J.C. Penney - Short Squeeze in the Making?

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According to Bloomberg, as of Mar. 21, J.C. Penney (NYSE: JCP) has a 42.6% short interest. This means that of J.C. Penney's entire float of 219.2 million shares, there are more than 93 million that have been shorted. What this immediately tells us is that investor sentiment for J.C. Penney is very low. Nearly half of all J.C. Penney investors are betting for the stock price to fall even more, and with good reason too! Over the past year, shares of J.C. Penney have fallen more than 43%, and even within 2013, share prices have dropped 20%. These drops are due to net income falling into the negative. Their annual report, released Jan. 28, 2012, illustrated a loss of $152 million. Things got even worse in their annual report released Feb. 2, 2013, however, as we saw net income falling even more, amounting to a grand total of a $985 million loss. To put this into perspective, the 2012 loss alone is equivalent to 81% of the net incomes of 2008, 2009 and 2010 combined. But, why this monumental loss, and what does it have to do with a short squeeze? We'll look into both of these.

On Feb. 1, 2012, J.C. Penney rolled out a new plan to stop advertising hundreds of sales each year and instead offer low prices every day, while attempting to rebrand itself simply 'jcp.' This new plan received poor reception from shoppers, who have traditionally waited for J.C. Penney's famous sales before shopping at the retail giant. Huge sales losses due to a decrease in the number of shoppers prompted management to announce plans to stop paying dividends on May 15, 2012, causing nearly a 20% crash in the share price in just one day. Additionally, the rebranding of the store's household name caused confusion to investors and shoppers, who were used to J.C. Penny, further pushing down sales revenue and share prices throughout the year.  

With that said, it shouldn't come as a surprise that many investors wish to short the badly beaten stock. A smart investor who predicted the J.C. Penney crash early could have made a fortune by shorting the stock before it fell 64% since Feb. 2012.  But, when 43% of the shares become a part of the short interest, the opportunity for profiting off a short sell diminishes. As can be expected, when a company like J.C. Penney, with a balance sheet containing $11.4 billion in assets, is in trouble, countless suggestions are made as to how they can turn around the company. Since the crash in May 2012, these suggestions have included everything from reverting back to the original J.C. Penney brand, to becoming a REIT. For the purposes of this article, we will focus on the potential for J.C. Penney to become a REIT.  

A REIT, or real estate investment trust, is an entity that trades on a stock exchange and directly invests in real estate. REITs rent out properties to other businesses, receive special tax considerations and typically offer investors high dividend yields. With 1,107 stores across all 50 states and Puerto Rico, J.C. Penney is a perfect candidate to transform into a REIT. In 2012, REITs returned a total of 20% to investors, compared to the S&P total return of 16%. Clearly, there is money to be made in this emerging industry.

DDR (NYSE: DDR), a good comparison to a hypothetical J.C. Penney REIT, owns and operates retail shopping centers in 41 states, Puerto Rico and Brazil. Successfully leasing out 93.4% of its portfolio in 2011, DDR leases to companies such as Wal-Mart, Kohl's, T.J. Maxx, Michael's and Bed Bath & Beyond. Operating 538 properties around the world, DDR brought in revenue of $800 million in 2012. Since its remodeling in Sept. 2011, DDR's stock has appreciated by more than 60%, despite missing EPS estimates in 3 out of 6 quarters. If J.C. Penney was to convert its 1,107 stores into a REIT business structure, a steep share appreciation would likely also occur, causing the short sellers to have their shorted shares called in and causing a short squeeze.

A short squeeze is a situation where a stock price is forced upward by an excess demand and a shortage in supply. Those who hold short positions are forced to repurchase shares to minimize losses, further pushing the stock price upward. This causes a chain reaction, especially in companies with large short interests, as more and more short sellers are forced to repurchase their shares. The effects of short squeezes can be as colossal as in 2008 when Volkswagen (NASDAQOTH: VLKAY) shares increased by nearly 500% in two days, making the German auto manufacturer the most valuable company in the world (for a short time). When Porsche announced plans to acquire a larger stake in the German auto manufacturer, Volkswagen's large number of short sellers were forced to cover (buy back the shares they shorted) their shorts, pushing the stock price further upward. The mind-boggling share appreciation, in this case, generated mighty profits for those who were long the company. To offer more insight, Volkswagen's stock had only a 12.8% short interest at the time. With J.C. Penney's short interest of more than triple that, this stock has the potential to be an even bigger short squeeze than Volkswagen.

Will J.C. Penney experience a short squeeze like Volkswagen did? We might not see the retailer overtake Apple and Exxon-Mobil as the largest company in the world, but it seems likely that if the company were to convert to a REIT and see a decent rise in share price like DDR did, the sheer number of shorts that would be covered would shoot the share price off the charts as investors tried to get out of their short positions as quickly as possible. The opportunity to profit from shorting J.C. Penney may be over, but if you buy in now you might just be a part of the biggest short squeeze of the century.

Jake Pompeo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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