APN News and Media

It has been a while since I did a post on an Asian stock, partly because of the drought of Asian ideas. I do have a number of Hong Kong listed stocks on my watchlist, but they have yet to hit prices which I am comfortable accumulating. Nonetheless, it was a lovely surprise when I was clearing some of the old sell-side initiation reports when I came across APN News & Media. Technically, it's an Australia company. Depending how you see it, some people count Australia as part of Asia, but that's another post by itself.

APN is a media company which generates most of its revenue from advertising. If you have been following Australia media companies diligently, you will know that a lot of them are struggling. Advertising has basically flatlined since the financial crisis (see below).

Advertising Spendings	2008	2009	2010	2011	E2012	E2013	E2014
TV	3,729	3,484	4,056	3,950	3,911	4,090	4,145
Newspaper	4,117	3,471	3,665	3,374	3,007	2,776	2,554
Magazines	1,032	857	871	814	675	608	590
Radio	971	936	1,001	1,008	1,009	1,029	1,053
Outdoor	454	400	477	494	502	518	533
Cinema	96	89	99	79	87	88	90
Online	1,710	1,871	2,265	2,824	3,284	3,756	4,272
Print Directories	1,547	1,472	1,243	938	879	813	782
Total Ad Market	13,656	12,580	13,677	13,481	13,354	13,678	14,019
Growth %	N.A.	-7.88%	8.72%	-1.43%	-0.94%	2.43%	2.49%

Coupled with the onslaught from new media, such as the internet and increasing smartphone penetration, many of the old world media companies are dying. APN is one such company, deriving its revenue from newspaper/magazine publishing, radio networks and outdoor advertising. At its peak,  APN traded at around A$6 in 2006. Now its trading at A$0.26. 

Yeap, you didn't see that wrong. A$0.26. Thats a 95% fall from the peak. 

Other examples include Seven West, a media conglomerate with businesses ranging from free-to-air TV, newspapers and magazines, trading at over A$16 in 2007. Now, its trading at A$1.90. Ten Network, one of Australia's three commercial metropolitan free-to-air TV networks, peaked at over A$4.40 in 2005, now trading at A$0.275.

A year ago, when I saw the valuations on these companies, I thought they were cheap. The problem is, they only got cheaper. Without knowing anything about the businesses, one would have thought these companies came close to bankruptcy, having fallen that low. You would have thought these companies must be unprofitable, except that they are, although margins and revenues are shrinking. At one point in time, APN was paying a DPU of A$0.32, which is higher than its current share price.  Don't get me wrong, APN is a shrinking ice cube. There are risks involved with investing in such companies. Nonetheless, I feel the valuation now justifies putting on a small position. 

Income Statement (A$ 000)	2007	2008	2009	2010	2011	2012
Revenue from continuing ops	1,314,573	1,193,398	1,030,666	1,059,085	842,142	857,151
Other revenue and income	25,666	28,530	21,332	4,731	25,722	10,176
Revenue	1,340,239	1,221,928	1,051,998	1,063,816	867,864	867,327
Employee benefit expenses	(1,031,979)	(347,184)	(315,866)	(327,418)	(328,417)	(337,555)
Selling and production		(321,041)	(284,468)	(288,521)	(238,103)	(265,401)
Rental and occupancy expense		(174,567)	(163,805)	(162,180)	(54,746)	(63,572)
Deprec and amot		(40,956)	(40,767)	(38,900)	(29,874)	(30,959)
Redundancies and associated costs		0	0	0	(17,332)	(8,436)
Asset write downs and business closure		0	0	0	(18,298)	(7,344)
Loss on sale of property		0	0	0	0	(2,353)
NZ Herald relaunch cost		0	0	0	0	(2,939)
Other		(51,127)	(65,186)	(49,695)	(57,551)	(52,951)
EBIT	308,260	287,053	181,906	197,102	123,543	95,817
Impairment of intangible assets	0	(202,953)	0	0	(159,495)	(638,448)
Finance costs	(63,359)	(75,533)	(52,234)	(50,457)	(57,190)	(44,416)
Share of profits of associates and JV	6,829	6,484	3,254	3,002	5,807	9,155
Profit from discontinued ops	0	(2,954)	(1,830)	(4,862)	19,703	77,543
Profit before Tax	251,730	12,097	131,096	144,785	(67,632)	(500,349)
Tax	(45,723)	(6,275)	(14,624)	(30,061)	48,696	68,392
Net Profit	206,007	5,822	116,472	114,724	(18,936)	(431,957)

At first glance, the financials are horrendous. Revenue is constantly shrinking. EBIT has done nothing but shrink in the last six years. Net profit is distorted by a number of non-recurring restructuring and write-off expenses. The table below shows normalised numbers to give a clearer picture of APN's profitability.

