The Deal: J.C. Penney's Dilemma: To File or Not File

NEW YORK ( TheStreet) - Distressed investors piling into department store chain J.C. Penney ( JCP) could be taking note of the company's liquidity crunch and figuring on either a turnaround or an eventual bankruptcy.

When hedge fund manager William Ackman left the company's board after a public feud over who should be managing the retailer, he promptly dumped his 18% stake through a Citigroup ( C)-underwritten share sale at $12.90 a piece.

JCPenney shares were gaining 0.1% to $14.24 in Friday trading.

But instead of staying away, other big-name hedge funds piled right on. Richard Perry, who knows a thing or two about retail distressed investing--last year with the help of Ron Burkle's Yucaipa Cos. LLC he engineered a debt-for-equity swap for Barney's Inc. with then owner Istithmar World PGSC--has an 8.62% stake in the company. J. Kyle Bass' Hayman Capital Management LP took a 5.2% stake, while Glenview Capital Management LLC revealed a 9.1% stake.

That doesn't mean, however, that those investors don't have their eye on the downside. Hayman Capital, for one, has reportedly picked up J.C. Penney debt in the form of investing in the company's secured loans.

One industry banker even has a timeline for when the retailer should start thinking about formulating plans for a bankruptcy filing. If the company isn't seeing momentum build by October, this person said, then it should start consulting its advisers about a trip to court.

What will tip the scales in favor of bankruptcy is when factors such as CIT Group Inc. begin to lose confidence in J.C. Penney, which would damage its ability to buy inventory. For now, however, the banker said, factors still expect to be paid so it's currently under no pressure to file. (Factors buy a company's accounts receivable, or invoices, at a discount.)

And one distressed investor, David Tawil, co-founder of hedge fund Maglan Capital LP, which does not have a stake in J.C. Penney, said it would be better for the company to file for bankruptcy sooner, rather than later. Tawil, a former bankruptcy attorney at Skadden, Arps, Slate, Meagher & Flom LLP and Davis Polk & Wardwell LLP, and then a fund manager at Credit Suisse Group analyzing distressed situations, said that when companies wait until they run out of cash to file for bankruptcy, they end up liquidating, rather than reorganizing.

That's what happened to both electronics retailer Circuit City Stores Inc. and Linens Holding Co., parent of housewares purveyor Linens 'n Things. In the case of Linens Holding, the company had its bankruptcy case converted from a Chapter 11 to a Chapter 7 case in 2010, because it did not have sufficient liquid assets to fund a Chapter 11, leading to the retailer's liquidation.

As for Circuit City, not only did it not have enough cash, but it lost out on debtor-in-possession financing it had arranged after missing several milestones or breaking several covenants, including failing to obtain junior financing and not hitting certain revenue targets.

And if J.C. Penney realizes it is going to have to file for bankruptcy, it needs to have a plan on how it will emerge already formulated before it files, the industry banker said. Companies that do not have a plan when they file often get liquidated, because there is not enough time after filing to put together a plan.

Plus because of changes to bankruptcy law, retailers have 210 days to reject leases, effectively limiting the time to actually come up with a plan to four or five months, the banker said, which means they can run out of time. Circuit City said a major factor in its liquidation was that 210 days was not enough to determine which leases to reject.

Tawil said, however, that Circuit City did not have a plan for its real estate when it filed for bankruptcy. He said a retailer must know which stores it plans to close and which stores it will keep open before even filing. While J.C. Penney is likely to make it through this holiday season, if it were to wait until December 2014 to file, Tawil said, it could be too late.

Instead, the struggling retailer should take a lesson from AMR Corp., parent of American Airlines, and file early so that it has enough cash, and therefore leverage, to reorganize and emerge from bankruptcy at least somewhat intact.

AMR, he said, surprised everyone by filing much earlier than expected while it was still flush with cash. And J.C. Penney may have few alternatives to filing for bankruptcy.

An out-of-court restructuring would do little to help J.C. Penney work out of its troubles, as it would be limited to restructuring debt. One option would be to issue new shares in the company and swap them for debt, but that would require approval by shareholders and is, therefore, hard to pull off.

"There's no out of court in this situation," Tawil said. Of course, when Linens Holding and Circuit City filed for bankruptcy during the fallout from the 2008 financial crisis, the pendulum had swung strongly in favor of lenders, and not only were covenants more onerous, but interest rates could be as high as Libor plus 1000, Tawil said.

In some cases if there are assets and/or a solid turnaround plan, since lenders are eager to advance money, DIP financing may be more feasible. But J.C. Penney has already collateralized all of its real estate and has few assets left that would be attractive to would-be lenders. The department store chain would be at the mercy of its existing lenders, which might choose to provide a minimal amount of additional financing, perhaps $100 million, but only in exchange for extra protections on existing loans, Tawil said.

One thing is for sure: Unless J.C. Penney slows its cash burn, it will have to do something drastic. In July, Moody's Investors Service calculated J.C. Penney would burn through $1.4 billion in cash by year's end, but in just the second quarter the retailer said it had spent more than $700 million, beating analysts' expectations on the downside.

Comparable store sales sunk another 11.9% in the second quarter, on top of sinking 21.7% for the same period a year ago and over 25% for all of fiscal 2012.

Its only assets left to monetize in order to fund operations are its Liz Claiborne and Monet brands, which it acquired for $268 million from Liz Claiborne Inc., now known as Fifth & Pacific Cos., in 2011. J.C. Penney said it expects to end this year with about $1.5 billion in liquidity.

-- Written by Leon Lazaroff in New York

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