A month ago, top U.S. mall owners Simon Property Group (NYSE:SPG) and Brookfield Property Partners (NASDAQ:BPY) were closing in on a deal to buy J.C. Penney (OTC:JCPN.Q) out of bankruptcy. Negotiations hit a snag in late August, though. That led the department-store chain to propose selling itself to its creditors in a last-ditch effort to avoid liquidation.
Fortunately, cooler heads have prevailed. On Wednesday, bankruptcy attorney Joshua Sussberg announced in court that J.C. Penney had resuscitated its deal with Simon and Brookfield and the parties had signed a letter of intent to sell the retailer to its top landlords. Let's take a look at what that means.
The sale to Simon and Brookfield is on again
Sussberg announced that Simon Property Group and Brookfield Property Partners have agreed to an enterprise value of $1.75 billion for buying J.C. Penney's operations. That would be $100 million higher than their initial bid and in line with the highest offer from the first round of bidding in July.
The actual cash contribution from Simon and Brookfield is just $300 million, though. The majority of the enterprise value relates to financing being rolled over by some of the retailer's existing lenders.
Thanks to favorable results from negotiations with the company's landlords, J.C. Penney currently plans to maintain a "go-forward" store fleet of 653 locations. While that would be down from 846 stores at the beginning of 2020, the company's initial bankruptcy plan called for shrinking to 604 stores. (Additional store closures in future years are still a possibility, of course.)
The agreement with Simon and Brookfield also includes a working capital "earn out" provision. The parties expect J.C. Penney's merchandise-accounts payable balance at the time of closing to be $235 million. For comparison, merchandise-accounts payable has averaged perhaps $800 million to $900 million in recent years
To the extent that the new J.C. Penney rebuilds its payables balance over the next two years -- which would effectively free up cash -- Simon and Brookfield will pay 20% of the difference to the bankruptcy estate. This could potentially add $100 million or a bit more to the recovery eventually available to creditors.
Real estate spinoff still in the cards
As part of its bankruptcy-exit plan, J.C. Penney still intends to spin off most of its real estate assets as a separate real estate investment trust (REIT). The new REIT will own 160 stores, which J.C. Penney's new owners will lease back for 20 years (with five five-year renewal options). The initial base rent will be $121 million a year. The master lease includes provisions enabling the REIT to recapture certain stores with high alternative-use value and for J.C. Penney to remove underperforming stores from the master lease under certain conditions.
A separate REIT subsidiary will receive title to the six distribution facilities that J.C. Penney owns. The new operating company will lease back these distribution centers under terms similar to the store master lease. The initial base rent will total $35.4 million per year.
What does it all mean?
By keeping J.C. Penney's retail operations intact, Simon Property Group and Brookfield Property Partners are keeping an important anchor tenant alive. (Both mall owners have dozens of JCPenney stores in their portfolios.) The agreement will also preserve approximately 70,000 jobs -- for now, anyway.
On the other hand, the bid price is rather low relative to the scale of J.C. Penney's liabilities, which totaled $8.5 billion at the beginning of August. J.C. Penney's secured lenders should eventually recover most of their investment, but unsecured creditors are likely to wind up with a token payout at best. Shareholders are almost certain to have their investment wiped out entirely.
Even with J.C. Penney shedding most of its debt, the retailer's long-term prospects are dubious. The company's formal business plan calls for earnings before interest, taxes, depreciation, and amortization to grow to $836 million by 2024 from $583 million last year. However, that assumes the retailer can maintain a roughly stable top line and increase gross margin while holding annual capital spending below $262 million and slashing key expenses, like marketing spending and store payroll costs.
J.C. Penney's thrifty investment budget and spending cuts may cause revenue to decline more than its official business plan contemplates. However, given that Simon and Brookfield aren't putting up that much cash to buy the business, the downside risk for the mall owners is minimal. And if J.C. Penney manages to hit its targets, the property giants could earn a big windfall from their $300 million investment.