(A$ 000)	2007	2008	2009	2010	2011	2012
Normalised EBITDA	308,260	328,009	222,673	236,002	189,047	147,848
Normalised EBIT	308,260	287,053	181,906	197,102	159,173	116,889
Normalised NPBT	251,730	218,004	132,926	149,647	107,790	81,628
Normalised Profit (20% tax)	201,384	174,403	106,341	119,718	86,232	65,302
Normalised EBITDA Margin	23.0%	26.8%	21.2%	22.2%	21.8%	17.0%
Normalised EBIT Margin	23.0%	23.5%	17.3%	18.5%	18.3%	13.5%
Normalised Net Profit Margin	15.0%	14.3%	10.1%	11.3%	9.9%	7.5%
CFO	211,327	173,942	119,374	165,245	123,063	87,274
CAPEX	(177,751)	(81,128)	(18,262)	(58,215)	(47,368)	(57,389)
FCF	33,576	92,814	101,112	107,030	75,695	29,885

Even after normalising for restructuring and non-recurring costs, all the various profitability metrics are declining. EBITDA and EBIT margins are at a historical low. APN currently has a market cap of AUD$170m. If post restructuring if APN can just maintain a net profit of AUD$65m, which is the normalised level in 2012, this is easily a PE 2.5x stock. Like all other media companies, it generates a decent amount of free cashflow which can go towards paying dividend. Shrinking margins is not their only problem. Their declining profitability has also affect the ability to pay their debt. 

	2007	2008	2009	2010	2011	2012
Short Term Debt	94,768	155,620	20,280	25,765	27,504	29,797
Long Term Debt	840,905	807,567	762,700	694,328	633,526	449,320
EBIT/Interest expense	4.87	3.80	3.48	3.91	2.78	2.63
Debt/EBITDA	2.75	2.76	3.37	2.78	3.37	3.10

Debt/EBITDA ratio and interest coverage ratio has been deteriorating despite total amount of debt shrinking from A$935m in 2007 to A$480m in 2012. The next major refinancing (A$400m) is expected in 2015, and APN has some time to reduce debt further using internally generated cashflow. The reason why I believe APN will mostly survive is because of their strength in outdoor and radio, which is highlight below. 

	2009	2010	2011	2012
Australian Regional  Media Revenue	272,195	288,036	276,002	248,760
New Zealand Media Revenue	321,498	320,077	301,067	287,360
Australian Radio Network Revenue	122,984	127,307	133,212	139,951
The Radio Network Revenue	84,709	85,682	86,712	86,708
Outdoor Group Revenue	229,280	237,983	263,740	110,485
Digital Group Revenue	0	0	11,661	55,311
Australian Regional EBITDA Margin	21.9%	20.8%	20.0%	15.5%
New Zealand Media EBITDA Margin	20.7%	22.3%	20.5%	16.6%
Australian Radio EBITDA Margin	35.5%	33.7%	35.7%	36.3%
The Radio Network EBITDA Margin	15.9%	15.0%	19.5%	17.4%
Outdoor Group EBITDA Margin	7.0%	12.1%	17.4%	17.7%
Digital Group EBITDA Margin	N.A.	N.A.	-35.1%	-1.4%

Above shows the segmental breakdown of APN's revenue and their respective EBITDA margins. 

(i) Australia Regional Media refers to APN's 12 Australian daily newspapers, over 56 non-daily newspapers and over 30 news websites. 

(ii) New Zealand Media refers to their publishing business in New Zealand, including seven daily regional newspaper, 35 community newspapers and magazines such as New Zealand Woman's Weekly and New Zealand Listener. 

(iii) Australian Radio Network refers to their radio network business in Australia. Similarly, The Radio Network refers to their radio network business in New Zealand.

