Ackman’s J.C. Penney Losses Signal Buyout Need: Real M&A

Bill Ackman’s best shot at salvaging his investment in J.C. Penney Co. is to push the department store to go private before it runs out of cash and loses another billion dollars for shareholders.

In the 2 1/2 years since hedge-fund manager Ackman became the largest shareholder, J.C. Penney has fallen 48 percent, handing Ackman losses. The retailer is now trading at a 72 percent discount to its $13 billion in annual revenue, the second-cheapest among U.S. department-store chains, according to data compiled by Bloomberg.

Because J.C. Penney also has the industry’s highest ratio of net debt to market value, a traditional leveraged buyout is unlikely, said Morningstar Inc. Instead, Ackman would need to find buyout firms willing to put up cash for a deal and buy time for Chief Executive Officer Ron Johnson, a former Apple Inc. executive, to attempt a turnaround by converting the department stores into collections of boutiques. Another option is to place some properties into a real estate investment trust, according to International Strategy & Investment Group LLC.

“Ackman needs to act sooner rather than later,” Sachin Shah, a special situations and merger arbitrage strategist formerly of Tullett Prebon Plc, said in a phone interview from New York. “It’s difficult because J.C. Penney has made so many missteps, burned a lot of free cash flow and sales have dropped. What he really needs are equity backers.”

Hiring Johnson

Daphne Avila, a spokeswoman for Plano, Texas-based J.C. Penney, declined to comment on whether the company is considering going private or any other strategic options. Ackman didn’t respond to a phone message or an e-mail seeking comment on plans for his J.C. Penney investment.

Johnson took over as CEO of J.C. Penney in November 2011 after working at Target Corp. and then helping Apple create its retail stores. When Johnson was hired, Ackman called it “a credit to the company.”

Instead, J.C. Penney’s stock has tumbled as the 111-year-old retailer lost $4.3 billion of revenue in the first year of Johnson’s turnaround plan as a model of “everyday low prices” drove away customers accustomed to promotions and special sales. The company reported a record $985 million loss for the year on what was its lowest annual sales figure since at least 1986, according to data compiled by Bloomberg. Same-store sales were down almost 32 percent in the quarter that ended in February.

The setbacks have left J.C. Penney’s equity priced at 28 cents for each dollar of revenue, a valuation that lags behind Macy’s Inc., Nordstrom Inc., Kohl’s Corp., Dillard’s Inc. and Saks Inc., data compiled by Bloomberg show.

Roth Sells

This month, one of Ackman’s longest-standing investment allies and fellow J.C. Penney board member Steven Roth dumped more than 40 percent of J.C. Penney shares held by his firm, Vornado Realty Trust. Ackman’s Pershing Square Capital Management LP faces potential losses of about $370 million on a $1 billion investment initially disclosed in October 2010, when he and Roth both bought stakes, data compiled by Bloomberg show. Ackman also is on track to lose money on derivatives tied to the stock.

“If the business keeps going in the direction that it has been going, the major investors will have to find an exit strategy,” Bernard Sosnick, an analyst for Gilford Securities Inc. in Melville, New York, said in a phone interview. “Vornado has already taken the first step.”

Ackman said in June that a private-equity firm, which he didn’t name, approached him about buying J.C. Penney shortly after he acquired a stake in the retailer.

Going Private

“While we welcomed this fund as an owner of the stock, we had no interest in selling the company for a quick premium because we believe in the long-term value creation opportunity,” Ackman said in a letter to investors at the time.

J.C. Penney would be better off as a private company while it attempts this turnaround because shareholders don’t have the stomach for further losses, according to Shah. The company’s shares have fallen 55 percent in the last 12 months, reducing its market value to $3.6 billion from $7.7 billion, after seven straight quarters of sales declines.

Ackman and any potential suitors need to act quickly to strike a deal, and retaining the company’s real estate and Johnson as CEO would be crucial for a successful buyout, Shah said.

