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Equity Versus Bonds II

Sunday - 3/3/2013, 10:56pm  ET

A few weeks ago I wrote about J.C. Penney . I tried to make a case against its equities despite the long position held by one of the smartest investors in the street, Bill Ackman. His theory about two J.C. Penneys within the same corporate roof -- one growing fast and the other one declining -- might still be valid but the results shown by the company this week were discouraging.

As I explained in my previous post about the company, I hold J.C. Penney fixed income because the company has a huge real estate portfolio and this makes the bonds somewhat secured. That said, I still don't clearly see the turnaround working and, hence, the company's equity could suffer further.

Time is running short for Ron Johnson, J.C. Penney's CEO and the creator of Apple’s stores, who was seen as J.C. Penney’s savior. After presenting dismal results, Johnson acknowledged making big mistakes and assured that he would reverse the decision of scrapping unpredictable discounts, which used to be a distinctive characteristic of this mid-tier department store.

Let's review the results and then try to forecast the retailer's future. Maybe, after all, there is some light ahead for J.C. Penny and its CEO.

Tough numbers

J.C. Penney’s fourth quarter was extremely worrying. Same-store sales, growing at other more expensive retailers such as Macy's by 3.9% year-over-year, dropped by a breathtaking 32%. No company can survive that kind of trend. Even gross margins suffered, falling by 6% year-over-year for J.C. Penney but only by 0.4% for Macy's. Comparable performance looks even worse when we compare J.C. Penney to my favorite U.S.-based retailer, Dillard's . Dillard's is growing gross margins by 0.3% year-over-year while growing same store sales by 3%. Growth numbers are worrying and also, in absolute terms, J.C. Penney looks terrible. Gross margins for J.C. Penney are 23.8% while Macy's and Dillard's have 40% and 34.3% respectively.

Losing money quarter after quarter and with its EBITDA still falling dramatically (it fell from $1.3 billion in 2010 to -$767 in 2012), I expect J.C. Penney to start considering issuing new shares. This would give Mr. Johnson the 18 months he says he needs to prove that he is on the right path. After all, the company generated $415 million in free cash flow in the quarter and its net debt position improved by almost the same amount. With more than $900 million in cash and room on its credit lines, the company is viable for one more year if the top line starts growing.

Equity versus bonds II

If we are talking about J.C. Penney, now more than ever before, I believe bonds are the only part of the capital structure that is relatively safe. On Wednesday shares slid almost 17%, but I think we might see an equity issuance coming. If that is the case, if you buy J.C. Penny's equity now, not even Mr. Johnson's success will bring you joy. The reason? It will come too late and you will have already taken too many loses.

This article was originally published as Equity Versus Bonds IIon

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