(iv) Outdoor Group refers to APN Outdoor which is their outdoor advertising segment with operations in Australia, New Zealand and Hong Kong. 

(v) The Digital Group is a bundle of various different businesses including GrabOne - the no. 1 group buying business in NZ, online shopping club BrandsExclusive and digital retail advertising network CC Media.  

A few quick observations. The Australian and NZ newspaper/magazine publishing business are struggling. Not only are revenues shrinking, margins are also shrinking. Whereas, the radio and outdoor advertising businesses are fairly robust. Revenues grew slightly and margins are relatively stable. APN Outdoor Group revenue fell over 50% in 2012 because APN sold half the business to Quadrant Private Equity. The resulting JV, called APN Outdoor is valued at A$272m and carry A$110m in debt. APN Outdoor generated EBITDA of A$45.8m in 2011. Assuming the JV doesn't not have any cash on its balance sheet, the transaction occurred at 8.3x EV/EBITDA. This is pretty close to the valuation which Ten network sold its Eye Corp outdoor advertising arm for, at 8.1x EV/EBITDA in November 2011. We will refer to these levels as benchmarks when making our calculation for a target price later on. Their digital group segment was built up through acquisitions in 2011. It is growing very fast but has yet to be profitable. 

The "jewel crown" here is actually the radio and outdoor advertising businesses. Unlike newspaper or magazines, these are not under direct attack from digital media. Drivers still listen to the radio on their way to work. People on their way to work still take public transport, where they are exposed to APN's posters. While they may not be high growth assets, these businesses are relatively mature and are good cash cows. Managed properly, in an industry structure that is stable with little market share competition, they can throw out a lot of cash. Fortunately, radio and outdoor advertising in Australia is fairly stable. Given that these are old world media businesses, no single player has the incentive to sacrifice margins for market share. Most are focused on maximizing cash flow generated from the businesses.

Valuation

	2012 EBITDA (A$'000)	EV/EBITDA Multiple
Australian Regional EBITDA	38,655	3	115,965
New Zealand Media EBITDA	47,810	3	143,430
Australian Radio EBITDA	50,777	6	304,662
The Radio Network EBITDA	15,130	6	90,780
Outdoor Group EBITDA	19,553	7	136,871
CC Media	1,500	8	12,000
Grab One	N.A.	N.A.	12,800
BrandsExclusive	N.A.	N.A.	36,000
		Total	852,508
		APN debt	479,117
		APN Cash	20,338
		APN Equity	393,729
		No of shares ('000s)	661,527
		Target Price	0.60

Let's do a quick sum of parts here to see what APN is worth. Both the Australian and NZ publishing business are dying businesses. There is no pure play Aussie/NZ newspaper or magazine listed on the ASX. Without a comparable peer, they are valued conservatively here at 3x EV/EBITDA. Both the Australian Radio Network and The Radio Network (NZ) are stable, growing slowly and generating free cashflow. They are valued at 6x, slightly below APN's Outdoor Group. As for the Outdoor Group, we will use 7x EV/EBITDA, a slight discount to the 8.3x EV/EBITDA benchmark where Quadrant Private Equity bought 50% of the group. GrabOne and BrandsExclusive, part of APN's digital Group, are valued conservatively at acquisition cost - A$12.8m and A$36.0m respectively. There is no data on the acquisition price of CC Media. Hence, we will apply a 8x EV/EBITDA multiple. The resulting valuation excuse yields a target price of A$0.60, which is over 200% higher than the closing price of A$0.26 today. Experienced market participants will then ask, why is it so cheap? There is no free lunch in this world. Something is horribly mispriced usually is associated either with a lot of uncertainty over future prospects, or is irrationally and widely hated. 

This is why I think the company is trading at such low levels. First of all, the company has been shrinking over a long period of time. While advertising is a cyclical industry, there hasn't been any meaningful growth since a 8.7% rebound in 2010. Analysts estimate that we will either see a recovery this year or in 2014. APN's publishing business have high operating leverage. Because the majority of costs are fixed, any incremental recovery in revenue will be magnified in the bottom line. 

