Despite today’s large equity rally, the S&P is still down over 2% for the year, in sharp contrast to a median S&P 8% pension actuarial investment assumption, while 10-year bonds yield 2.64%, a long way from the needed 5.8% median discount rate assumption.
Continued monthly job losses and a weak housing market are not the stuff of bull markets. Although these metrics are most often viewed as lagging indicators, with cash flow from operations adjusted for normalized working capital (to eliminate a bit of financial engineering) showing tepid growth, the outlook for the consumer, the backbone of any long-term expansion, must be viewed as very uncertain.
Regarding pensions, if you don’t think contributions into defined benefit plans are significant, take a look at the retirement expense versus the actual cash contributions for HJ Heinz (HNZ) during its past 5 fiscal years, shown in the table and chart below:
Heinz had been paying out benefits in the $150MM range, yet, it wasn’t until 2009 the Board recognized it was under-contributing to its plans. Although for P&L purposes during 2009 and 2010 it recognized a combined $115.3MM in pension expense, it actually contributed $675 MM. During its latest fiscal year, its pension contribution was 62% of net income.
During 2010, the large outflow was financed, in part, by hard-working of the balance sheet, without which cash flow from operating activities would have been considerably below the prior year. Also, HNZ set up a receivable securitization facility from which it received $84 MM and brought in an additional $48 MM from a total return swap.
The liability of its pension plan was directly responsible for these financial engineerings, events which are sure to be emulated by other firms. But other firms may not have the flexibility of Heinz.
One would think given HNZ’s stepped-up contribution, it would be in the clear, especially given, in its 10K it shows its plans are currently over-funded. After all, it expects to contribute just $50MM or so this year.
This is not the case however, as its actuarial assumptions are not in touch with today’s financial environment. Its discount rate, at 5.6%, reflects a settlement yield which is just not available given current yields, although its discount rate is slightly lower than the median S&P firm. HNZ’s 8.1% long-term investment assumption, however is slightly higher than the 8% S&P 500 median assumption, odd given their 58% exposure to equities. We would thus adjust HNZ’s cash flow from operating activities lower to reflect this reality, just as HNZ was overstating its historic cash flows prior to last year’s contribution.
While HNZ is a stellar producer of free cash flow and should have little problem servicing its plans, financial realities must be reflected by cash flow and credit analysts who should not rely on reported data for plan assessment. Given HNZ’s estimated $150MM in annual benefit payments and $750MM underfunding when using more realistic assumptions, we would penalize annual cash flow from operations by $75MM this fiscal year from what is reported.
In almost all cases, cash flow needs to be adjusted. It also impacts firm valuation and cost of capital, regardless of credit strength.
Please see our related articles on pensions and free cash flow implications of underfunding:
- GM: Who’s Next? Answer: At Least 1,300 More
- You Ain’t Seen Nothin’ Yet!
- What Investors Don’t Understand About Pension Plans
- Pension Facts: Why The Hit to Earnings and Cash Flow Is Upon Us
- IBM – Again, Pension Underfunding a Leading Indicator
- CNBC Strategy Session – Underfunded Pensions Earnings Bombshell
- With 3-, 5-, and 10-Year Stock Returns Negative: Why Are Pension Funds Assuming 8% Returns?
Disclosure: No positions
If you are interested in learning how to analyze the pension plan, including plan accounting, effect on earnings, cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.