Item 1 of J. C. Penny Funding Corporation Form 10-K
Excerpt from J. C. Penny Funding Corporation Form 10-K
PART I
1. Business.
Business Overview
Effective January 27, 2002, J. C. Penney Company, Inc. changed its corporate structure to a holding company format. As part of this structure, J. C. Penney Company, Inc. changed its name to J. C. Penney Corporation, Inc. (“JCP”), and became a wholly-owned subsidiary of a newly formed affiliated holding company (“Holding Company”). The new holding company assumed the name J. C. Penney Company, Inc. (“Company”). The Holding Company has no direct subsidiaries other than JCP. The Holding Company has no independent assets or operations. All outstanding shares of common and preferred stock were automatically converted into the identical number of and type of shares in the new holding company. Stockholders’ ownership interests in the business did not change as a result of the new structure. Shares of the Company remain publicly traded under the same symbol (JCP) on the New York Stock Exchange. The Company is a co-obligor (or guarantor, as appropriate) regarding the payment of principal and interest on JCP’s outstanding debt securities. The guarantee by the Holding Company of certain of JCP’s outstanding debt securities is full and unconditional. The Holding Company and its consolidated subsidiaries, including JCP, are collectively referred to in this Annual Report on Form 10-K as “Company” or “JCPenney”, unless indicated otherwise.
JCPenney was founded by James Cash Penney in 1902; JCP was incorporated in Delaware in 1924 and the Company was incorporated in Delaware in January 2002. The Company has grown to be a major retailer, operating 1,017 JCPenney department stores in 49 states and Puerto Rico. In addition, the Company operates 62 Renner department stores in Brazil. The Company’s business consists of providing merchandise and services to consumers through Department Stores and Catalog/Internet. Department Stores and Catalog/Internet generally serve the same customers and have virtually the same mix of merchandise. In addition, department stores accept returns from sales initiated in department stores, catalog or via the Internet. The Company markets family apparel, jewelry, shoes, accessories and home furnishings.
Discontinued Operations
Direct Marketing Services
In 2001, JCP closed on the sale of its J. C. Penney Direct Marketing Services, Inc. (“DMS”) assets, including its J. C. Penney Life Insurance subsidiaries and related businesses to a U.S. subsidiary of AEGON, N.V. (“AEGON”). DMS was reflected as a discontinued operation in the 2000 Annual Report. Concurrent with the 2001 closing, JCP entered into a 15-year strategic licensing and marketing services arrangement with AEGON designed to offer an expanded range of financial and membership services products to JCPenney customers. Over the term of this arrangement, the Company will receive fee income related to the marketing and sale of certain
financial products and membership services. Such amount will be recognized as earned in the Company’s financial statements.
Mexico Department Stores
Effective November 30, 2003, the Company closed on the sale of its six Mexico department stores to Grupo Sanborns S.A. de C.V. of Mexico City. The stock sale transaction, which included the Mexico holding company and operating companies, comprising the Company’s Mexico department store operation, resulted in a loss of $14 million, net of a $27 million tax benefit. The loss was principally related to currency translation losses of $25 million accumulated since operations began in 1995 that were previously reflected as reductions to stockholders’ equity. Additional components of the loss included potential liability on certain real estate and merchandise and transaction costs. In 2004, the Company recognized a gain of $4 million related to additional tax benefits realized.
Eckerd Drugstores
On July 31, 2004, the Company and certain of its subsidiaries closed on the sale of its Eckerd drugstore operations for a total of approximately $4.7 billion in gross cash proceeds. The figure included a $209 million adjustment for the estimated increase in Eckerd’s working capital from January 31, 2004, to July 31, 2004. After deducting taxes, fees and other transaction costs, and estimated post-closing adjustments, the ultimate net cash proceeds from the sale are expected to total approximately $3.5 billion. The Jean Coutu Group (PJC) Inc. (Coutu) acquired Eckerd drugstores and support facilities located in 13 Northeast and Mid-Atlantic states, as well as the Eckerd Home Office located in Florida. CVS Corporation and CVS Pharmacy, Inc. (collectively, CVS) acquired Eckerd drugstores and support facilities located in the remaining southern states, principally Florida and Texas, as well as Eckerd’s pharmacy benefits management, mail order and specialty pharmacy businesses. Proceeds from the sale are being used for debt reduction and common stock repurchases, as announced on August 2, 2004, and more fully discussed in the Company’s 2004 Annual Report to Stockholders (“Capital Structure Repositioning”) (pages 35-36).