Secondly, there is a lack of leadership in the company. The previous CEO Brett Chenoweth, Chairman Peter Hunt and three other independent directors resigned in Feb 2013. This is in response to major shareholders, Independent News and fund manager Allan Gray Australia's rejection to their plan of raising equity financing to pay down debt. I too agree that this is a very short term solution which only serves to dilute existing shareholders, especially at such depressed valuations. Allan Gray is the Australian subsidiary of Global Fund Manager Orbis. Orbis is a long-only mutual fund manager which I respect. Both companies have newsletters on their website available for download. I highly recommend going through these newsletters to search for potential ideas.

Thirdly, the strength of their radio and outdoor businesses has been drowned out by their bleeding publishing business. Ideally, if APN could divest their publishing business, the stock should be re-rated. But, I suspect there may be few buyers for these assets and the prices they fetch will be quite poor. Not to mention, their debt ratios have not shown much improvement despite paying down debt over the years. Without any further asset sales, I imagine it will take APN quite a few years to pay down existing debt using their free cashflow. 

That being said, I believe APN is trading at a very attractive level. There is little threat of bankruptcy. APN has a good chance of survival, but the next few years will be tough as further restructuring is required to reduce costs and pay back debt. 

 

Hess Corp

I have been busy this week which explains the lack of action on this blog. My apologies for that. I started writing this post a week ago and it remained half written. Nevertheless, I finally gotten around to finishing it today.

Hess Corp (HES) is a medium size oil major listed on the NYSE. Many of the integrated oil companies (Royal Dutch Shell, Exxon Mobil, Chevron Crop, etc) have seen valuation compression over the last decade to reach a historical low. A number of them struggle with the same problems - reserve depletion, poor project execution, and poor E&P cost controls. These problems are no strangers to HES. What is unusual about HES is that, it is widely known to suffer from poor management. The company has a long history of poor corporate governance and operational performance.

Over the last few months, HES started popping up in a number of hedge fund portfolios and I felt compelled to take a look. Some of the famous hedge fund managers that have taken up position in HES includes Michael Price, David Einhorn, John Paulson, David Tepper, and Dan Loeb. The reason why is that, HES is currently the target of an activist hedge fund, Elliott Management, due to its poor operational performance. In case you don't know who Elliot Management is, they have been very active in activist type investments, even at a sovereign level. There was a historical example, when Elliot won a court order to size an Argentine naval vessel docked in Ghana in their attempt to get the Argentine government to repay its bond. In other words, these guys mean business and are well respected in the hedge fund industry. When they take on an activist position in a company, you can be sure they will try all means to bring about restructuring.

The catalyst, which has swept so many big names along for the ride is really the proxy fight on the 16 May 2013. Elliott Management, in their attempt to bring about changes to the company, is trying very hard to push five of their candidates on to the board of directors. Much of Elliott's argument can be found on the self created site www.ReassessHess.com, which unfortunately, has been taken down following a truce. In any case, I have summarized the flaws in HES identified by Elliott below:
(i) Persistent operational issues - drilling costs which are 17-38% higher than peers for Bakken, their main unconventional shale gas asset.
(ii) Undisciplined capital allocations - loss of US$4bn from exploration programs over the past five years, which is billions more than any other peers. Hess lost US$800m at Eagle Ford Shale (the most lucrative unconventional shale plays in the US), whereas many peers have made fortunes there.
(iii) Endless restructurings that the HES management touted, with little to show.
(iv) Ineffective hedging program, losing 9% of E&P revenue from 2002-2012, 9X worse than peers.
(v) Poor corporate governance. Many board members are related to the CEO. None of the independent directors have oil & gas operating experience. The CEO, John Cess hardly speak to the press and has poor accountability to Hess's shareholders. There has been multiple attempts by shareholders to de-stagger Board re-elections, but thus far blocked by John Hess.

To sum up, the picture portrayed here by Elliott is that, the management has been failing and needs a wake up call. Where many oil majors including BP and Exxon Mobile have been rationalizing their balance sheet, disposing of their non-relevant and downstream assets, listing their midstream assets, HES has been fixated on growing company size, at the expense of shareholder value.


