How To Avoid Ackman’s JC Penney Mistake

Hedge fund manager Bill Ackman’s fund Pershing Square recently sold its shares of JC Penney for an approximate 50% loss of nearly $500M. While the overall market has enjoyed significant upward momentum, Pershing Square seemingly picked the wrong company, JC Penney, at the wrong time, $25 a share in 2010.

Ackman is an activist investor, he takes on board rooms in an effort to unlock value or resuscitate failing companies. Ackman has achieved varying degrees of success and failure; JC Penney being illustrative of a significant failure.

What Went Wrong?

First of all JC Penney was not keen to Ackman and Vornado stepping into the picture; the company reportedly enacted a “poison pill” that could dilute the newcomers shares. Ackman helped bring in Ron Johnson from Apple, who was a leader in the Apple Store effort; unfortunately Johnson’s ideas includead eliminating coupons from JC Penney and having “one low price.” This proved very unsuccessful and coupons had to be restored to entice shoppers.

Furthermore JC Penney has serious competition from Wal-Mart (WMT), Kohl’s (KSS), T.J. Maxx (TJX), Macy’s (M) and Ebay (EBAY) to name a few. This March Vornado Realty (VNO) sold off 10M shares of JC Penney, over half their large investment.

So basically, everything that could go wrong, went wrong. Ackman left the board of JC Penney and arranged to sell what was left of his massive investment to Citigroup — who then put those shares up for sale.

A Look At Penney Bonds

Keep in mind, many bond trading platforms will automatically filter out junk bonds — they are not investment grade. The importance of understanding this is paramount, they are called junk, there is a very real possibility they could default.

I have looked at JC Penney bonds before, their yield is attractive; the underlying company is not. JC Penney has more name recognition, whereas I’ve never heard of most junk rated companies; perhaps this is what made some think JC Penney would be able to manage. (Just remember Kodak though, the company went bankrupt, and has now cancelled all of its previous common stock — and issued new stock to pay creditors, leaving former shareholders empty handed.)

Let’s look at a few of the JC Penney bonds out there, it is very unusual that currently the nearer-term bonds have greater yields than the longer-term bonds.

In forming this table I noticed all of these were issued in the 1990s, granted the bonds have paid income since being issued, their Caa1 credit rating begs the question:  Is the principle at risk? You will have some arguments on both sides, perhaps more on the side of the company ultimately failing at this point — JC Penney is certainly distressed and seems unable to break out of its tailspin.

Ackman & Icahn: Big Fish vs. Bigger Fish

This battle, it turns out, was more about big egos than big money — and it has left both men spitting expletives. The scrape finally ended this month, with Mr. Ackman victorious. But, before it was over, the affair occupied a Who’s Who of powerful lawyers and ran up millions of dollars in legal fees, all because of an otherwise forgettable deal the pair cut back in 2004.

Azam Ahmed, New York Times, Nov. 2011

As an activist investor Ackman took on what he viewed to be an unjustifiable AAA rating of MBIA (MBI) in the early 00’s, MBIA, Ackman argued was far too leveraged (approximately 150 : 1) to deserve the top credit rating. Ackman went into Wendy’s (WEN) and fought to spin-off Tim Horton’s, another major Wendy’s investor, Nelson Peltz, agreed with Ackman. After Tim Horton’s spun-off Ackman sold his shares, while Peltz remained; Wendy’s struggled for many years, with some complaining Ackman’s meddling was to blame.

Now the tug-of-war of the day is over Ackman’s anti-Herbalife (HLF) stance. Ackman has shorted Herbalife, while Carl Icahn and George Soros have invested in the Cayman Island based nutrition company. The feud around Herbalife has been heated, with Ackman accusing Soros of insider trading, and Soros pulling hundreds of millions he invested with Pershing Square. Soros is sustaining his investment in JC Penney.

This is not the first time Bill Ackman and Carl Icahn have squared off. Ackman sued Icahn over an investment deal in Hallwood Realty that he brokered around 2003 — Ackman brought Icahn into the company (though both sides argue on most of the specifics) a short time later Hallwood merged for a nearly 100% gain. Ackman had a contract signed by Icahn, agreeing to a few million dollars once Icahn divested, however Icahn argued he did not sell his shares, though they were cashed out as part of the merger. Ackman won his case in court, this did not go over so well with the powerful Carl Icahn — even though in the grand scheme of their multi-billion dollar hedge funds, the amount of money sparred over is a pittance.

