J.C. Penney: KTP Looks Less Attractive At The Moment Based On 2097 Bond Values

|
About: J. C. Penney Company, Inc. (JCP)
by: Elephant Analytics
Summary

Javier Teruel's open market purchase of over 900,000 shares is another indication that J.C. Penney is quite unlikely to file for bankruptcy in 2019.

I believe that J.C. Penney should be able to deliver over $500 million EBITDA in 2019.

This does require a bit of gross margin improvement during the rest of the year, as its EBITDA would end up around $400 to $450 million based on Q1's results.

KTP has historically traded at a slight to moderate discount to the value of the 2097 bonds. It has recently traded at even a slight premium.

I would continue to argue that J.C. Penney (NYSE:JCP) is quite unlikely to file for bankruptcy in 2019, and the recent open market purchase of nearly 1 million shares by one of its directors is another point against the idea of a 2019 bankruptcy. That being said, I have sold my position in KTP for now since its price has run up a bit recently, while the value of its underlying securities has essentially remained unchanged. This has resulted in it momentarily trading for a slight premium to the 2097 bonds.

Insider Purchases

Javier Teruel (one of J.C. Penney's directors) recently purchased around 941,000 shares of J.C. Penney's stock on the open market for a bit under $0.99 per share. This more than doubles his position in J.C. Penney to 1.764 million shares.

I'd view this purchase as another strong data point that J.C. Penney is very unlikely to file for bankruptcy in 2019. There have been suggestions that J.C. Penney should file for bankruptcy soon, so that it can clean up its balance sheet and avoid liquidation (with the idea that waiting until the situation gets more desperate to file for bankruptcy increases the risk of liquidation). However, this purchase appears to be a clear indication that J.C. Penney is not considering this course of action at the moment.

That being said, Teruel has purchased J.C. Penney shares on the open market in the past (in 2014 and 2017), when it was trading significantly higher. I wouldn't read too much into his purchase other than that it suggests that J.C. Penney has no immediate plans to file for bankruptcy, and that gives it at least some time to take a shot at a turnaround.

About EBITDA

I'd agree that using Q1 run rates to project J.C. Penney's full-year EBITDA is not the best method to use. Results for Q2 and Q3 tend to be fairly similar to Q1 in terms of sales, SG&A and average gross margins. Thus, it would not be surprising for J.C. Penney to record around $70 million EBITDA in each of those quarters (and perhaps a bit less due to the timing of credit income).

However, Q4 sales are typically much higher than Q1 sales (often around 40% higher), while the increase in SG&A is significantly lower (such as 15%). Gross margins are lower in Q4, but assuming that there is no improvement from Q4 2018's gross margins (outside of the positive impact from discontinuing the sales of major appliances and in-store furniture), Q4 2019's EBITDA would probably be in the $200 million to $250 million range. This is based on Q1 2019 sales and SG&A numbers and adjusting for the typical Q4 increases compared to Q1.

Thus, it would be probably fair to estimate that J.C. Penney's 2019 EBITDA would end up in the $400 million to $450 million range based on a continuation of Q1 2019's results.

My estimate for 2019 is a bit higher at $526 million due to my assumption that a cleaner inventory situation and reduced shrink should boost its gross margins a bit.

Notes On KTP

I've sold my position in KTP for now, partly because the value of its underlying securities is now slightly less than what KTP is trading for.

The underlying securities (the 2097 bonds) are now trading at roughly 25 cents on the dollar. Including accrued interest, this translates into a price of approximately $6.78 for KTP. The price of KTP itself has touched $7 recently.

Historically, KTP has traded for at least a few percent less than the value of its underlying securities, and sometimes at a significantly greater discount. For example, in the first half of April, the 2097 bonds traded at approximately 35 cents on the dollar. Including accrued interest, this would suggest a value of around $8.95 for KTP, but KTP traded for approximately $7.50 at the time.

I believe that KTP's expected return at $7 is still a bit favorable based on my estimates around its bankruptcy risk by each year. However, KTP's risk-reward profile at around $7 post-Q1 earnings isn't as attractive as before (such as when it traded at around $7.50 pre-Q1 earnings and at below $6 post-Q1 earnings).

Conclusion

All signs continue to point to J.C. Penney's bankruptcy risk in 2019 being quite low. While it does face major challenges, the chance of it getting at least one more holiday season is probably around 99%. J.C. Penney does need to start showing some progress in terms of improving its gross margins in 2019 and then improving its comps in 2020, though, since it needs higher EBITDA in order to reduce its leverage to more reasonable levels.

I'd continue to favor J.C. Penney's bonds and bond trusts over its stock, although as mentioned above, KTP doesn't appear to be as good a value now that it has gone up over 20% since the beginning of the month.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.