Value Enhancing Initiatives
To unlock the value of HES's various assets, Elliott proposed a number of measures:
(i) Spin off retail assets, such as their gasoline stations, petroleum terminals and gas fired power plants. The rationale here is that oil and gas are commodities. A Hess branding will not enable the company to sell oil and gas at a higher margin.
(ii) Divest their energy marketing business (a supplier of natural gas, electricity and fuel oil to commercial, industrial and utility companies) and their retail marketing business (independent gasoline convenience store retailing). These are non-core to HES's business and should be divested such that the market price them efficiently.
(iii) Monetize their Midstream assets through a MLP. Fund raising for MLPs today is relatively easy and offers a low cost of capital due to the stability of the cashflow that a MLP generates. Thus, their Midstream assets can achieve a much higher valuation multiple compared to being part of a integrated oil major.
(iv) Separating their conventional and unconventional oil & gas businesses.
(v) Create a Bakken standalone entity, which will house their crown jewel shale gas asset.

All of the above measure serves to simplify HES's balance sheet, making it much more cleaner and easier to for the market to analyse. Capital markets have always favor clear cut business models, which is why conglomerates are commonly priced at a discount to NAV.


The Restructuring & Valuations
Elliott argues for the breakup of Hess Corp into two separate corporate entities and divestment of non core assets. Their valuation estimates are shown below:
1) Creation of Hess Resource Co. to house their unconventional assets, which includes 725,000 net acres in the Bakken, estimated to be worth TEV of US$13bn-14.4bn.
2) Creation of Hess International to house global offshore and conventional assets including long-life, oil-weighted reserves in Shenzi, Valhall, Ceiba & Okume, as well as gas assets in Southeast Asia including JDA and Natuna Sea Block. Elliot estimates this to be worth a TEV of of US$21.4bn-30.2bn.
3) Monetise their resource infrastructure through selling their midstream assets in Bakken, which includes the Tioga gas plant and Bakken rail terminal - estimated TEV US$2bn-2.5bn
4) Divest their downstream and other non related businesses. These have low rates of return and drag down the overall ROE of Hess. Elliot estimates that this will be worth TEV of US$3.1bn-3.5bn.

Overall, the net outcome of the restructuring will create entities worth TEV of US$39bn-50bn, which translates to a share price of US$95.70-US$128.46, a lot higher than the last traded price of US$67.50. I don't profess to be an expert in analyzing integrated oil companies. This to me is a event-driven trade, where the success of unlocking value depends on the activist attempt. A lot of the valuation work hinges on valuing the individual oil and gas assets in HES, which is really a job for industry experts rather than financial analysts. Nonetheless, the price range of US$95-128 is awfully high. I have only seen sell side target around 80ish-90.


Current Situation
In response to aggression from Elliott and the proxy fight on the 16 May, the board has been pressured into announcing several restructuring initiatives to unlock hidden value. Now, the announced long-term strategy is to transform Hess into a pure play E&P company. A list of the changes they have brought about so far includes:
(i) Complete exit from its legacy downsteam retail and energy marketing business. This should release working capital for redeployment to fund other growth opportunities. This includes closing its Port Reading refinery in New Jersey and selling its terminal network.
(ii) Sell non-core assets in Indonesian and Thailand.
(iii) Sale of its interests in the Beryl area fields and Scottish Area Gas Evacuation System to Royal Dutch Shell for US$525m.
(iv) Sales of its minority interest in the Azeri, Chirag and Guneshli Fieds in Azerbaijan and associated BTC pipeline to ONGC Videsh for US$1bn.
(v) Selling its 15.7% interest in the BP operated Schiehallion field and associated share in the Schiehallion Floating, Production Storage and Offloading vessel and West of Shetland pipeline system to Royal Dutch Shell.

(vi) Monetization of their Bakken midstream assets by 2015.

(vii) Plowing US$4bn of proceeds back into share repurchase.
(viii) Increase ordinary dividend by 150% with annual dividend of US$1 per sare with effect 3Q2013.

This is a very welcomed change as opposed to the management's previously aloof approach. Short of splitting the company between conventional and unconventional oil and gas companies, these measures help instill capital discipline and lowers the capital intensity of HES. This will definitely be beneficial for valuation.

