A story that never received the proper publicity during the bull market of 2009-2010 was its very positive (savior) effect on pension funding status, and employer contributions. The rise in equity markets allowed many hundreds of billions of dollars to appear on the balance sheet as equity instead of having to be spent to plug the pension gap.

But most of those firms which benefited are not out of the woods, as the negative stock performance during 2010 is sure to re-introduce such large employer expenditures which could very well impair security analyst estimates.

The following is a list of firms which

• Have, for their most recent fiscal year, accrued a greater expense for their pension plans than they actually contributed;
• Have seen a decline in the value of their plan assets over the past 2 years;
• Have either maintained or increased their discount rate (assumed rate of return) over the past 2 years;
• Have seen an increase in their pension benefit obligation over the past 2 years.

Table 1[1]

Source: S&P Data Services, Company reports

Presumably, firms which have suffered a decline in their plan assets should not be forecasting an increase in their settlement rate, which is the rate their projected benefit obligation could be settled. Firms might do this to show a lower liability and to lower their plan contributions. Their auditors and actuaries should only allow this for a short time before demanding stepped-up contributions.

The following table shows, for the same firms in Table 1, last year’s pension expense as a percentage of net income, the funded status of their plans, these firm’s total debt which to which we include operating lease obligations and shareholders’ equity.

Table 2

Source: S&P Data Services, Company reports

While there might be to some, a number of surprising names on the list, keep in mind that additional large funding into the plans would most likely cause a disappointment to earnings estimates, even though the firm might have the credit capacity to fund with low cost of capital. In the game of expectations, such firms are particularly vulnerable given their funding status and have not, of late, contributed their actual expense.

Several firms on the list look particularly vulnerable. One such is Goodyear Tire (GT), whose plan (see Table 3 summary below) is very underfunded, they have not had the financial ability to catch up, and have a high cost of capital. However, as the list shows, many firms are vulnerable.

Table 3

Source: S&P Data Services, Company reports

The pension and other post-retirement benefit area should be receiving greater scrutiny that it currently receives, as time is sure to tell.

Kenneth Hackel, C.F.A.

President, CT Capital LLC
www.credittrends.com

Data Source: Research Insight, CT Capital, Company 10Ks

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[1] Pension-Funded Status Indicates the funded status of a pension plan as either overfunded or underfunded.  This item is the sum of: Pension – Long Term Asset  minus the sum of  (1) Pension – Current Liability and (2)   Pension – Long-Term Liability

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Investors have been selling risk. This is not uncommon during periods of uncertainty, but is rare when the economy is just a year or so out of recession, when earnings and cash flows are expected to rise over the coming years.

When this risk divergence occurs, undervalued and oversold equities often result in large returns compared to other asset classes, as well as stocks in general. Investors, who assign risk based on beta, rather than on fundamental factors, may not be properly calibrating the credit health of the entity.  The list below was assembled with those investors in mind, who believed they were selling (or avoiding) risky assets, when in fact, they were not.

The list was run for entities which are value adding, that is, they have a higher return on invested capital than their cost of capital. After all, that is the primary responsibility of corporate executives. These firms have lower than average leverage, even when including operating leases and pension underfunding. For firms which have seen their operating leases growing by greater than 5% per year over the past 5 years, we assumed such growth would continue, instead of using the GAAP mandated 5-year minimum signed lease obligations. These firms have also been generating positive free and operating cash flows, although over the short-term, even firms in distress tend to produce free cash flows as they take any and all actions to produce maximum cash. Obviously, this can only go on for so long.

Although these firms appear undervalued, they may not be appropriate to all investors, hence strongly urge you do your own due diligence. They would appear, however, as a group, to offer significantly greater value, than the equity market in general.

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