Buy Protection on JCP with CDS or Go Short the Stock

I recommend investors buy protection on JC Penney CDS (short risk) at 15 pts upfront (~920 bps) with a target of ~21 pts upfront (~1,140 bps). For investors that can’t transact in CDS, I recommend shorting JC Penney stock with a target of $8 to $10 per share for a total return of 31%-44%.

Under recently fired CEO Ron Johnson, JC Penney has been potentially irreparably harmed with sales down 25% in 2012 (~$4 billion in lost sales), same store sales down 25% and a cash burn of $1.3 billion before asset sales. In addition, I project in Q1 (May 18th) a potential cash burn of up to $908 million and a full year burn of $1.1 billion. As the company burns cash, I expect it to have to draw on its revolver for the first time in its history. The revolver is secured and will subordinate all the current debt, which is unsecured. In addition, I expect the company to look to do a capital raise, priming the bonds even more (it is rumored the company is looking at a $500 million term loan backed by the company’s inventory).

Recently JC Penny fired Ron Johnson and replaced him with Mike Ullman, the former CEO that was pushed out by Bill Ackman. JC Penney doesn’t have the luxury of time and a new CEO would probably need 6 months to get to know the company. Ullman is familiar with JC Penney and doesn’t need a lot of time to get up to speed. As a familiar face he can help in soothing some of the company’s vendors fears about a bankruptcy (especially in light of the fact the company is stretching payables). However, if he was not the right man the first time around for JC Penney (Bill Ackman was very vocal about how poorly run JC Penney was and how poorly its stock price faired under Mike Ulman’s reign), why is he the right man the second time around? Wall Street didn’t like the choice when Mr. Ullman was named CEO last Monday night and on Tuesday, JC Penney equity fell 12%.

I expect JC Penney to continue to report poor results. As JCP brings back coupons and promotions, traffic may come back but I feel it will be at the expense of margins. This will effect Q1. For Q1, I expect same store sales to fall 18% (despite lapping easy comps of -18.9% in Q1 of last year), EBITDA of -$200 million and a cash burn of $908 million. For full year 2013, I expect a cash burn of $1.1 billion. As the company continues to build out its shops within a shop, capex will be elevated.

For 2014, I expect same store sales to rise 3.3%, sales of $12.5 billion and EBITDA of $215 million. On a lease adjusted basis, JC Penney will have lease and net adjusted leverage of 11.8x and 11.2x. Based on where certain retailers trade, I believe that JC Penney CDS should trade for about 21 pts or ~1,140 bps.

CDS Valuation

Company 5Y CDS Net Lease Adj Lev Spread/turn of lev
Neiman Marcus 198 4.8x 41
Levi Strauss 260 3.8x 68
Jones Group 315 4.4x 72
Office Depot 305 4.7x 65
Toys R Us 742 5.6x 133
RadioShack 1,453 7.5x 194
Sears 707 7.1x 100
Best Buy 397 2.8x 142

Average 547 5.1x 102

Using 2014’s estimated net lease adjusted leverage of 11.2x for JC Penney and a 102 average spread per turn of leverage, I believe JC Penney CDS should trade at ~1,140 bps or 21 pts upfront.

Equity Valuation

Because I expect JC Penney to be unprofitable over the next few years I have used an EV/Sales valuation. JC Penney’s past 5 year average EV/Sales ratio has been 37%. Using a slight premium of 41% to 44% gets a valuation of $8-$10 per share for JCP equity. Bulls will argue that there is significant real estate value to JC Penney and its owned store base of ~426 stores and its below market rents (~$4/sq ft). However, Vornado bailed on their investment and valuations of JC Penney’s real estate values are all over the map. One cannot easily evaluate JC Penney’s store value without going through a detailed store by store valuation, which is nearly impossible. Valuations of over $1 billion to between $2-$5 billion dollars have been thrown about. I think the clearest statement yet about just how low the valuation of JC Penney’s real estate might be is from the fact that Vornado has hit the eject button on most of its investment and will probably look to get out of the remainder.

JC Penney faces real bankruptcy risk. I just don’t see how the company survives and that credit spreads don’t go wider and equity prices go lower. I think JC Penney is doomed because:

1.) US marketplace is very crowded
2.) JC Penney was trying to reposition itself to begin with because the old way wasn’t working. Think now going back to it will work?
3.) Difficult to reposition a dinosaur- no loyalty, people can go and shop elsewhere
4.) Kind of have to continue with Ron Johnson’s plan in some form because what are you going to do, leave 80% of the store as old JC Penney and 20% as new JC Penney? Stores will look really weird.
5.) Assume you continue and go through with the Ron Johnson strategy and get to new JC Penney, you still don’t know that it is a viable model to compete in the marketplace.

Ultimate, JC Penney will continue to bleed cash. I think that the company will look to do a secured capital raise, which will subordinate the bonds and push down recoveries. In the long run, it is a business model problem and throwing liquidity at it will not help. It will only prolong the day of reckoning.

As a result, I recommend buying protection on CDS with a target of 21 points upfront or shorting the equity with a price target of $8-$10 per share. However, investors should initially buy protection/short equity on about 30-50% of their full position so that there is dry powder in case the company successfully raises additional capital.