J.C. Penney's Bonds Decline

New CEO’s turnaround plan deepens losses on retailer’s debt.

J.C. Penney Co. Chief Executive Officer Ron Johnson is finding it harder to convince bondholders than stockholders that his plan to turn around the fourth-largest department-store chain is “on track.”

After the Plano, Texas-based company reported a loss that exceeded analysts’ estimates on Aug. 10 and withdrew its annual profit forecast, J.C. Penney’s shares reversed course to rise the most since January when Johnson told investors that he’s “completely convinced that our transformation is on track.” The company’s $325.6 million of 7.4 percent notes due April 2037 dropped 1.5 cents on the dollar to 78.5 cents.

Johnson, the former Apple Inc. retail chief who joined as CEO in November, is trying to win back customers at the 110-year-old chain. While his hiring prompted a 17 percent one-day stock rise, the extra yield investors demand to own J.C. Penney’s bonds rather than Treasuries has more than doubled to 7.66 percentage points, which would represent an extra $41.6 million in annual interest on each $1 billion of new financing.

“Investors on the bond side are concerned in the medium term what cash flow starts to look like, whether they can actually turn around sales,” James Goldstein, an analyst at CreditSights Inc. in New York, said in a telephone interview. “At this point, they’re relying on promises.”

Daphne Avila, a spokeswoman for the company, declined to comment.

Johnson embarked in January on a four-year overhaul of the retailer in a bid to make it “America’s favorite store.” The executive, who also helped create Target Corp.’s persona of “cheap chic,” has been struggling to communicate a shift to “everyday low prices” to customers as it cuts sale events and coupons in pursuit of a pricing model similar to that of Wal- Mart Stores Inc.

His project hasn’t paid dividends. Comparable-store sales fell 21.7 percent in the quarter, the company said in an Aug. 10 statement. It also has the retailer running through money, with a cash burn of $934 million so far this year, Virginia Chambless, an analyst at JPMorgan Chase & Co. in New York, wrote in an Aug. 10 report. J.C. Penney suspended its 20 cent-a-share quarterly dividend in May.

The spread, or yield premium over government debt, that investors demand to hold J.C. Penney’s bonds has climbed from 350 basis points on June 13, before Johnson’s hiring. The 7.4 percent notes have lost 9 percent since then, including interest, while the Bank of America Merrill Lynch High Yield Super Retail Index has returned 9 percent.


Liquidity Concern

Chief Financial Officer Ken Hannah, who started in May, said on the Aug. 10 conference call that he “was really surprised” to hear investors express concern about the company’s balance sheet and liquidity. J.C. Penney ended the quarter with $888 million in cash and $2.9 million of long-term debt, according to the statement. J.C. Penney will end the year with more than $1 billion of cash, he said.

“It’s important to note that even when you look at some of the credit downgrades that have come through, it’s not because of the company’s liquidity,” he told investors and analysts. “It’s a question as to whether or not we are going to be able to execute the pricing and merchandising and shops strategy that we are talking about.”

Moody’s Investors Service downgraded J.C. Penney to Ba3, three levels below investment grade, after the earnings announcement, while last month Standard & Poor’s cut its rating to B+, one grade lower. Performance will remain weak for the next year, S&P said.

J.C. Penney’s stock, which dropped as much as 12 percent between the 6 a.m. earnings release and Johnson’s comments on the 8 a.m. conference call, ended Aug. 10 up 5.9 percent at $23.40. Credit-default swaps on J.C. Penney climbed 42 basis points to 919 basis points, indicating derivatives traders viewed the company as more risky. Investors are now paying $919,000 annually to protect $10 million of the retailer’s debt.

The contracts pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt.

“I can’t really explain the stock market unless it is a combination of short covering and mass brainwashing,” Carol Levenson, an analyst at Gimme Credit LLC, said in an e-mail. “The bond market sees things more clearly, as usual -- results are horrible and visibility is increasingly poor.”

Johnson’s plan is supported by activist investor Bill Ackman’s Pershing Square Capital Management LP, which holds an 18 percent stake in the company, and Vornado Realty Trust, which has 10.7 percent. Ackman reiterated his belief in Johnson’s transformation efforts at a conference last month, saying he may make 15 times his investment.


Appealing Products

Johnson plans to make J.C. Penney more appealing by building small shops within each store that sell products such as Levi’s jeans, Martha Stewart housewares and Joe Fresh clothing. The new mini-stores will draw crowds like Apple’s introduction of the iPod and iPad, Johnson said in a Bloomberg Businessweek interview published Aug. 9.

“The same thing will happen here,” Johnson said. “Next spring it’s Joe Fresh, Martha Stewart, all our new partners. It will be just like Apple: boom, boom, boom.”

In January, the company entered an agreement for a $1.5 billion asset-backed line of bank credit tied to its inventory levels, J.C. Penney’s Hannah said. While the company doesn’t plan to tap that line of credit this year, if it needed to, it could get the money overnight, he said.

“Right now the balance sheet looks good and you have the bank lines behind you for incremental liquidity if you need it,” Noel Hebert, chief investment officer at Concannon Wealth Management LLC, which oversees about $250 million, said in an e-mail. Johnson’s strategy may pay off eventually as long as he can “stem the bleeding,” Hebert said.

J.C. Penney generated $1.34 billion in earnings before interest, taxes, depreciation and amortization in the year ended Jan. 29, 2011 and $1.16 billion in its prior fiscal year, according to data compiled by Bloomberg. Bond investors generally prefer predictable earnings to gambling on massive growth, CreditSight’s Goldstein said.

“Cash flow is just getting crushed relative to where it had been,” Goldstein said. “The last couple years, J.C. Penney wasn’t exactly thriving as a retailer but they were still a pretty decent cash cow.”


Bloomberg News


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