ACCOUNTING TOP 10: PENSIONS

Transcription

1 MACRO RESEARCH Accounting & Tax Policy Quantitative Research Portfolio Strategy March 28, 2014 ACCOUNTING TOP 10: PENSIONS This is our second report on the Top 10 accounting items to watch for and how to spot them. Over the coming weeks and months, we will publish a new topic each Friday. Last week, we published a report on Cookie Jar Reserves. When investors hear the word pensions in the context of financial statement analysis, they often run for the hills as the time and knowledge required to decipher the topic may not be deemed worthy of the ultimate benefit. Notwithstanding, in this week s Accounting Top 10, we explain how to efficiently use the pension footnote to assess whether companies are using pension assumptions to manage earnings, assess whether there are non-recurring gains in earnings, and how to uncover companies with hidden earnings power due to their pensions. Currently, we see more distortions from pensions in the income statement than on the balance sheet. Mark Assumptions to Reality. Companies use several assumptions in calculating the pension cost reported in earnings. The most subjective and important assumption to analyze is the expected rate of return on pension assets. The median rate across US companies is currently 7.5% (average pension asset allocation of equities 49%, bonds 40%, and other 11%). Managements are incentivized to keep the rate of return as high as possible to boost earnings. Further, we believe the rate itself contains directional information content into the tone of management as a lower than median rate suggests a conservative management posture toward financial reporting. Using Delta Air Lines (DAL), we show how to adjust earnings to reflect a more reasonable assumed rate of return. Hidden Value: Are Pension Losses Depressing Earnings? The earnings of companies with large pension plans are depressed by market/interest rate losses occurring in prior years. Even though pension plans have become much better funded, companies still must smooth these past losses into earnings over time under complicated pension accounting rules. This distorts the ongoing earnings power of some companies and economic reality. If rates and asset levels continue to increase (or at least do not materially decline), companies currently reporting large losses will see the biggest tailwind to pension cost. In this report, we illustrate how to interpret the aforementioned pension accounting issues using Delta (DAL), MeadWestvaco (MWV), and Caterpillar (CAT). Chris Senyek, CFA, CPA Adam Calingasan, CFA, CPA Clinton Chang, CFA, CPA Chip Miller, CFA, CPA Natalie Capasso (646) (646) (646) (646) (646) csenyek@wolferesearch.com acalingasan@wolferesearch.com cchang@wolferesearch.com cmiller@wolferesearch.com ncapasso@wolferesearch.com This report is limited solely for the use of clients of Wolfe Research. Please refer to the DISCLOSURES located at the end of this report for applicable disclosures. WolfeResearch.com Page 1 of 5 Accounting & Tax Policy

2 IS THE COMPANY USING THE EXPECTED RATE OF RETURN TO MANAGE EARNINGS? Perhaps we re old school, but we strongly believe that financial statement analysis leads to alpha generation. We re also big believers that many things move in cycles and the pension cycle is on the upswing. Along these lines, not long ago, investors were questioning the balance sheet viability of companies burdened with large pension plans. After a 32% U.S. stock market return and 85 basis point rise in interest rates in 2013, investor s pension focus has shifted from the balance sheet to the income statement. In the discussion that follows, we explain three ways that corporate pensions may paint a different earnings picture than economic reality. 1. Expected Rate of Return The pension cost amount a company reports in earnings is comprised of 5 main components. The expected rate of return assumption is a subjective item set by management and a possible tool to directly manage earnings. In fact, the reported pension expense in earnings is directly impacted by the expected rate of return. That is, a higher expected rate of return reduces pension cost thereby increasing earnings. Conversely, a lower expected rate of return increases pension cost and lowers earnings. The expected long-term rate of return on pension assets is an assumption reflecting 1) the current or target asset allocation and 2) the anticipated average rate of return on the company s pension assets over the long-term. It is typically based on a long-term historical average of actual fund performance (anywhere from years is possible based on discussions with fund managers and actuaries). Therefore, year-to-year volatility in the performance of the pension fund s actual returns will not immediately portend a change in the expected rate of return assumption. A company s expected rate of return assumption should be reviewed and compared to the 7.5% median rate across all companies for reasonableness, particularly in the context of the underlying pension asset allocations. Below we use Delta Air Lines (DAL) as an example to illustrate the earnings benefit from using a higher than median expected rate of return assumption. The company used an 8.94% expected return compared to the 7.5% median rate used by companies in In turn, by multiplying the amount by which the rate is higher than reality (company rate less median rate or one s own rate) by the pension assets of $8.2 billion, we calculate the amount of earnings benefit in the current year. We estimate that DAL had a $118 million pre-tax benefit (or $0.14 per share) to earnings in 2013 from using an 8.94% return compared to the median company s rate of 7.5%. Impact of Reducing the Expected Rate of Return on Plan Assets Delta Air Lines Given If-reduced 2012 Year-end Assets $8,196 $8,196 Expected rate of return 8.94% 7.50% 2013 Expected return on plan assets $733 $615 Pre-tax earnings impact EPS Impact* ($118) ($0.14) *Assumes % tax rate and 858 million diluted share count. Company has reversed valuation allowance and will begin using 39% tax rate in Source: Wolfe Research Accounting & Tax Policy Research. WolfeResearch.com Page 2 of 5

