Back in April, in a desperate scramble to raise liquidity courtesy of a hail mary Goldman syndicated term loan, we penned "Confused By What Is Going On At JCP? Here's The Pro Forma Cap Table And The Cliff Notes", where in addition to the obvious - that this is merely buying a few months for the melting icecube company which with every passing day is closer to a Chapter 11 (or 7) bankruptcy filing - we also laid out that what Goldman was doing was merely positioning itself to be at the top of the company's capital structure with a super secured and overcollateralized credit facility, through what is effectively a pre-petition DIP. Of course, if that was the case, then after a certain period of time Goldman was actively start agitating to destabilize JCP in a way that slowly but surely (or rapidly and even more surely) pushed it into bankruptcy before even more collateral/assets was wasted away. As it turns out we only had to wait for five months before the same Goldman that raised the company's emergency liquidity term loan turned around and launched a vicious attack on the same company that paid it millions in dollars in underwriting fees.

Specifically, what Goldman just did is write a report (perhaps one of the best bearish cross-asset investment theses we have seen to come out of the firm in a long time) in which it laid out, in a lucid and compelling manner, why JCP is doomed. The report is titled appropriately enough: "Initiate on JCP with Underperform: Looking for cash in the name"... and not finding it. Furthermore, not only is Goldman saying the company's unsecured bonds are impaired, with a recovery on the tranche reaching as low as 13% in a liquidation bankruptcy scenario or as "high" as 65% in the best case going concern outcome (which also suggests the equity is pretty much worthless) but is advising clients to buy either 5 Year CDS (with expectations of a near term blow out in default risk) or alternatively a CDS steepener (sell 1 Yr, buy 5 Yr).

But before we get into the nuances of the report (which for those who have read our extensive coverage on the name will be nothing new), here are some of the more amusing, and confusing, aspects of the Disclosure section:

Goldman Sachs beneficially owned 1% or more of common equity (excluding positions managed by affiliates and business units not required to be aggregated under US securities law) as of the month end preceding this report: J.C. Penney Company

(excluding positions managed by affiliates and business units not required to be aggregated under US securities law) as of the month end preceding this report: J.C. Penney Company Goldman Sachs expects to receive or intends to seek compensation for investment banking services in the next 3 months: J.C. Penney Company

In other words, Goldman is now actively trying to destroy the value of its equity investment in JCP. Obviously, the firm would not be doing this unless it had some other motive at hand. Namely: to offset equity losses through other means, be it more investment banking fees (for which it intends to be compensated in the next three months), or from cap structure arbitrage. Because nothing helps forget an equity wipe-out, like a blockbuster CDS blowout from 1000 bps to several thousands basis point wider. In fact, the more dramatic the bankruptcy, the greater the return. It is precisely the CDS that Goldman is now long, in what is a bet that the end for JCP is nigh.

Going back to the report, here is how Goldman frames the endgames for JCP:

We initiate on JCP’s 7.95% unsecured bonds due 2017, its 5.65% notes due 2020, and its 6.375% notes due 2036 with an Underperform rating. We recommend that investors buy 5-year CDS, and also recommend a steepener, whereby investors sell 1-yr CDS and buy 5-yr CDS. Additionally, although we are comfortable with the collateral value at the top part of the structure, in our view, the company’s term loan could experience downside if the company were to tap the debt markets for incremental liquidity as discussed below. As a result, we are waiting for a better entry point on the term loan. JCP is now in our HY coverage.

Of course Goldman is right that should JCP raise more funding (and as Goldman lays out further on, the most likely source of cash is a 2nd Lien), it would impair the existing secured Term Loan: a Term Loan which is likely still mostly on Goldman's own books. Which is why it is in Goldman's interest that JCP does not dilute the corporate collateral any more, and proceed straight to Chapter 11 (or better yet, 7). After all, as Goldman notes, even in a worst case scenario the term loan is fully covered (that remains to be seen).

The reason why Goldman is coming to the public now with its bearish thesis, is as follows:

In our view, a combination of weak fundamentals, inventory rebuilding, and an underperforming home department will likely challenge J.C. Penney’s liquidity levels in 3Q. In order to safeguard against a potentially poor 4Q holiday season, it is likely that management will look to build a bigger liquidity buffer, as has been suggested by recent press reports. Although we believe this would be a prudent measure for the company, given our expectation for new capital to come in the form of additional debt (rather than equity), we believe this will be a negative catalyst for creditors.

Especially those creditors who bought the Goldman syndicated term loan (the part that Goldman was able to offload from its balance sheet).

So what happens next if Goldman is right? First CDS blows out to fresh wides, which means at least 300 bps of imminent widening as the company attempt to conduct a new secured leveraging transaction.

