In recent days, J.C. Penney Company, Inc. (NYSE:JCP) added another world-class hedge fund manager to its shareholder list. George Soros reported buying a stake worth 7.9% of the company in a new 13G filing with the SEC.
In filing a 13G instead of a 13D, Soros indicated that he has little interest in activism. Rather, Soros is along for the ride, potentially to team up on proxy votes with activist investor Bill Ackman, but not to make waves of his own.
J.C. Penney Company, Inc. (NYSE:JCP) rose on the announcement of a Soros stake. The stock also rocketed as Wall Street received word J.C. Penney may get a much-needed lifeline.
J.C. Penney’s good news
Goldman Sachs Group, Inc. (NYSE:GS) has agreed to help secure a round of debt financing for the company worth as much as $1.8 billion, which will be backed by the company’s real estate, leases, and other assets.
Investors have been particularly concerned about the quality of J.C. Penney’s balance sheet, especially its vast real estate holdings. J.C. Penney owns 41 million of its 111-million square feet of retail space.
Real estate heavy retailers have been under the watchful eye of investors for years. Commercial real estate markets are cyclical and prone to quick revaluations during times of recession. Vacancies are only now coming off a multi-year high, and are still above 8% for shopping malls.
J.C. Penney Company, Inc. (NYSE:JCP)’s anchor properties are especially illiquid. Only large retailers can take their place – and there are significantly fewer department stores than small- scale storefront tenants. Selling pressure is also driving real estate values lower.
Sears Holdings Corporation (NASDAQ:SHLD), which owns Sears and K-Mart department stores, owns its own real estate, which it has recently sought to liquidate. Closing stores mean more supply, which begets lower valuations.
After closing 120 stores in 2012, Sears Holdings Corporation (NASDAQ:SHLD) could close even more in 2013. The company’s reliance on appliances is dragging down profits at a time that the whole department store model is in flux.
Unfortunately for J.C. Penney Company, Inc. (NYSE:JCP), Sears Holdings Corporation (NASDAQ:SHLD)’ freed up real estate will constrain the value of J.C. Penney’s-owned real estate. Sears is rumored to be closing as many as 125 Sears stores in 2013, as well as 225 K-Mart locations as it thins out its money-losing store count.
In securing a new term loan, J.C. Penney shakes off a key concern: raising cash to survive a turnaround. Once the loan goes through, investors no longer have to worry about its real estate portfolio since it got what it needed in the first place – much needed cash. J.C. Penney won’t need to sell its properties either, which limits cash-flow strain from future leases.
Why J.C. Penney still isn’t out of the danger zone
Financing is only one of many woes. J.C. Penney Company, Inc. (NYSE:JCP)’s latest quarter was nothing short of disastrous. Its changing marketing strategy from promotions to everyday prices to promotions isn’t helping its top line. The company reported same-store sales were down 32% in the fourth quarter. Later, the Wall Street Journal reported that the company’s first-quarter sales weren’t much better. Sales were on pace to decline 10%.
That’s no good.
Analysts see J.C. Penney Company, Inc. (NYSE:JCP) burning through roughly half of its $930 million in cash in the first quarter. That would leave J.C. Penney’s financials to weaken substantially, as upon securing a new term loan, the company will have roughly $2.1 billion in cash against debt of $4.7 billion. The new loan would add $120 million to its pre-tax interest expense.
Compared to the competition, J.C. Penney is in for a world of hurt. Macy’s, Inc. (NYSE:M), one of its strongest competitors, trades at a big discount to the market despite its strength.
Macy’s, Inc. (NYSE:M) market share grew to 15% in 2012, much of which likely came from the decline in J.C. Penney’s same-store sales. The two rivals both sell branded clothing.
Macy’s, Inc. (NYSE:M) also has a track record for impressive cash-flow generation (more than $1 billion per year since 2009), and its BBB-debt ratings allow it to borrow to fund share repurchases. J.C. Penney Company, Inc. (NYSE:JCP) can barely borrow against its real estate assets just to buy more time. Furthermore, Macy’s has the balance sheet to survive a price war. The company can tolerate lower margins to steal share and drive competitors to the brink of bankruptcy.
A compelling valuation at less than 10 times forward earnings and 13 times free cash flow makes Macy’s a much better play on the same customer.
Why play turnaround when you can play strength?
The next question for investors is why? Why position yourself in a retailer in a competitive industry that might turnaround its slumping business model when two competitors sell so cheaply?
The department store business is in a material, terminal decline. Department store revenue fell by more than 20% through the 2000s. This trend will certainly take a bite out of J.C. Penney before it touches profitable and cash-flow positive Macy’s.
A real estate-driven thesis for J.C. Penney is slowly losing credit as other department stores liquidate money-losing locations. Sears’ exit from department stores would have the greatest impact on J.C. Penney’s-owned real estate comps.
Sell the laggard and buy the winner in this highly-competitive industry. J.C. Penney Company, Inc. (NYSE:JCP)’s first quarter sales figures suggest it has forever lost its customer base. Those customers are happy Macy’s customers, and at 10 times forward earnings and 13 times very routine cash flow generation, Macy’s is a much better wager.
The article Neither J.C. Penney’s Loans nor Soros Can Keep It From Failing originally appeared on Fool.com and is written by Jordan Wathen.
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