3 IS PENSION INCOME ARTIFICIALLY BOOSTING EARNINGS? 2. Pension Income As pension funding improves, some companies may begin to report net pension income once again in earnings. One particular warning sign for pension income is an overfunded pension plan. For investors, the good news is that pension income is easy to spot by reading through a pension footnote. As an example of a company reporting net pension income, below is MeadWestvaco s (MWV) K pension cost disclosure. The company reported $85, $69, and $82 million in pension income in 2013, 2012, and 2011 (or ~38% of pre-tax income in 2013), respectively. In our view, pension income should be excluded from earnings as it is not recurring cash earnings power of the underlying business. After all, companies cannot access the assets/cash in an overfunded pension plan without paying a 50% excise tax to Uncle Sam. For earnings analysis, we view the service cost component of pension cost/income (shown as the first line below) to be the only recurring cost that should be included in EBIT as an ongoing operating cost to the business (akin to compensation cost). The other pension income items should be removed from earnings. In this example, we reduce EBIT of MeadWestvaco by $125 million to remove the net pension income excluding service cost ($40 million). MeadWestvaco: Pension Income The components of net periodic benefit (income) cost for the company s retirement plans for the years ended December 31, 2013, 2012 and 2011 are presented below. Years ended December 31, In millions Service cost-benefits earned during the period $ 40 $ 43 $ 42 Interest cost on projected benefit obligation Expected return on plan assets (289) (293) (285) Amortization of prior service cost Amortization of net actuarial loss Curtailments 0 (21) 0 Settlements Termination benefits Net periodic pension income $ (85) $ (88) $ (70) Net periodic pension income continuing operations $ (85) $ (69) $ (82) Note: Per K. Source: Wolfe Research Accounting & Tax Policy Research; Company filings. WolfeResearch.com Page 3 of 5

