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Should You Buy JCP?

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On the heels of some much needed good news that its October same-store sales made considerable progress, JC Penney is drawing some attention from big ticket investors. Representing the fund Legg Mason Inc., Bill Miller have been assembling an unconstrained high-income fund based on JC Penney bonds.

Miller said, “We bought some JC Penney bonds with 12 percent yield. JC Penney has a lot of levers they can pull to get the customers back.”

JCP’s stocks remain low, consistently below $10. For the year overall, share prices are down 58 percent. However, the retailers bonds have held strong; a bond that comes to maturity in October 2036 gained 11 percent in the last week to 71.8 cents, now yielding 9.4%.

And Miller is not the only investor interested in picking up JC Penney’s distressed debt. Avenue Capital Group LLC, manager of more than $12 billion in financial assets, recently purchased unsecured bonds of JC Penney’s.

But other investors have been less sanguine about JC Penney’s future prospects. Third Avenue Management, sold most of its JC Penney holdings, a sign that it believes the retailer’s turnaround strategy is unlikely to yield successful results.

JC Penney’s October performance has piqued the interest of many investors and analysts alike. Sales jumped 0.9% for October, a substantial improvement in light of the fact that September suffered a 4% decline. A company spokesperson said that the stronger performance was largely attributable to improved inventory in central private brands as well as an overhaul of the home goods department.

CEO Myron Ullman said, “JC Penney has made significant progress in addressing the challenges it faces, and we believe the company is on the right track to return to long-term profitable growth.” Still, considerable anxieties remain regarding the snail’s pace of JCP’s rebound back into profitability. Many industry analysts acknowledge that the increased sales are a good sign, but that other metrics are actually more significant portents of JCP’s future viability as a retailer.

Speaking to the Wall Street Journal, David Tawil, portfolio manager of Maglan Capital, said, “The important metrics will be gross margin and cash burn, not comp store sales.”

Kristen McDuffy, a credit analyst at Goldman Sachs, concurred: “We expect results to be weak, as improving comps are offset by poor gross margins.”

The prospect of a future liquidity crisis looms large for many.  Just recently, the company watched  its credit rating humiliatingly downgraded by Fitch Ratings from “B-Minus” to “CCC.”

A spokesman for Fitch said that the downgrade was issued to reflect “higher than expected cash burn in 2013.” Also, they anticipate that JC Penney, despite its recent share  sell-off, will still have to see additional funds next year.

A “CCC” classification, under Fitch’s ratings system, indicates that “default is a real possibility.”

According to Fitch, the principal concern is twofold: a much higher than expected cash burn in 2013 and a projected cash shortfall in 2014, pinching JC Penney’s into straitened circumstances. Even with JC Penney adding an additional $3 billion in liquidity this year (and access to $850 million more) it remains a real possibility that the retailer would have to raise even more funds in 2014, especially after what promises to be a punishing holiday shopping season.

As it stands, Fitch forecasts that JC Penney will conclude 2013 with a cash burn of approximately $3 billion, about a billion more than the projections it released in May. JC Penney suffered this year from much weaker than anticipated comp store sales, a listless home department performance, massive markdowns necessary to move piling excess inventory and a significantly contracting gross margin.

As Fitch interprets it, the central problem is not immediate liquidity, since the recent equity offering generated more than $800 million. They also still have the $2.25 billion loan they secured, with the oversight of Goldman Sachs, last May. The more pressing problem is that, sometime during 2014, JC Penney is compelled to borrow even more, likely sinking its stock, frightening already anxious investors and vendors, and leaving itself so over-leveraged it has to sell off physical assets to raise the money it needs to survive.

According to Fitch’s analysis, for JC Penney to continue to fund its annual $400 to $500 million in expenses, plus interest expenses of $360 to $375 million, it must earn at least $750 million before interest, depreciation, taxes and amortization. This means the retailer would have to perform between 14% and 16% above its own projections for 2014, a return to sales between $13.4 billion and $13.6 billion.

Still, Miller’s interest in JC Penney’s, and his unabashed vote of confidence, has generated interest on Wall Street. Miller’s success as an investor is near legendary, beating Standard & Poor’s 500 Index for a record fifteen consecutive years. He manages the Legg Mason Opportunity Trust, worth $1.7 billion, which has enjoyed a return of 21 percent over the last five years, outperforming almost all of its competition. This year, the fund is up 53 percent.

 

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