There are a few lessons any investor can take away from this conflict.

• First, the real world of business is not going to be “fair”
• Friends are far more valuable than enemies (though friends generally don’t take advantage of true friendship to the tune of a multi-million dollar disagreement.)
• A comprehensive contract should attempt to address various scenarios, such as broker’s compensation in the event of a merger (think of the multitude of bond prospectuses that address change of control.)
• Large activist investors take risks, they may not always be successful, so look before you leap.

Finally, if the company you’re going into opts to implement something called a poison pill , tread lightly. There is a time and place for hostility, however, investors and fund managers must pick and choose battles.

Know When To Fold ‘Em

You got to know when to hold ’em, know when to fold ’em,
Know when to walk away and know when to run.

The Gambler (Don Schulz, Kenny Rogers 1978)

The old saying goes, “you got to know when to hold ’em, know when to fold ’em” and it remains to be seen whether Ackman really knew the right time to fold. Ackman and JC Penney’s board did not see eye to eye, additionally the investment was off nearly 50%.

Based on Insider Monkey’s overview of Pershing Square, the hedge fund’s top holdings (as of 3/31/2013) included:

1. Canadian Pacific Railway (CP) $3.1B
2. Procter & Gamble (PG) $2.1B ($73M CALL)
3. General Growth Properties (GGP) $1.4B
4. Beam (BEAM) $1.3B
5. Burger King $732M
6. JC Penney $590M
7. Howard Hughes Corp (HHC) $299M
8. Mondelez International (MDLZ) $183M
9. Matson (MATX) $74M

Now let’s look at a more recent picture from Whale Wisdom (as of 06/30/2013), which shows Pershing Square exited Mondelez and entered Air Products & Chemicals (APD):

1. Canadian Pacific Railway $2.9B
2. Procter & Gamble $688M (& $1.9B CALL)
3. General Growth Properties $1.3B
4. Beam $1.3B
5. Air Products & Chem. $924M
6. Burger King $748M
7. JC Penney $667M
8. Howard Hughes Corp $399M
9. Matson $5M

Now we know JC Penney is no longer on the table, and Pershing Square has cash on hand for another large investment, however must contend with a very large loss. (Notice JCP actually recovered slightly between the two 13-Fs, however sank since then.) I get a sense that Pershing Square felt pressured to exit Mondelez and from the looks of it Matson, in order to balance the losses of JC Penney. Howard Hughes on the other hand was the real winner.

Again what makes matters far worse, is the fact during this period of time the overall market has done stupendously. Though investors can not predict bull / bear markets, had Ackman thrown a dart randomly at S&P 500 companies, or better yet invested in many of them, he would not be looking at a 50% loss. Very few people can simply pick the winners consistently, this is why many investors opt to invest in funds with broad exposure to the S&P 500 — had Ackman done this with his JC Penney investment he would have done much better than -50%.

This would have deprived Ackman from his attempt to control parts of JC Penney’s business as an activist, however, that attempt was unsuccessful. JC Penney is losing money, has no net income, negative EBITDA, and $1.5B cash on hand against $5.8B in debt. Did I mention the company suspended its dividend in May 2012. One moral to the story is to invest amounts that are comfortable, had the Ackman / JC Penney investment been implemented differently, he might be buying up more of the company right now (like Soros.)

Short-Term vs. Long-Term

On the subject of hedge funds, former Medtronic CEO Bill George recently wrote a must read article detailing some of the hasty decisions by some large hedge fund managers. In the article Mr. George points to insistence by Nelson Peltz that PepsiCo (PEP) buy Mondelez, then break up into separate companies:

These activists have a keen sense of timing, buying up shares when the stock is down because of near-term events. There is nothing wrong with that. Warren E. Buffett does the same. The difference is that Mr. Buffett invests for the long term…

A relevant example is Mr. Peltz’s demands to restructure PepsiCo. After forcing the spinoff of Kraft’s North American business into a company called Mondelez, Mr. Peltz’s Trian Partners is left holding 3 percent of a company that cannot compete with global leaders like Nestlé and Unilever. So Mr. Peltz wants PepsiCo to buy Mondelez and then split into two companies: beverages and snacks, including Mondelez. This financial engineering makes no sense. Rather, it demonstrates Mr. Peltz’s lack of understanding of what is required to run successful global enterprises.