John Hess himself has stepped down from the chairman role in favor of John Krenicki a former vice chairman of General Electric. That wasn't enough to appease angry shareholders and the 16 May proxy fight culminated in a truce between HES and Elliott. In the end, both parties reached an agreement, with Elliott pushing three of its nominated directors onto the board. Bear in mind here that HES has a total of 14 board members and Elliott thus far only has 20% representation on the board. While the management seems to have bowed down to shareholder pressure, further restructuring of the company other than that of those announced is not a certainty.

Recap
Now, revisiting Elliott's original proposal, they estimate that Hess Resource Co. which houses the unconventional asset will be worth TEV US$13bn-14.4bn, and Hess International which houses their global offshore and conventional assets is worth TEV US$21.4bn-30.2bn. Both of them together accounts for ~88% of the target TEV US$39bn-50bn that Elliott estimates the restructuring will bring about. So far, the HES management has not been willing to go down this path. Without debating whether the conventional/unconventional spilt is the right move (some analysts argue that what HES is doing is the right thing, funding their unconventional drilling and production with cashflow from their mature conventional business); we are unlikely to reach the mid/upper range of Elliott's US$95.70-US$128.46 price estimate without this spilt. Unless, markets recognize the hidden value of HES's unconventional assets and prices them in accordingly. To achieve a spilt, I believe Elliott will require majority representation on the board, which will take quite some time.

And how have markets reacted to this truce? Shares plummeted below US$70 on the announcement and has been rolling over since. I am inclined to think that markets do not believe that truce will result in further unlocking of value from the company. The share price is a far cry from that estimated by Elliot. Plus, HES has already announced and implemented quite a number of balance sheet rationalisation initiatives that are in line with those proposed by Elliot. We have to assume here that those are already baked into the price. In the absence of any further catalyst, I do not see HES rallying further on a short term basis.

Conclusion
I do not recommend jumping in so late in the game, the stock having rallied 25% YTD. Most of the fund managers that jumped on the bandwagon did so early during 1Q and have gains to show for it. If anything, I am inclined to think they will be exiting and taking profits, given that the activist attempt has stalled somewhat. Most managers have jumped on to make a quick buck, and they did. Conversely, they will be equally quick to take their profit. However, if the selling forces HES to US$55-60, I may be a buyer at that point.

JC Penney

JC Penney (JCP) is a company which I have followed with much interest since Bill Ackman publicly announced his position in the company during 2012's Ira Sohn conference. He has put together an interesting presentation on JCP that is available at this link should you wish to have a read. Since then, the turnaround of JCP has been lackluster, culminating in the ousting of former Apple retail guru, CEO Ron Johnson. Myron Ullman has been brought back as CEO, and the company announced a new five-year US$2.25bn senior secured term loan credit facility from Goldmans and other IB to try and buy some time.

Short Thesis
JCP is one of the most heavily shorted large cap stocks on the NYSE. The stock has seen a nice rally in the last couple of months due to (i) an announcement of George Soro taking a position in the company and (ii) a short squeeze as the US stock market rally continue unabated. A lot of financial professionals have been trying to call the top of this market rally and have been proved wrong so far. While I do think a correction is overdue, I believe that the momentum will continue on a short term basis. Many months back I was considering a long position in JCP, based on a turnaround of the company. Fortunately, I wasn't entirely convinced that the turnaround initiatives put forth by Ron Johnson will work and remained on the sidelines. After the disasterous recent 4Q2012 and 1Q2013 results, which showed a Same Store Sales (SSS) growth of -25.2% and -16.6%, I am certainly glad I sat on my hands. Now the company is caught with the old CEO, who got the company in this mess in the first place, without a coherent turnaround strategy. Ironically, I am now considering a position on the short side, through put options on JCP to hedge some of my US market exposure.

Liquidation Value
There are some investors who believe that JCP is an attractive real estate play. International Strategy & Investment Group estimates that JCP stores should be valued at US$70/square foot, whereas the average cost of ownership is recorded at book at US$5/square foot. Spinning off the top 300 JCP stores into a REIT will yield an entity with an enterprise value of about $40/share. However, Cushman & Wakefield has a much lower estimate of JCP's real estate, with its stores, distribution centers and HQ at US$4bn.

