Honeywell (HON) announced a change to its method of pension accounting whereby it will reflect changes in market value each year instead of the smoothing them, which helped show a healthier plan when market values were declining for Honeywell. Now that market values are rising, Honeywell is desirous of changing its methodology. The company then revised its earlier results in conformity with the changes.
Despite this past week’s 3.4% earnings-related stock rally, as of this writing, the S&P 500 Index is just near break-even for the year.
I bring up this unfortunate news as we are about to close out another month for the calendar year 2010, now 58% done. By August end, the year will be two-thirds over, and so will vacation time.
This week, a prominent financial journalist was reporting on the cash flows of a well-known company, accentuating its strength and growth.
The reporter detailed the analysis of this public company by a firm which “specializes” in cash flow-based security analysis; however, as I looked into their analysis (which I have a hunch is a computer generated number as they are a small firm, yet issue cash flow reports on every S&P segment), I discovered they neglected the effect of lease obligations, which for this company, was substantial. The company does produce healthy and consistent cash flows, and its credit strength allows them to sign large capital leases which, under Generally Accepted Accounting Standards (GAAP), appear on the balance sheet, as opposed to operating leases, which do not, but should. Thus, capital leases result in more conservative reporting as they are included in normal debt and leverage ratios. This is not always the case with operating leases, similar to other post-retirement benefits, like health care, which are not normally included on the balance sheet and are not pre-funded.
Pension plans are making news-from local and state governments to large corporations. They are being cut back, eliminated or, for many, in trouble without the workforce recognizing the extent of the problem.
Most firms have been forced to prop up their plan’s health with additional cash contributions, while many other firms are simply hoping the financial markets, as they did during 2009, will bail them out.
Meanwhile, for others, the plans are so underfunded, it is just a matter of time before the inevitable takes hold-larger than expected contributions or a bailout by the Pension Benefit Guaranty Corp. Those firms have been able to make it this far due to overzealous actuarial assumptions which have moderated the true liability. However, with both stocks and hedge fund performance below zero the past three years, which firms stock prices are the most vulnerable?
The list below shows the bottom 20% of that S&P grouping, with each firm on the list underfunded to the extent such amounts to at least 5% of both their total debt (including capitalizing the operating leases, shown as a separate column), and 5% of its current stock price. Many are in much more precarious position, as is shown. In addition, each company on the list has both an expected return on plan assets and a discount rate at least equal to the market average. Of the S&P group of companies, the average investment assumption is 8% and the average discount rate 5.8%, both of which is presently too high and understates the true liability confronting firms with defined benefit plans. The firms on the list have expectations greater than that! Also shown are last fiscal year’s plan contributions, benefits paid and projected benefit obligation (PBO).
The PBO is the actuarial present value of all benefits earned by an employee as of a specified date for service rendered prior to that date plus projected benefits attributable to future salary increases. Indicated is the funded status of a pension plan as either overfunded or underfunded, however, all of these firms plans are currently underfunded as of their latest fiscal.
The underfunded status of defined as the sum of:
Pension – Long Term Asset
minus the sum of
Pension – Current Liability
Pension – Long-Term Liability
Accumulated pension plan benefits are reflected at present value to remain on a comparable basis with plan assets. The assumed rate of return on assets is the discount rate used to arrive at the present value of plan benefits.
If the financial market does not bail these firms out, the alternative could quite well be additional significant and currently unforeseen contributions which will impair reported and expected earnings, cash flows, return on invested capital, and cost of capital.
I would strongly urge all investors in these firms to thoroughly review the actuarial soundness of their plans as this represents significant risk that can be avoided prior to the headlines.
Disclosure: No positions
Kenneth S. Hackel, C.F.A.
President
CT Capital LLC
To learn how to analyze pension soundness and the pension soundness and the pension footnote and reporting requirements, please pre-order “Security Valuation and Risk Analysis“, out this fall from McGraw-Hill, by Kenneth Hackel, C.F.A.
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.
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.
Data Source: Research Insight, CT Capital, Company 10Ks
[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
