week. The stock’s stunning rally is by no means a result of operational improvement or other change in fundamentals, but rather of a rumor of an impending takeover. The fact is, Billionaire investor Ron Burkle’s Yucaipa Investment company has taken a large, friendly position and has consequently gained board representation.
Further proof of a potential change of ownership was a German newspaper article reporting that GAP’s largest shareholder, the Tengelmann group, is investigating the feasibility of the sale of their entire ownership stake. Interestingly enough, GAP’s corporate bonds have stayed relatively flat in the same timeframe and offer the investor a chance to exploit the inefficiencies of an efficient market by enabling them to buy into a much stronger scenario without having to pay a higher price.
Second quarter earnings: Sales of the regional grocer (who runs both Pathmark and A&P) fell by more than 4% from $2.2 billion to $2.1 billion. While the company’s loss expanded from -$1.97 to -$3.97, its gross profit margin surprisingly improved 30 basis points from 29.8% to 30.1%.

Although the supermarket chain attributed its poor results to a soft economy and its inability to get its Pathmark acquisition up to full potential, it is still cash flow positive. The company announced that it would be seeking a new CEO immediately with the resignation of its current CEO, Eric Claus. Board Chairman Christian Haub will assume interim CEO responsibilities until a successor is named.
The bonds: Gap corporate bonds (GAJ) are very unique. These 9 3/8%, 30 year bonds (aka quibs) were issued ten years ago when the prime rate was 8.25%. They were sold in $25 units (par value) and are traded on the NYSE (8 million shares were issued raising $200 million). Most bonds are sold in $1000 increments and are not traded on the NYSE, that is why these bonds are so unique. Their annual payout of $2.34 equates to a current yield of 10.7% and obviously with a yield so high, they are non investment grade.
The upside: If GAP is eventually acquired, bond holders would have to be paid par value before the acquisition could take place. That would give the holder an immediate 14% gain from the bond’s current price. Another scenario would be GAP calling the bonds at par value so they could reissue new bonds at a lower interest rate (today’s prime rate of 3.25% is more than 60% lower than what the prime rate was (8.5%) when the bonds were originally issued).
Shrewd investors are buying the bonds: Both Gamco Asset Management (managed by Mario Gabelli) and Barclays Global Investors have been aggressively acquiring bond shares. GAMCO who owns 5.4 million shares and recently acquired another 256,000 shares, while Barlcay’s added another 66,000 shares, bringing their total to 2.1 million shares. Further accumulation by these two major bond holders should bode well for GAJ’s price, especially considering its low liquidity status (average trading volume of only 17,000 shares creates substantial volatility).
Bottom line: Buying these bonds is appropriate for those with both short term and long term horizons. Those with a buy and hold approach will be getting a very juicy return, thanks to the dividend. Those wishing to make a fast buck could see a nice 10% pop in the very near term as the bonds are now at about the midpoint of their $20-24 trading range and have been trending higher.
Author's Disclosure: long GAP and GAJ