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Penney’s Stock Soars on LBO Talk

Shares of J.C. Penney Co. shot up 8.4 percent on Thursday based on reports it could be bought out by at least two private equity firms.

NEW YORK — Amid indications that the management of J.C. Penney Co. will resist a takeover attempt by private equity firms, the national retailer’s stock shot up 8.4 percent on Thursday.

Myron Ullman 3rd, Penney’s chairman and chief executive officer, said in a statement, “We have developed a long-range plan that will be discussed with our investors at our analyst meeting on April 19 and 20. We believe this long-range plan lays out a strong set of goals and strategies for taking J.C. Penney to a leadership position in the retail industry and will deliver value to our investors.”

Ullman did not comment directly on reports that Cerberus Capital Management LP and the Carlyle Group, along with another private equity player, were contemplating a move on Penney’s in a $16 billion to $18 billion leveraged buyout.

But Merrill Lynch analyst Daniel Barry said in a research report that a potential deal between Cerberus-Carlyle and Penney’s “has validity” because Vanessa Castagna, the former number two in charge of Penney’s, is joining Cerberus as a senior member of its operations team and executive chairwoman of Mervyn’s department stores, which Cerberus partly owns.

Barry speculated that the deal’s price tag might be higher than the $16 billion to $18 billion number floated in the market on Wednesday, citing improved margin opportunity at Penney’s. “EBIT margin was 7.2 percent last year, up from 1.2 percent in 2000, and our forecast is 7.9 percent this year,” Barry wrote. “New management has said that its target is 8 percent to 10.5 percent.”

The analyst said Penney’s catalogue/Internet division has “double-digit growth potential and should command a premium to the company itself.”

In addition, Barry wrote that, because of Cerberus’ ownership of Mervyn’s, it could convert some of those stores to Penney’s locations and create “value that Penney could not do on its own.”

Barry concluded that he “expects [Penney’s] management to contest the offer, possibly by buying back a large amount of stock.”

Ullman, who succeeded Allen Questrom at Penney’s last year when the board passed over Castagna, is a takeover veteran, having led the unsuccessful fight against Federated Department Stores’ purchase of R.H. Macy. Ullman was ceo of Macy’s.

This story first appeared in the April 1, 2005 issue of WWD.  Subscribe Today.

A Carlyle Group spokesman declined to comment on the possible deal. Cerberus Capital did not return calls.

Penney’s shares closed up $4.02 to $51.92 in New York Stock Exchange trading, just shy of a seven-year high. The company’s market capitalization rose to $14.1 billion from around $13 billion on Wednesday.

People familiar with the stock weren’t surprised with its price increase, but were mixed on whether the potential transaction makes sense largely because the estimated price is too high.

If the private equity firms paid that much, it would make it difficult for them to realize an adequate return on investment, should they own the company for around five years.

The possible $16 billion to $18 billion price tag would make each share of Penney’s stock worth $56 to $63. Still, one hedge fund player, who holds a position in shares of Penney, hoped for a deal that could go as high as $65 a share.

A buy-side analyst at a New York-based hedge fund speculated that the two private equity firms could put 25 to 35 percent of the $16 billion to $18 billion price tag down and borrow the remainder. The firms would likely then prove Penney’s is a cash cow by drastically cutting costs.

With interest rates low, the private equity group might then borrow more money next year. “With the money they borrow, they pay themselves a private dividend, so they take half of their equity out and then effectively have zero equity in the deal….They still own the company, but they have no equity in capital investment from the stock,” the buy-side analyst said. The firms would likely want to make their total investment in Penney’s last around two years, rather than the typical expectation for five to six years.

One reason a deal where Penney’s is bought for its cash flow potential is possible — even at the expense of hurting the company — is because the high yield market has too much money in it, the buy-side analyst stressed.

“At a certain point, [Penney’s] can’t turn down a legitimate offer…even if you feel like the company can’t survive in the long run,” he said. “It’s all predicated on what the high yield market will swallow.”

Yet, a different buy-side analyst echoed the views of others in the equity investment market, saying a buyout of Penney’s doesn’t make sense because the price is too high. “I can’t see how a private equity guy will get the math to work at that type of level,” said Francis Radano of Gartmore Global Investments, whose firm owns shares of Penney’s. “J.C. Penney is already trading with the assumption of 8 percent EBIT margins, which are much closer to peak than trough — if not at peak levels.”