On Wednesday, J.C. Penney (NYSE:JCP) released its 2011 SEC 10-K form. News organizations quickly pounced on a juicy nugget early in the filing; as Reuters put it, "J.C. Penney Co Inc said its brand new pricing strategy could hurt sales for some time and there was no guarantee its store and merchandise revamp announced in January would work." Investor's Business Daily followed up with a similar story later in the day.
However, this was not really news. Analysts and commentators (including myself) have been stating for months that Penney's results were likely to get worse in the near term, but probably (though not definitely) would improve in a year or two. Furthermore, the statement was in a discussion of risk factors in the annual report. It's standard practice for companies to cover their "bases" related to anything that could plausibly go wrong in these sections of the report. There is no reason to believe the company is having sudden doubts about its strategy.
That said, looking further into the 10-K filing, there were some red flags. The most important is the discussion of pension obligations. On page F-29, the company reports that the combined primary and supplemental pension plans went from $541 million overfunded to $430 million underfunded over the course of 2011. Part of that was due to low investment returns last year, which meant that the plans paid out more in benefits than they earned in interest/capital gains. Another part of the increase was due to the company's voluntary early retirement plan, which gave employees additional retirement benefits for leaving the company last year. Most important, though, was that J.C. Penney cut the expected return on pension plan assets from 8.4% to 7.5%, which increases the present value of the pension liability.
The substantial decrease in pension funding is important because it creates a potential future liability that can eat away at the company's earnings. J.C. Penney already disclosed that it expects non-cash qualified pension expense to increase from $87 million in 2011 to $197 million in 2012. Management may see a substantial portion of the cost savings from restructuring siphoned off into pension expense, instead of being available for investing in the company or rewarding shareholders. For now, J.C. Penney will leave its pensions underfunded and hope to get better than expected returns to fill the gap. If that doesn't happen, though, the company could see a substantial amount of cash diverted to the pension plans in future years.
Some of J.C. Penney's potential near-term cash problems may be helped by higher than usual stock option exercises this year. On page F-22, the company reports nearly 6.5 million exercisable, in-the-money options outstanding, at an average strike price of $29 as of January 28. If all of these options are exercised, the company could bring in $180-$190 million, which could then be invested in CapEx or used to plug the pension deficit. The downside is that current shareholders would be diluted by about 3%. However, given the combination of underfunded pensions and J.C. Penney's hefty transformation expenses, dilution may be the lesser evil for shareholders.
Disclosure: I am short JCP.