Goldman continues:

With this as a backdrop, we recommend investors put on a steepener (sell 1-year CDS and buy 5-year CDS), based on the view that the company has some liquidity triggers available that should enable it to extend its life, but that it will continue to encounter a difficult fundamental backdrop within which to effect a turnaround. Liquidity triggers include: Sell fringe land (est. value: $100mn)

Sell tire, battery, and automotive locations (est. value $115-135mn)

Sell mall partnership interests (est. value $100-150mn)

Tap debt markets for $500mn of incremental second lien bank loan or bonds (est. value $500mn)

Raise equity (up to $1bn)

Monetize portion of its below-market leases (up to $400mn)

But it is what comes next that is the biggest kick in the groin of the company's recent (and soon to be future) client: Goldman's tongue in cheek discussion of JCP's bankruptcy.

Finally, although we believe handicapping a bankruptcy filing for JCP is premature, we do believe that understanding likely recovery values in the event of a bankruptcy is an important exercise. To that end, we view the term loan as the safest liquid instrument in the capital structure given our base case of a par recovery. We expect recovery on the unsecured bonds to range from 47-65%. However, under the scenario where the company issues $500mn of incremental secured debt, the recovery range would fall to 35-54%. We provide a full recovery waterfall later in this report.

Before Goldman discloses its waterfall residual value analysis, it naturally has to make sure that at least the term loans are not impaired in even a worst case scenario. While it can't explicitly do that, it goes as close as possible.

In Exhibit 3, we compare JCP’s secured term loan to other term loans in the space that are secured by real estate. As discussed in a later section of this report, we think that JCP’s real estate collateral offers ample coverage for the loan. However, we are looking for a better entry point. We think that JCP’s term loan could see near-term weakness if the company were to issue a 2nd lien bond with a pledge on the ABL collateral. At a price (ask) of $98.5, the JCP term loan yields 6.4%. This compares to the Toy Delaware term loan, which trades at $96.5 and yields 6.1% and Toy’s Propco I unsecured term loan, which trades at par and yields 6%. We think it is appropriate for JCP to trade wide to Toy Delaware and Propco, and think this relationship could widen slightly. Although we acknowledge that JCP has some liquidity triggers at its disposal we think that JCP would likely encounter liquidity difficulties prior to TOY (Toy still generates positive free cash flow).

We disagree with Goldman that the JCP Term Loan is money good: in fact, in even a simple Chaper 11 with DIP, it is quite likely that the term loan will end up being the fulcrum security, but that is a bridge we will cross when we get to it. For now, the question is what options the company has in order to raise near-term liquidity when things once again turn out worse than expected. There aren't many.

While J.C. Penney pledged the vast majority of its real estate assets to its term loan, it still has some liquidity levers left. Additionally, in fiscal 2012, the company incurred a federal net operating loss (NOL) of $1.5 billion of which approximately $284mn was carried back. The remaining $1.2 billion carry-forward (expiring between 2013 and 2032) is available to offset future taxable income. As a result, the tax implications of any asset sales should not be onerous. Below we provide a list of potential triggers divided between “simple” levers and those that would likely prove more complicated Liquidity triggers Sell fringe land (est. value: $100mn): JCP owns 240 acres of vacant land surrounding its headquarters in Plano Texas. This fringe land is not part of the term loan’s collateral package. In 2011, when JCP began marketing the land, the Collins County Appraisal District appraised it at $150 million. Given that JCP has not yet sold the land, it is possible that its actual market value may be below appraisal value. We assume a 30% haircut and estimate potential proceeds of $100mn. We note that the credit agreement allows JCP to contribute fringe land to a joint venture for the purpose of developing it. As a result, JCP may choose to develop the land to garner a higher value; therefore it is not clear that monetization of fringe land is a near-term liquidity lever. Tire, Battery, and automotive locations (est. value: $115-135mn); J.C. Penney owns 30 tire, battery, and automotive locations that are not pledged as collateral. Assuming an average store size consistent with history, the square footage of these locations would total 2.5-3.0mn. Assuming a valuation of $45/square foot (JCP’s assets have a lit appraisal value of $55-60/square foot) translates to $115-135mn valuation. Regional mall partnership units (est. value: $100-150mn); J.C. Penney owns 8 regional mall partnerships that they could monetize. Last year, they sold one for $65 million. The company has not provided information about where the mall partnerships are located. Issuing an additional $500mn of bank loan or bonds ($500mn); The company’s ABL has a $400mn accordion. Its bank loan has a carve-out for $500mn of “debt issued under the ABL credit agreement”. The company would have the ability to issue new debt with a second lien on the inventory that comes ahead of the term loan but behind the ABL. We think that it would be difficult for the company to issue incremental ABL because its current ABL has a clause that could require the company to reprice its existing ABL, making it a costly option. Equity raise (est. value: up to $1 bn); According to Bloomberg, JCP’s top five equity holders own almost 50% of its equity. If equity holders are confident that JCP can re-attract its customer base, they may be willing to commit more capital in the form of backstopping a rights offering, a convertible, or an outright incremental equity offering. We’ve listed these in order of our view of probability.

That said, and here we do agree with Goldman, the most likely option for JCP is more secured debt in the form of a Second Lien.