The loss on the sale was $713 million pre-tax, or $1,433 million on an after-tax basis. The relatively high tax cost is a result of the tax basis of Eckerd being lower than its book basis because the Company’s previous drugstore acquisitions were largely tax-free transactions. Of the total after-tax loss on the sale, $1,325 million was recorded in 2003 to reflect Eckerd at its estimated fair value less costs to sell, and during 2004 the remaining $108 million was recorded to reflect revised estimates of certain post-closing adjustments and resulting sales proceeds.
Additionally, $3.4 billion of the present value of operating lease obligations (PVOL), which was an off-balance sheet obligation under generally accepted accounting principles (GAAP), was eliminated with the transfer of these leases to the purchasers of the Eckerd drugstore operations upon the closing of the sale.
The Company established reserves at July 31, 2004 for estimated transaction costs and post-closing adjustments. Certain of these reserves involved significant judgment and actual costs incurred over time could vary from these estimates. The more significant estimates relate to the estimated working capital adjustment, the costs to exit the Colorado and New Mexico markets, severance payments to former Eckerd associates, assumption of the Eckerd Pension Plan and various post-employment benefit obligations and environmental indemnifications, which are discussed below. Management reviewed and updated the reserves in the fourth quarter of 2004. While adjustments were made to individual reserves, management believes that, in total, reserves remain adequate at year-end 2004. Cash payments for the Eckerd-related reserves are separately presented in the Company’s consolidated statements of cash flows as cash paid to discontinued operations.
Management is currently negotiating with both CVS and Coutu regarding the working capital adjustment required in the sale agreements, which could take several months to finalize. The two sale agreements provide for an arbitration process between the respective parties in the event that agreement cannot be reached regarding the proper amount of adjustment.
As part of the Asset Purchase Agreement with CVS, it was agreed at closing that, with respect to the Colorado and New Mexico locations (CN real estate interests), any of these properties which were not disposed of would be transferred to CVS. On August 25, 2004, the Company and CVS entered into the CN Rescission Agreement, whereby the Company received a one-time payment from CVS of $21.4 million, which represented the agreed-upon limit of CVS’s liability regarding the CN real estate interests plus net proceeds from dispositions as of August 25 minus expenses borne and paid by CVS as of August 25 relating to the CN real estate interests. Effective August 25, CVS transferred to the Company all CN real estate interests not disposed of, along with corresponding third-party agreements and liabilities. The Company has engaged a third-party real estate brokerage firm and is working through disposition plans on an individual property basis.
At the closing of the sale of Eckerd on July 31, 2004, JCP assumed sponsorship of the Eckerd Pension Plan, the Eckerd Contingent Separation Pay Programs and various other terminated non-qualified retirement plans and programs. The Company assumed all severance and post-employment health and welfare benefit obligations under various Eckerd plans, employment and other specific agreements. The Company is evaluating its options with respect to these assumed liabilities, including, but not limited to, termination of agreements, plans or programs and/or settlement of the underlying benefit obligations.
As further discussed in the Environment subsection below, as part of the Eckerd sale agreements the Company retained responsibility to remediate environmental conditions that existed at the time of the sale.
Both CVS and Coutu entered into agreements with the Company and the Company’s insurance provider in order to assume the obligations for general liability and workers’ compensation claims that had been
transferred to the purchasers at closing. The agreement with CVS was entered into concurrent with the closing, while the agreement with Coutu was finalized in the third quarter of 2004. At closing, the Company had approximately $64 million in letters of credit pledged as collateral to its insurance provider in support of general liability and workers’ compensation claims that were transferred to Coutu as part of the Eckerd sale. Upon the finalization of the insurance assumption agreements, this amount was reduced to approximately $8.5 million. Based on a separate agreement between Coutu and the Company, Coutu will provide replacement letters of credit to the insurance company no later than September 17, 2006, which will release the Company from any further potential obligation.
