Who Owns the Company (Bon-Ton Stores)

May 30, 2009

Of course, the previous post is common knowledge. By way of example, and to illustrate a strategy that commonly arises from market misconception (I’m glad to say I thought of before I read an excellent out-of-print book, Margin of Safety by value investor Seth Klarman) is to buy the junk bonds of a company and short its stock. This opportunity arises from a confusion in the public’s mind about who actually owns the company–not in the legal sense, but in the sense of who receives the economic benefit of owning it. Normally, buying the bonds and shorting the stock is a losing bet because bond buyers generally insist that debt service payments be covered several times by the issuer’s income and the bonds do not participate in any expansion of the company. However, when a company’s earnings are barely sufficient, or insufficient, to cover debt service, hardly anything flows through to the equity owners. Thus, the bondholders have all the benefit of owning the company, and the stock becomes an afterthought, a thing that only exists because someone has to hold it.

Of course, it is necessary that these facts have not crystallized in the minds of the investing public. When the stock has already dried up to nothing, or the sub-1$ graveyard area, shorting it will not provide much of a hedge. In fact, very low-priced stock behaves more like a call option on the company’s future. So, in the unlikely event that the company recovers, the bonds will certainly regain some of their price, but the recovery will be dwarfed by a massive loss in the short position. But if the stock has room to fall, then it can serve as a useful hedge. Any losses taken on the bonds will be offset by gains on the short position. On the other hand, if the company should strengthen its position, then to a degree the bonds should benefit before the stock does, at which point the position can be closed. Even in the likely event of default, the insolvency proceedings will more than likely make the stock worthless, or at least severely diluted. The bonds, which will have paid a nice high interest rate until the default occurs, may or may not decline to zero. And in bankruptcy, the bondholders usually emerge as the new owners of the reorganized company, thus enshrining in law the economic reality of the situation.

Bon-ton Department Stores offers an example of this sort of arrangement. In 2006 the company engaged in what was in retrospect a dramatically ill-timed expansion fueled by leverage. In 2007 they barely earned enough to cover their interest, and in 2008 they didn’t earn enough. In mid-2008 the bonds stood at around 64 with a current yield of 16% and the stock was around $5 a share and, inexplicably, paying 20 cents a share in dividends, or 4%. During the market panic, the bonds declined to the teens in March and the stock dropped to 75 cents. As of today, May 28, 2009, the stock is around $4 and still inexplicably paying dividends, and the bonds are at 46. The company is projecting losses in 2009 as well; in fact, the losses are projected to be between $3.40 to $4.30 a share, about the share price of the stock. Adding back in 2008’s interest payments (not all of which is attributable to the bonds, of course) produces $.81 to $1.71 in profits. So it should be pretty clear who really owns Bon-Ton, and pretty unclear why the stock is trading at above graveyard prices. Management claims to be belatedly enacting a program of cutting costs and improving margins, but even if their projections are accurate, the improved situation will inure to the benefit of the bondholders, and their prices should recover before the stock explodes.

I hope you found this informative. Thank you for reading and good luck.

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