“As time diminishes for Johnson to turn this around, the chance that this company is taken private also diminishes,” he said. “The sooner that they’re able to do that, the smaller the equity check would have to be. But if they wait and keep burning cash, J.C. Penney will have to burn the assets they have, and once you sell real estate, it’s gone.”

Buying Time

An acquirer with deep pockets that’s skilled in restructuring floundering businesses could take advantage of J.C. Penney’s weakness and buy it out, said Rick Snyder, a New York-based analyst for Maxim Group LLC. Still, going private won’t necessarily bring back J.C. Penney’s customers, which were turned off when it moved away from a coupon and promotion model, he said.

“This is the kind of makeover that people sometimes do in private equity,” Snyder said in a phone interview. “It could buy them time, but it may not solve the problem -- they have fired their customer.”

Other department store chains are unlikely to bid for J.C. Penney, Snyder said. The company’s debt would be a hurdle to a traditional LBO because such a transaction would involve borrowing more money, said Joscelyn Mackay, a Chicago-based analyst with Morningstar who added the retailer to her list of bonds to avoid.

Debt Overload

According to Shah, the trick will be finding financial suitors willing to contribute equity for a deal so that its debt load doesn’t increase.

The retailer already has $2.9 billion of debt and $930 million of cash and equivalents, and had negative free cash flow last year. It’s the only U.S. department store chain larger than $1 billion that has net debt equal to more than 50 percent of its market value, data compiled by Bloomberg show. On Feb. 28, Standard & Poor’s downgraded its credit rating one level to CCC+, five rungs above default, and called its liquidity position “less than adequate.”

An LBO “could give current shareholders an exit strategy before the bleeding gets worse,” said Carol Levenson, a Chicago-based analyst with Gimme Credit LLC. “But it would be a terrible idea, loading an already struggling company with additional debt. That perhaps would turn out to be fatal.”

Cash Burn

J.C. Penney spent $810 million on capital expenditures in the fiscal year ended Feb. 2, and Chief Financial Officer Ken Hannah said its adjusted cash is about $850 million. That means it can operate without financing for about 12 months, based on a free cash flow deficit of $822 million for the past year, according to data compiled by Bloomberg. Hannah said at a conference last week the company hasn’t tapped a $1.85 billion revolving credit line and that it still plans to self-fund the company’s transition to its new business model.

Deborah Weinswig, a New York-based analyst with Citigroup Inc., expects the company will have to either raise $1 billion or draw that amount from its revolver to fund the turnaround this year. Still, the potential for asset sales, a private takeover and senior leadership changes could help support the stock price, she wrote in a March 6 note to clients.

J.C. Penney could spin off its top 300 stores into a REIT-like entity that would sublet space to other brands, such as Ugg, H&M and Calvin Klein, and take on all of the company’s debt, according to Omar Saad, an analyst with ISI in New York. He estimates the REIT’s shares would trade for about $40 apiece, with the remaining J.C. Penney business worth $6 a share.

Short Sellers

Shares of J.C. Penney rose 6.2 percent yesterday, the most in almost a month, after Saad’s report was published.

Today, the stock fell almost 1 percent to $16.28.

Still, Maxim’s Snyder estimates J.C. Penney’s shares could drop an additional 39 percent this year to only $10 apiece -- what he called a short seller’s dream. In a short sale, traders sell borrowed stock on the assumption the price will decline and make money by buying it back at a lower price.

Short interest was 27 percent on March 1, the highest since at least 2006, according to Markit. More than 43 million of J.C. Penney’s 219 million shares outstanding were sold short as of March 14. At almost 20 percent, that’s higher than the proportion at 99 percent of companies in the Standard & Poor’s 500 Index, data compiled by Bloomberg and Markit show.

With analysts and investors wagering on a further deterioration in J.C. Penney’s value, Morningstar’s Mackay says speculation is mounting regarding the retailer’s next move.

“The turnaround really hasn’t borne any fruit to date,” Mackay said. “Both equity and credit investors are getting impatient.”

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