Step back a moment, Bill George could be right, and he could be wrong. Remember Nelson Peltz has thus far stayed in Wendy’s for a longer-term, than say Bill Ackman. On that same note remember Berkshire Hathaway owns Dairy Queen. Bill George goes on to say:

In 2009, Mr. Ackman tried to pressure Target to break up its integrated portfolio of retail, real estate and credit card holdings, mimicking Eddie Lampert’s disastrous strategy at Sears. Target fought back, won 80 percent of shareholder votes in a proxy fight over Mr. Ackman’s proposed board slate and focused on its long-term strategy to compete with Wal-Mart Stores. Since then, Target’s stock is up 64 percent.

So hopefully you get a sense for George’s valid concern, some of the fund managers want to make a quick buck — entering on weakness, shouting from the mountain tops something should be done, and walking away after a brief recovery, that potentially leaves the company at a disadvantage.

Hindsight is 20/20: Thoughts on JC Penney’s Business Model

Somewhat incredibly Morningstar still has JC Penney stock rated four stars, I can only presume there is some sort of lagging in their analysts’ review process. The company does not have a dividend anymore, therefore legions of dividend investors likely have jumped ship. It is understandable to stand by a company with a dividend, think Hewlitt-Packard (HPQ) and Ford (F).  Though Ford cut its dividend in 2006 and resumed it in 2011, the automaker is in a vastly different industry than JC Penney (ie: Ford produces vehicles and supplies credit so buyers can buy or lease a vehicle, JC Penney sells much less expensive products.)

JC Penney tried offering barber services (with over 900 salons in its stores) to improve the experience and become a destination for shopping moms. But simply put they need to have the clothes people want at unbeatable prices. On top of this they must supply products made in compliance with labor laws — in fact the winner of the apparel / retail industry may be the company who can, for the most part, fully automate the production of clothes and make them affordable enough to manufacture domestically. Such a system could reduce margins, by working to fulfill actual demand.

JCP has lines of clothing it sells exclusively, like Olsenboyye (Mary Kate & Ashley Olsen’s clothing brand), the company also hosts 375 Sephora beauty departments, Sephora is a subsidiary of French powerhouse LVMH (LVMUY). From 2011 to 2012 the most recent 10-K showd JC Penney’s home sales dropped from 15% of total business to 12%, while fine jewelry went up from 4% to 7%. JC Penney bought Liz Claiborne from Fifth & Pacific (FNP) in October 2011, and also owns Original Arizona Jean Company — still the business is currently troubled (though with all of the property, high end cosmetics and the unfulfilled potential to sell high quality clothes at low prices, I begin to see why some think there is value in Penney, though be mindful again of Eastman Kodak.)

To avoid the mistake Ackman made, look at the company’s debt, look at their credit rating and interact with the company; do they meet your expectations as a customer, or not? Most importantly, is the company pulling in a profit — are the shares being liquidated by a few executives, or diluted through executive stock packages? Can your portfolio sustain a 50% or greater loss, in case the company falls flat? Furthermore determine whether the company is effectively engaged in e-commerce, JC Penney does have a website; however similar to Wal-Mart, in my opinion, they are not nearly as functional as Ebay and Amazon.

Mutual Fund Ownership

At this point the only logical way to invest in JC Penney, if there is anyone left who believes the company is salvageable, is through mutual funds. It is possible for JC Penney to bounce slightly, however remember currently it is losing money.

American Funds and Loomis own a considerable amount of JC Penney bonds, American Funds even loaded up on $8M worth recently; though I wonder if the managers are having second thoughts. Investing is complex, however the core principles are simple: what works, works and should be emulated; what does not work, doesn’t and should be avoided.

It is essential for investors to research mutual funds with long histories of success. Had Ackman modeled Pershing Square along the lines of a quality mutual fund he’d likely have reduced risk. Ten percent or more of Pershing Square’s total assets into a very distressed company, turned out not to work. Ironically Ackman made his name saying MBIA was not AAA, however dove into a company actually headed to CCC-, so the moral of this story is to be observant of credit ratings and debt situations before leaping.

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