... we conclude that secured debt is the most likely near-term liquidity lever for the company. Although unsecured issuance is possible, with outstanding debt trading at double-digit yields, it is unlikely that the company would be able to issue at palatable levels. This leaves us with secured debt as the most likely liquidity lever for the company nearterm. Here the company’s options are limited by the term loan credit agreement. Our reading of the credit agreement suggests that the only available carve-out for secured debt that is raised for the purpose of putting cash on the balance sheet is a carve-out for indebtedness under the ABL credit agreement up to $2.35bn. This provides the company with room for an additional $500mn of ABL debt. Although the ABL credit agreement provides for a $400mn accordion, our understanding of the covenants suggests that the company would need to re-price the entire ABL to take advantage of this. As a result, we believe it is most likely that the company would issue a 2nd-lien instrument backed by ABL collateral.

Which then brings us to the meat of the matter: Goldman's bankruptcy "waterfall" residual value analysis, which unfortunately for the bondholders, and certainly the equity, runs dry about half way through:

Based on our recovery analysis, JCP’s bank loan and ABL would recover par (plus postpetition interest) under each scenario and its unsecured bonds would recover 47-65% under two of three scenarios, and 15% under a full scale liquidation, which we view as unlikely. The scenarios are discussed below. However if the company were to issue bonds that have a 2nd lien on inventory, our waterfall suggests that this would reduce unsecured recovery by 11-12pts, leading to an estimated recovery of 35-54% under Scenario 1 and 2. If the JCP were also to grant new debt an unsecured guarantee on its guarantor subs, it could reduce the recovery potentially more. Because the real estate collateral is sufficient to cover the bank loans in most cases (except dark value appraisal), the pledge of second lien on inventory is less onerous to the bank loan than to the unsecured bonds. In terms of the bank loan, $3.2 billion of assets are pledged to cover $2.25bn of term loan. The collateral value would have to fall by $950mn, or approximately 30% before the term loan recovery even relied upon inventory value. As shown in Exhibit 7, the bank loans are issued by J.C. Penney Corporation Inc., and are guaranteed on a senior secured basis by J.C. Penney Purchasing Corporation, JCP Real Estate Holdings, Inc., and J.C. Penney Properties, Inc. The company’s unsecured bonds are co-issued by J.C. Penney Corporation, Inc. (OpCo), and J.C. Penny Company Inc. (Holdings) and have no subsidiary guarantees.

For those curious about the intercreditor nature of the Org Chart linkages, you are in luck - it is shown below, although...

... it is largely irrelevant. Once the pre-bankruptcy filing tailspin begins, the only constant will be utter chaos as every stakeholder in the ungainly capital structure scrambles to generate whatever recovery they can. Which again, won't be much:

We considered three scenarios in estimating the recovery values for JCP debt: Scenario #1: Going concern with no DIP loan. In this hypothetical scenario, we postulate that CEO Ullman could choose to file the company earlier than absolutely necessary given a higher level objectivity (he was brought in to fix an existing problem). However, under a scenario where traffic, conversion, and margins do not improve, and cash levels fall below what we view as a $500mn minimum threshold, if he has already pulled the “simple” liquidity triggers, it is possible he may file it and restructure it as a going concern. This scenario assumes that he files the company with $450 million of cash on its balance sheet and a fully drawn ABL (minus $125mn because if ABL availability falls below this level JCP becomes subject to a 1.0x fixed charge covenant requirement). Because of the cash on its balance sheet, we assume that the company files without a DIP loan. We think it is most likely that JCP would operate as a going concern if it were to restructure. Generally, the most important factor in identifying retailers who have reorganized as a going concern has been their ability to access new capital (rights offerings, new debt put in place at emergence). Many of the retailers that liquidated did so in the tight credit years of 2008-2009, which are not representative of current market conditions. Scenario #2: Going concern with DIP loan. In this hypothetical scenario, we examine the scenario where CEO Ullman runs cash down to minimal levels in hopes that he can save the company with a longer liquidity runway. Because of these minimum cash levels, a DIP would be needed to fund working capital needs and other expenses. We postulated that the company would need an $800mn DIP. In this scenario, the term loan is still not garnering any of its par recovery value from its 2nd lien on inventory. Scenario #3: Liquidation and no capacity for DIP: In this hypothetical scenario we assume that the company files when cash levels fall to $500 million but that it is a liquidation scenario. Because we are using dark store appraisal values, the company does not have capacity for a DIP (any DIP would result in the impairment of the term loan and ABL). Given our view that JCP would continue as a going concern, we think this scenario is the least likely of the three scenarios, and give it little weight in our ultimate assessment of unsecured recovery values.

There is more but this is the gist: the countdown to a filing has begun, because once Goldman uses the words "waterfall analysis" and invokes the dreaded "filing" word there is no turning back. We only wonder if Goldman waited until Bill Ackman was out before it issued this report, which objectively gives the company 6-9 months.

Aside from that, our only question is whether JCP will be just another Movie Gallery: yet another sterling Goldman debt deal, that resulted in a bankruptcy before even one coupon could be paid. It will take some special talent for JCP to overtake Movie, but Goldman has been known to do even more impossible things in the past (see: Lehman Brothers).