In my last article I discussed the importance of evaluating the ability of a company to service all claims senior to common shareholders. This first article focused on assessing the ability of a company to service its debt obligations; in this follow up article, we will take a look at how to quantify pension risk, and then end with a brief look at some additional factors that can impair a company’s financial strength.
The funded status of a company’s pension plan can present a risk to a company’s financial strength, as a decline in the value of plan assets (always possible during a bear market) can in some cases require a company to make contributions that are a significant fraction of the company’s earnings. A pension’s funding status is given by the difference between the plan’s assets at market value and the projected benefit obligation (the sum of expected future benefits discounted to the present), with a positive value indicating over-funding and a negative value indicating under-funding.
Although a pension surplus might seem to indicate low pension risk, this is not always the case. The problem is that a bear market can cause the funded status of a company’s pension plan to move from over-funded to under-funded in a single year. For this reason, I prefer to focus on the relative size of a company’s potential required contribution compared to the company’s earnings.
Under the new ERISA requirements (“CRS Report for Congress”, April 10, 2008), a company has seven years to make up a pension shortfall, over which the minimum company contribution is equal to the “target normal cost”, which is equal to the benefits expected to be paid out in the current year. With this in mind, I quantify pension risk as the ratio of the expected benefits to be paid in the current year to the company’s pre-tax earnings. When computing this ratio, I also add in postretirement health benefits. I prefer this ratio to be less than 10%, and avoid companies where it is larger than 20%. In practice, since earnings can be volatile, I compute this ratio using a company’s pre-tax sustainable earnings. The computation of sustainable earnings is discussed in this article.
To get an idea of the level of this ratio that can be indicative of future financial distress, in 2004 General Motors paid $11,215 million in benefits, and earned $1,894 million pre-tax, giving a ratio of 590%. Being charitable, we could use General Motor’s free cash flow of $5,308M in place of pre-tax earnings, bringing the ratio down to 211%, still in considerable excess of our upper limit. In comparison, we can look at Procter & Gamble’s 2008 ratio of benefits paid to pre-tax sustainable earnings, which is 4%; here it is pretty clear that the company’s pension does not create a significant risk.
Inflation caused by wage-price spirals can create significant increases in a company’s employment costs. This can occur when employees expect prices to increase, and have the bargaining power to demand corresponding increases in wages. This is more of a problem with a unionized workforce, particularly if there are cost of living increases built into long-term contracts. Whatever the cause of an increase in employment costs, a company will be less affected when total employment costs are a smaller percentage of the company’s pre-tax earnings. Some companies do not disclose total employment costs, so instead we can look at pre-tax profit per employee, with a higher number indicating a lower sensitivity to an increase in employment costs.
As an example, let’s compare Procter and Gamble (PG) with Wal-Mart (WMT). In FY 2008, Procter and Gamble had pre-tax income per employee of $129,100, whereas in FY 2008, Wal-Mart had pre-tax income per employee of $10,000. Although labor costs are not currently an issue with Wal-Mart’s cost advantage, legislation is currently being considered that will make it easier for employees to form a union. If this legislation were passed, the increased employee bargaining power could pose a threat to Wal-Mart’s cost advantage. Although Procter and Gamble would also be negatively impacted by increased employee bargaining power, the effect would be less than in Wal-Mart’s case for two reasons. First, Procter & Gamble’s higher per employee pre-tax profit indicates that the company’s earnings are less sensitive to the cost of labor than Wal-Mart. And second, Procter & Gamble competes on the basis of differentiation as opposed to cost. Note that the purpose of this comparison is not to give an opinion as to which is the better company (I personally think Wal-Mart is a great company), but rather to provide a comparison of two company’s relative sensitivity to changes in employment costs.
Industry Specific Risks
I also take a close look at any risks specific to the business the company operates in. Some examples of these types of risk include litigation risk for tobacco companies, or the risk of huge claims payouts for bond insurers that decided to insure CDOs. When analyzing a bank, we would need to look at other factors, including the stability of liabilities used to fund assets, net interest margin, the ratio of total assets to tangible equity, liquidity profile (maturing liabilities compared to maturing assets), the credit quality of borrowers, the loan book’s loan to value distribution, and much more.
A company’s competitive position also has a large bearing on its financial strength. However, I analyze this separately when I quantify a company’s demonstrated competitive advantage and assess a company’s future prospects, which will be the subject of my next article.
For a complete list of metrics I use to evaluate a company’s financial strength, check out Chapter 5 of my book, which can be downloaded from my website.
Но сейчас только без четверти. Двухцветный посмотрел на часы Беккера. Его лицо казалось растерянным.