Valuing a company based on a liquidation value can be potentially dangerous. Just because something trades at a discount to its liquidation value doesn't mean that it can be liquidated and will be liquidated. A good example is Sears, which many fund managers have been arguing that the real estate carried on its book at cost is massively undervalued. That hasn't done much for the stock price. When a discount to liquidation value is the cornerstone thesis of a position, one needs to have some certainty on (i) the timeframe for the liquidation and (ii) the cost of liquidation. If liquidation takes a long time frame to execute, your IRR will be stretched out. That can easily be the difference between a mediocre track record and a fantastic one. In the case of JCP, liquidation will probably be a messy affair, involving litigation costs, and the cost of laying off a huge labour force. That is not only politically difficult but also rather expensive. And in the meantime, the retail operations continue to bleed cash, gradually reducing your discount and the associated margin of safety. Here, we will mostly be focusing on analysing JCP from a ongoing concern basis.

Investment Analysis

At this stage, there are two crucial questions an investor should ask before forming an opinion on this company.
1) Does the company have a coherent, realistic turnaround strategy?
2) Does the company have sufficient liquidity to implement the strategy without running the risk of declaring chapter 11?


We do not yet have an answer on question 1 since the new (or rather old) CEO just took over and have yet to formulate a strategy. My belief is that, Myron Ullman is merely a filler for the position while the Board search for someone else more suitable. Given JCP's track record as a career wrecker (it certainly ruined Ron Johnson's career), I do not think finding someone who is willing to take the job will be an easy task.

As for question 2, we can hazard an educated guess. As of end 1Q2013, JCP has equity of US$2.86bn, cash and equivalents of US$821m, total debt of about US$3.7bn, and off balance-sheet operating leases of present value ~US$1.28bn. From a debt/equity ratio perspective, JCP's leverage is high but not overwhelming so. More importantly, let's take a look at JCP's debt capital structure.

Long Term  Debt breakdown	US$m
5.65% senior notes due 2020	400
5.75% senior notes due 2018	300
6.375% senior notes due 2036	400
6.875% med term notes due 2015	200
6.9% notes due 2026	2
7.125% debentures due 2023	255
7.4% debentures due 2037	326
7.625% Notes due 2097	500
7.65% Debentures due 2016	200
7.95% debentures due 2017	285
Total	2868

None of the long term debt on JCP's balance sheet is maturing any time soon. The earliest maturing bond is due 2015 with a face value of US$200m.

Short Term Debt	US$m
Short term borrowings	850

Credit facilities   Revolving credit facility by JPM 1850 Amount drawn down 1000 Amount left 850 5Yr term loan facility by GS 2250 Amount drawn 0 Amount left 2250 Cash left 821 Total available cash for operatings 3,921

Although JCP has short term loans of US$850m (which I believe is drawn from the JPM revolving credit facility), there is still US$821m of cash on the balance sheet, US$850m undrawn from their JPM revolving credit facility, and an entirely new US$2.25bn loan facility from Goldmans. Based on the cash and undrawn credit facilities, JCP can raise up to US$3.9bn for its turnaround attempt. Just to put things in perspective, in its most recent quarter 1Q2013, JCP had pre-tax operating losses of US$547m, negative CFO of US$752m and Capex of US$196m.

