J.C. Penney Swaps Erase 3 Years of Progress: Corporate Finance

J.C. Penney Swaps Erase 3 Years of Progress
Customers carry J.C. Penney Co. Inc. shopping bags in a store at the Queens Center Mall in Elmhurst, New York. Photographer: Emile Wamsteker/Bloomberg

J.C. Penney Co.’s creditworthiness is back where it was three years ago in the eyes of derivatives traders as Chief Executive Officer Ron Johnson struggles to revive the fourth-largest U.S. department store chain.

Credit-default swaps on the Plano, Texas-based retailer have soared 165 basis points this week to 620 basis points at 10:57 a.m. in New York, the highest level since December 2008, according to prices compiled by Bloomberg. J.C. Penney’s debt rose to five times earnings before interest, taxes, depreciation and amortization at the end of the first quarter, the highest leverage since 2002.

Investors are losing confidence in Johnson, who arrived in November amid hopes he’d restore the 110-year-old chain to health after leading Apple Inc.’s entry into retailing and overseeing its growth to more than 300 stores. J.C. Penney reported a $163 million first-quarter loss on May 15, its third consecutive deficit, as same-store sales tumbled 18.9 percent and gross margins shrank.

“I expected better with the Apple retail guy taking over,” said Adrian Miller, director of global markets strategy at GMP Securities LLC in New York. “I would not be a buyer yet as we are likely to see more downside pressure over the near term as a further shake-out is likely.”

Kate Coultas, a spokeswoman for J.C. Penney, didn’t respond to a voicemail and e-mail seeking comment on the market moves.

S&P Cuts Rating

Standard & Poor’s downgraded J.C. Penney today to BB- from BB and put the rating on CreditWatch Negative, citing earnings “significantly below expectations” and deteriorating credit metrics.

It’s rated Ba1 by Moody’s Investors Service. Credit-default swaps tied to J.C. Penney have climbed to levels implying its debt should be rated B1, according to Moody’s Corp.’s capital markets research group.

J.C. Penney was listed as one of 29 rising-star candidates by JPMorgan Chase & Co. analysts in April 2011. At the time, they forecast an upgrade in the second quarter of this year.

The retailer has $3.1 billion of debt, with $230 million of 9 percent bonds coming due Aug. 1, according to data compiled by Bloomberg.

The company’s biggest bondholders according to reported filings are Capital Research & Management Co., which runs the American Funds mutual-fund family; Loomis Sayles & Co., and Metropolitan Life Insurance Co., Bloomberg data show.

J.C. Penney shares dropped 19.7 percent yesterday to $26.75 after the company suspended its dividend to conserve cash, erasing a 2.6 percent gain for the year through April. The stock rose 2.3 percent to $27.37 today.

‘Leap of Faith’

“We’re trying to essentially convert the Titanic into 1,100 WaveRunners,” Johnson said during a May 15 conference call with analysts and investors to discuss first-quarter earnings. “And that’s really hard to do. But we’re making a heck of a lot of progress.”

Gross margin, the percentage of sales left after subtracting the cost of goods sold, shrank to 37.6 percent from 40.5 percent a year earlier, and sales slumped 20 percent to $3.15 billion, the company said in a May 15 statement. Johnson has simplified pricing into three tiers and is reconfiguring stores into a collection of branded shops, causing disruption in sales.

“Results in the quarter reiterated that investors are being asked to take a leap of faith in a new strategy and a new management team that is still learning what makes JCP shoppers tick,” James Goldstein, a debt analyst at CreditSights Inc., wrote in a note yesterday.

Swap Gap

The company said discontinuing the 20 cent-a-share quarterly dividend will result in annual cash savings of about $175 million. That failed to sway credit derivative traders, who pushed the contracts tied to the company’s debt, which typically fall as confidence erodes, up 120 basis points since it reported earnings, according to prices compiled by Bloomberg.

Investors now pay $620,000 annually on a contract protecting $10 million of debt that pays out face value if J.C. Penney fails to meet its obligations, less the value of the defaulted debt.

The price gap between default swaps for J.C. Penney and those tied to Sears Holdings Corp., which said in December it would close as many as 120 of its 4,000 stores in the U.S. and Canada, has narrowed by 483 basis points this year, Bloomberg prices show.

“It’s very hard to turn around retailers, and the new CEO has taken a damaged company and he’s really throwing everything up in the air in a big way,” said Bernie Williams, a fund manager at USAA Investment Management Co., which oversees $52 billion in San Antonio. “He’s got to produce some pretty quick results or this thing’s toast.”

‘Getting a Benefit’

In the quarter ended April 28, the company incurred $76 million in restructuring and management-transition charges. Excluding those items, the loss totaled 25 cents a share. The average of 16 analysts’ estimates compiled by Bloomberg was for a loss of 8 cents. J.C. Penney said it will record additional restructuring charges throughout the fiscal year.

Other retailers have been benefiting from the turmoil.

“In markets where we’re competing against Penney’s, we have seen an uptick in business,” Macy’s Inc. Chief Financial Officer Karen Hoguet said on an earnings call last week. “It’s hard to quantify how much, but clearly, we are getting a benefit from what’s happening there.”

Retailers are having to differentiate themselves to attract customers, according to Guy LeBas, chief fixed-income strategist at Philadelphia-based Janney Montgomery Scott LLC.

‘In the Middle’

“Being a ‘general’ retailer isn’t a path to success anymore,” he said. “That’s leading to some companies climbing further upscale, some moving more downscale, but almost none remaining in the middle.”

U.S. retail sales rose at the slowest pace of the year in April, Commerce Department figures showed May 15, as Americans took a break from a shopping spree induced by unseasonably warm weather in prior months and an earlier Easter holiday.

“In a weak consumer environment, he’s trying to reach a more affluent customer, him and everybody else, and that could take years to do,” Williams said. “I just don’t know that he has years to do it.”

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