The Company is providing to the purchasers certain information systems, accounting, banking, vendor contracting, tax and other transition services as set forth in the Company’s Transition Services Agreements (Transition Agreements) with CVS and Coutu for a period of 12 months from the closing date, unless terminated earlier by the purchasers. One Transition Agreement with Pharmacare Management Services, Inc., a subsidiary of CVS, involves the provision of information and data management services for a period of up to 15 months from the closing date. Under the Transition Agreements, the Company will receive monthly service fees, which are designed to recover the estimated costs of providing the specified services. To the extent actual costs to provide such services exceed the estimates, any additional costs incurred are reflected in discontinued operations.
Discontinued operations in the consolidated statements of operations reflect Eckerd’s operating results for all periods presented, including allocated interest expense. Interest expense was allocated to the discontinued operation based on Eckerd’s outstanding balance on its intercompany loan payable to JCPenney, which accrued interest at JCPenney’s weighted average interest rate on its net debt (long-term debt net of short-term investments) calculated on a monthly basis.
Competition and Seasonality
The business of marketing merchandise and services is highly competitive. The Company is one of the largest department store retailers in the United States and it has numerous competitors. Many factors enter into the competition for the consumer’s patronage, including price, quality, style, service, product mix, convenience and credit availability. The Company’s annual earnings depend to a significant extent on the results of operations for the last quarter of its fiscal year. Fourth quarter operating profit for the past few years has averaged about half of the full year amount.
Incorporation by Reference; Website Availability
Information contained in the Company’s 2004 Annual Report to Stockholders regarding certain aspects of the business of the Company included under the captions of “Discontinued Operations” (pages 33 to 35), and which appears in the section entitled “Notes to the Consolidated Financial Statements”, and “Five-Year Financial and Operations Summary (Unaudited)” (page 49), all as set forth in the
Company’s 2004 Annual Report to Stockholders on the pages indicated in the parenthetical references, is incorporated herein by reference and filed hereto as Exhibit 13 in response to Item 1 of Form 10-K.
In addition, information about J. C. Penney Funding Corporation, a wholly-owned consolidated subsidiary of JCP, which appears in Item 1 of its separate Annual Report on Form 10-K for the fiscal year ended January 29, 2005, is incorporated herein by reference and filed hereto as Exhibit 99(a) in response to Item 1 of Form 10-K.
The Company’s Annual Reports on Form 10-K (since April 13, 1994), quarterly reports on 10-Q (since June 10, 1994), current reports on Form 8-K (since June 22, 1994) and all related amendments are available free of charge by accessing the Company’s website at www.jcpenney.net.
Suppliers
The Company purchases its merchandise from approximately 2,776 domestic and foreign suppliers, many of which have done business with the Company for many years. In addition to its Plano, Texas Home Office, the Company, through its international purchasing subsidiary, maintained buying offices in fourteen foreign countries and quality assurance inspection offices in an additional ten foreign countries as of January 29, 2005.
Employment
The Company and its consolidated subsidiaries employed approximately 151,000 persons as of January 29, 2005.
Environment
Environmental protection requirements did not have a material effect upon the Company’s operations during fiscal 2004. While management believes it unlikely, it is possible that compliance with such requirements will lengthen lead-time in expansion plans and increase construction, and, therefore, operating costs due in part to the expense and time required to conduct environmental and ecological studies and any required remediation.
As part of the Eckerd sale agreements discussed above, the Company retained responsibility to remediate environmental conditions that existed at the time of the sale. Certain properties, principally distribution centers, were identified as having such conditions at the time of sale. Preliminary cost estimates have been established by management, in consultation with an environmental engineering firm, for specifically identified properties, as well as a certain percentage of the remaining properties, considering such factors as age, location and prior use of the properties. Further studies are underway to develop remediation plans and refine cost estimates.
2. Properties.
At January 29, 2005, the Company operated 1,079 retail stores, comprised of 1,017 JCPenney department stores throughout the United
States and Puerto Rico, and 62 Renner department stores in Brazil, of which 217 JCPenney and three Renner department stores were owned. The Company also owned and operated four catalog fulfillment centers. The Company operated thirteen store support centers, and owned and operated three regional warehouses. The Company owned its Home Office facility and Renner’s corporate headquarters in Porto Allegre, Brazil. In addition, the Company owned as part of its Home Office approximately 240 acres of property in Plano, Texas, adjacent to the facility. Information relating to certain of the Company’s facilities included under the caption “Five-Year Financial and Operations Summary (Unaudited)” (page 49) of the Company’s 2004 Annual Report to Stockholders, is incorporated herein by reference and filed hereto as Exhibit 13 in response to Item 2