Income Statement (US$m)	E2Q13	E3Q13	E4Q13	E1Q14	E2Q14	E3Q14	E4Q14	E1Q15	E2Q15	E3Q15	E4Q15
Revenue	2,720	2,781	3,690	2,635	2,856	3,059	4,059	3,030	3,284	3,518	4,668
COGs	(1,882)	(1,924)	(2,915)	(1,792)	(1,828)	(1,988)	(2,922)	(1,818)	(2,036)	(2,181)	(3,267)
Gross profit	838	857	775	843	1,028	1,071	1,136	1,212	1,248	1,337	1,400
SG&A	(979)	(1,001)	(1,218)	(949)	(971)	(1,040)	(1,263)	(1,091)	(985)	(1,126)	(1,214)
Pension	(40)	(40)	(40)	(40)	(40)	(40)	(40)	(40)	(40)	(40)	(40)
Depreciation and amortization	(142)	(142)	(142)	(142)	(142)	(142)	(142)	(142)	(142)	(142)	(142)
Real estate and other, net	0	0	0	0	0	0	0	0	0	0	0
Restructuring and management transition	(72)	(72)	(72)	(72)	0	0	0	0	0	0	0
EBIT	(395)	(399)	(697)	(360)	(125)	(152)	(309)	(61)	80	29	4
Net interest expense	(71)	(69)	(83)	(86)	(102)	(105)	(113)	(107)	(117)	(120)	(125)
Profit before tax	(466)	(467)	(780)	(446)	(227)	(257)	(422)	(168)	(37)	(91)	(120)
Tax	(176)	(177)	(295)	(169)	(86)	(97)	(160)	(64)	(14)	(35)	(46)
Net profit	(290)	(291)	(485)	(277)	(141)	(160)	(263)	(105)	(23)	(57)	(75)
CFO + CIO	(724)	(603)	(186)	(826)	(169)	(404)	313	(532)	(147)	(252)	631
Revenue (yoy) Growth	-10.0%	-5.0%	-5.0%	0.0%	5.0%	10.0%	10.0%	15.0%	15.0%	15.0%	15.0%
Gross margin	30.8%	30.8%	21.0%	32.0%	36.0%	35.0%	28.0%	40.0%	38.0%	38.0%	30.0%
Pretax margin	-17.1%	-16.8%	-21.1%	-16.9%	-8.0%	-8.4%	-10.4%	-5.6%	-1.1%	-2.6%	-2.6%
Net Margin	-10.7%	-10.4%	-13.1%	-10.5%	-5.0%	-5.2%	-6.5%	-3.5%	-0.7%	-1.6%	-1.6%

I did some quick modeling to see how much cash JCP could consume during the turnaround process. I assumed that operations will stabilise by end 2013 and revenue growth coming back in 2014 before accelerating in 2015. Margins will began to recover from beginning 2014 onwards. Based on my margin and growth assumptions, JCP has yet to be profitable by end 2015, but will almost be. Adding up total CFO and CIO till end 2015 results in a cash deficit of US$2.9bn. Without accounting for the cash inflow of US$631m in 4Q2015, the peak cash deficit will be US$3.5bn. This can be covered with JCP's existing cash and debt facilities, but there isn't a large margin of safety. Do I feel comfortable enough to short the stock? Probably no. With the current debt structure in place, JCP can keep operating for a long time, even if they continue to bleed. And in the meantime, any short squeeze and paying short interest/option premium will make this an unenjoyable ride.


Long Thesis?
Can we consider a long position instead? After all, George Soros has taken a position in the stock. To answer this question, let's look at the historical margins for JCP below. It was really from 2009 onwards that the company began to slip and struggle. What will be the right net profit margin for a turned-around JCP? Your guess is as good as mine here. Somewhere in the realm of 3-4% (which is what a typical discount retailer earns) should not be too far off the mark. Using my estimates above, 2015 will see a revenue of about US$14.5bn. Under the bullish scenario that JCP turns around completely in 2015, and based on a net profit margin of 3-4%, JCP will see between US$435m-US$580m of profits. Currently, JCP has a market cap of US$4.2bn. This translates into a PE of 7.2-9.6x. Peers listed on NYSE trades between 12-18x PE, with the average around 14x-ish. If we assume PE expands to 14x when the turnaround is successful, we will be looking at a gain of 45%-95%. The result can be very different depending on what you plug in as the net profit margin. On the higher end of the range, this results in an almost doubling of your position in 2.5yrs. At the low end of the range, this is an arithmetic return of ~18% a year. Both are very respectable results, contingent on the turnaround being successful.

	2007	2008	2009	2010	2011	2012
Gross Margin	38.6%	37.4%	39.4%	39.2%	36.0%	31.3%
EBIT  Margin	9.5%	6.1%	3.8%	4.7%	0.0%	-10.1%
Pre-tax margins	8.7%	4.9%	2.3%	3.3%	-1.3%	-11.8%
Net Margin	5.6%	3.1%	1.4%	2.1%	-0.9%	-7.6%

Conclusion
Although I was initially looking at JCP from a short perspective, I believe that the risk/reward favors a long position better. I do not yet feel comfortable that the turnaround is happening, in the absence of a new strategy from JCP. However, they do have sufficient liquidity to last them for quite some time. If they find a good CEO to take over the company, with a new turnaround strategy, I may consider a position. Until then, I have no conviction on either the long or short side. So it's back to the sidelines again.