4 HIDDEN EARNINGS POWER: ARE PENSION LOSSES DEPRESSING EARNINGS? 3. Actuarial Losses As a result of volatile asset returns and a large decline in discount rates since the mid-2000 s, most companies have built up large so-called unrecognized actuarial losses from their pension and postretirement plans. Such amounts are held on their balance sheet within accumulated other comprehensive income in shareholder s equity and smoothed into earnings over time under convoluted GAAP rules. In effect, companies are expensing sunk costs through earnings related to past events and not future ones. We think this paints a distorted view of company profitability particularly as the funding levels of corporate pensions have markedly improved and as cash contributions will decline over the coming years. In other words, companies that are currently reporting large actuarial losses are under-earning on a GAAP earnings basis if you believe pension funding levels will not deteriorate materially in the future. To illustrate the hidden earnings power and distortion of economic reality, consider Caterpillar (CAT). Below is Caterpillar s K U.S. pension cost disclosure. The company reported $546, $504, and $451 million in actuarial losses over the past three years, which was greater than or almost equal to the entire pension cost amount in each of those years! The company has disclosed that the expected amount of actuarial loss recognition in 2014 will decline to $392 million. To calculate 2013 and 2014 normalized earnings, we remove the actuarial losses from earnings by adding them back to pre-tax income. On an EPS basis, by adding back the tax effected 2014 actuarial losses of $392 million (or $286 million after tax) to 2014 consensus earnings estimates, Caterpillar s adjusted EPS would be $0.44 higher. Caterpillar: Large Actuarial Losses in Pension Cost U.S. Pension Benefits (Millions of dollars) Components of net periodic benefit cost: Service cost $ 196 $ 185 $ 158 Interest cost Expected return on plan assets 1 (832) (812) (798) Other adjustments 31 Curtailments, settlements and termination benefits 3 7 Amortization of: Transition obligation (asset) Prior service cost (credit) Net actuarial loss (gain) Total cost included in operating profit $ 540 $ 512 $ 482 Note: Per K. Source: Wolfe Research Accounting & Tax Policy Research; Company filings. WolfeResearch.com Page 4 of 5

5 DISCLOSURE SECTION Wolfe Research, LLC does not assign ratings of Buy, Hold or Sell to the stocks it covers. Outperform, Peer Perform and Underperform are not the respective equivalents of Buy, Hold and Sell but represent relative weightings as defined above. To satisfy regulatory requirements, Outperform has been designated to correspond with Buy, Peer Perform has been designated to correspond with Hold and Underperform has been designated to correspond with Sell. Wolfe Research Securities and Wolfe Research, LLC have adopted the use of Wolfe Research as brand names. Wolfe Research Securities, a member of FINRA ( is the broker-dealer affiliate of Wolfe Research, LLC and is responsible for the contents of this material. Any analysts publishing these reports are dually employed by Wolfe Research, LLC and Wolfe Research Securities. The content of this report is to be used solely for informational purposes and should not be regarded as an offer, or a solicitation of an offer, to buy or sell a security, financial instrument or service discussed herein. Opinions in this communication constitute the current judgment of the author as of the date and time of this report and are subject to change without notice. Information herein is believed to be reliable but Wolfe Research and its affiliates, including but not limited to Wolfe Research Securities, makes no representation that it is complete or accurate. The information provided in this communication is not designed to replace a recipient's own decision-making processes for assessing a proposed transaction or investment involving a financial instrument discussed herein. Recipients are encouraged to seek financial advice from their financial advisor regarding the appropriateness of investing in a security or financial instrument referred to in this report and should understand that statements regarding the future performance of the financial instruments or the securities referenced herein may not be realized. Past performance is not indicative of future results. This report is not intended for distribution to, or use by, any person or entity in any location where such distribution or use would be contrary to applicable law, or which would subject Wolfe Research, LLC or any affiliate to any registration requirement within such location. For additional important disclosures, please see The views expressed in Wolfe Research, LLC research reports with regards to sectors and/or specific companies may from time to time be inconsistent with the views implied by inclusion of those sectors and companies in other Wolfe Research, LLC analysts research reports and modeling screens. Wolfe Research communicates with clients across a variety of mediums of the clients choosing including s, voice blasts and electronic publication to our proprietary website. Copyright Wolfe Research, LLC All rights reserved. All material presented in this document, unless specifically indicated otherwise, is under copyright to Wolfe Research, LLC. None of the material, nor its content, nor any copy of it, may be altered in any way, or transmitted to or distributed to any other party, without the prior express written permission of Wolfe Research, LLC. This report is limited for the sole use of clients of Wolfe Research. Authorized users have received an encryption decoder which legislates and monitors the access to Wolfe Research, LLC content. Any distribution of the content produced by Wolfe Research, LLC will violate the understanding of the terms of our relationship. WolfeResearch.com Page 5 of 5