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Pensions - The Sucking Sound Returns

 December 03, 2012 03:47 PM

(By Mani) With discount rates for 2012 looking likely to be down about 40 basis points (bps), many companies are facing another year of pension pressure in 2013.

For a number of years, this has proved to be a negative event for earnings as sub par investment returns, and more importantly lower discount rates, have led to increased year-on-year pension expenses in the income statement.

"The scale of the pension impact on both earnings and cash is perhaps surprising, and we expect this to be one of the biggest movers of EPS for 2013, especially if discount rates continue to fall," RBC Capital Markets analyst Robert Stallard wrote in a note to clients.

Many defense companies have pension funds that are significantly underfunded, and cash contributions to retrieve the pension situation could deplete the resources available for dividends, buybacks, and acquisitions.

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"Given the impact on EPS, and the cash contributions made to the funds, we think investors should avoid the temptation to ?ignore pension, even if it is not part of the underlying business," Stallard said.

Unlike other sectors, large portions of a defense company's pension expense are reimbursed by the US Government, but many companies continue to experience significant pension expense as a result of the 2008 collapse of the equity markets.

As of the most recent quarterly results, most companies are seen pension returns at or above their arguably optimistic targets for the year, with the average target being 8 percent. However, calculated discount rates have reduced by about 40bps, and, barring a major change, are the principal negative factor weighing on estimated pension expense for next year.

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"Companies have continued to make significant discretionary cash pension contributions this year, which we tally to be $6.6bn as of 3Q12," the analyst said.

A significant and growing offset to the accounting pension expense (Financial Accounting Standards, or FAS) is the US Government's reimbursement of allowable pension expense for defense contractors and US government, which is termed a Cost Accounting Standards, or CAS.

Meanwhile, defense contractors are benefiting from the changes to pension accounting smuggled into last year's Highway Bill. This has positively impacted the minimum cash contribution required for company pension funds as an average versus spot discount rate can now be used for calculating liabilities.

"Defense companies are expecting a lower non discretionary cash contribution going forward. However, we still see many making discretionary contributions in excess of the minimum, as they seek to reduce their underfunded positions," Stallard noted.

The ongoing pension issue has seen some companies take proactive steps to sort the problem. Most companies closed defined benefit schemes years ago, but more radical steps have been seen, including adoption of mark-to-market accounting.

The trend for marking the pension gains/losses to market came after the 2008 financial crisis as the losses stemming from the plan assets were going to be amortized over 5–10 years depending on the company, creating a relatively long-term future earnings drag.

Companies including Honeywell International, Inc. (NYSE: HON), AT&T, Inc. (NYSE: T), and Verizon Communications, Inc. (NYSE: VZ) have opted for the marked-to-market approach, thereby recognizing all pension gains/losses in the financial years in which they occurred.

Honeywell, which moved to a mark-to-market structure in 2010, moving $7.5 billion of future costs into the past. Exelis, Inc. (NYSE: XLS) recently offered to buy out former employees on defined plans, which should take the risk off the table.

"Our analysis shows that the "losers" are BA and LMT, with the biggest EPS headwind in 2013. In contrast, NOC and GD have the least headwind," Stallard noted.

Boeing Co. (NYSE:BA) could be the most affected by pension as a percentage of EPS on account of its $2.5 billion pension expense this year, which is estimated to grow to $3.5 billion next year. Lockheed Martin Corp. (NYSE: LMT) also has significant FAS costs estimated at about $2 billion a year in 2012–13, which takes a bite of about 20 percent from EPS.  

In addition, Northrop Grumman Corp. (NYSE: NOC) is currently seeing a pre-tax income tailwind from pension with the least underfunded pension as a percentage of the pension benefit obligation.

However, General Dynamics Corp. (NYSE: GD) is an exception within the defense community because it accounts for the FAS/CAS adjustment as a deferred asset that is capitalized on the balance sheet under contracts in the process, which eventually run through the P&L as cost of goods sold rather than a discreet pension item.

"Consensus estimates have encapsulated much of this (pension), but if these trends continue (low discount rates, par/sub vs. punchy target returns), we could see more pressure on 2014 estimates," Stallard added.



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