*Graham and Doddsville Revisited* -- "The Intelligent Investor in
the 21st Century" (7/19/98)
*********
"The underlying principles of sound investment should not alter
from decade to decade, but the application of these principles
must be adapted to significant changes in the financial
mechanisms and climate." (Benjamin Graham)
*********
Rightsizing GM (Cont'd)
-------------------------------
[The following continues a discussion how to value GM's future
postretirement benefits. Some of the earlier discussion may be
found at:
www4.techstocks.com]:
Part of what makes the issue of GM's postretirement benefits
confusing is that there are liabilities and there are
LIABILITIES. The pensions are defined benefits to which
GM is contractually bound. The status of the accrued medical
benefits is less clear cut. In the "fine print" to Note 13
of GM's 1997 10-K (See:
edgar.whowhere.com
0124-98-001456.txt) [700k text file], it states:
"GM has disclosed in the consolidated financial statements
certain amounts associated with estimated future postretirement
benefits other than pensions and characterized such amounts as
'accumulated postretirement benefit obligations' ['APBO'],
'liabilities,' or 'obligations.' Notwithstanding the recording
of such amounts and the use of these terms, GM does not admit or
otherwise acknowledge that such amounts or existing
postretirement benefit plans of GM (other than pensions)
represent legally enforceable liabilities of GM."
In other words, though the Financial Accounting Standards Board
requires that these extrapolations of current policies on medical
benefits be characterized as "liabilities" or "obligations", GM
itself isn't promising to continue these policies.
Maybe this is just wishful thinking on GM's part. But, not
necessarily. GM recently won a legal case concerning a reduction
in these medical benefits. GM had imposed a co-payment
requirement on certain medical benefits that hitherto did not
require co-payments by the beneficiaries. The retired GM workers
sued, and lost. And, there has already been a significant
reduction in the original APBO total (see below).
It is in a sense analogous to dividends on common stock and
interest on bonds. Interest on bonds is a legal liability, and
must be calculated as such in valuing a stock. Dividends are
optional. Their expected returns must also be considered in
valuing a stock. But the latter consideration is less tangible
than the first.
Of course, even in the absence of a legal obligation, if GM's
postretirement benefits are cut enough, workers are likely to
strike. Similarly, though dividends are not a legal obligation,
if they are cut sufficiently, capital may "go on strike",
depressing the price of GM stock. Nevertheless, there is
considerable leeway on the dividends, and this is likely the case
with the medical benefits as well.
In 1997, GM funded $3 billion of this APBO "liability", which it
characterizes as a "contribution" to the "Voluntary Employees'
Beneficiary Association trust (VEBA)", maintaining its stance
that it is not legally obligated to do this. The $3 billion is
about the amount by which this presumed obligation accumulates
annually. Interestingly, the medical benefits themselves that
accumulate annually have varied from a low of $617 million to a
high of $668 million over the past 3 years. What accounts for
the difference is the implied interest that is accruing on the
previous balance.
Because of annual compounding, small variations in the
assumptions underlying these forecasts can produce widely
divergent results. Here's an example, given by GM, in the 10-K:
"A one percentage point increase in the assumed health care trend
rate would have increased the APBO by $4.8 billion at December
31, 1997 and increased the aggregate service and interest cost
components of non-pension postretirement benefit expense for 1997
by $462 million. A one percentage point increase in the
weighted-average discount rate would have resulted in a $4.9
billion decrease in the APBO at December 31, 1997."
[The idea behind the "weighted-average discount rate" is
expressed in the fundamental axiom of every business school
curriculum: A dollar today is worth more than a dollar tomorrow.
Conversely, a promise to pay a dollar in the future is worth
less than a dollar, today.
Thus, a promise to pay $1000 in 10 years might be met by
purchasing a bond for $500 that pays $1000 at maturity in 10
years. This assumes the bond is yielding a shade under 7.2%.
Thus, the present value of this $1000 obligation, when
discounted at 7.2%, is $500. If bonds of comparable
quality should yield begin to yield less than 7.2%, then an
amount higher than $500 would be required for the compounding of
that interest to bring the bond's value at maturity to $1000.
Thus, a decline in interest rates causes an
increase in the present value of the obligation (i.e., an
increase in the cost of a bond that would meet the obligation at
the end of 10 years). The reverse is also the case. A rise in
interest rates above 7.2% means a bond can be bought for less
than $500 that will pay $1000 in ten years. Hence, an increase
in interest rates causes a decrease in the present value of the
obligation.]
As it turns out, in the past 2 years the actual plan experience
has varied almost 100% in both directions. Perhaps these annual
variations will balance out in the long run; perhaps not.
And, so far, the $600+ million assumed annual accruals in medical
plan benefits already are being reduced by $116 annually on the
basis of cutbacks in the plan that have been made so far.
The longer the current strike at GM continues, the more more
likely that the plan will have further cutbacks, more plants will
be closed, car models eliminated, and the like. Thus, the more
likely that there will be fewer workers accruing benefits in the
future.
Regarding GM's assumptions about the level of healthcare cost
increases, Note 13 of the 10-K continues: "Rate increases to
6.0% in 1999 and then decreases on a linear basis through 2004,
to the ultimate weighted-average trend rate of 5.0%."
Does anyone have anything more than an informed speculation as to
whether national healthcare costs will rise 3%, 6%, 10%, or some
other figure in the year 2004?
With each succeeding year, these figures are "adjusted" (in
accordance with FASB and IRS regulations) to reflect the actual
payment experience. For the 3 years from 1995 through 1997 the
healthcare cost increases have turned out to be 6.5%, 6.5%, and
5.5%, respectively. And the weighted-average discount rate has
been adjusted from 7.5% up to 7.8%, then back down to 7.2% in the
same 3 year span.
To say that GM will pay out a lot of cash for medical benefits in
the future is no doubt true. To say that this sum has a present
value of $70 per share is, we think, less solid a number than it
appears. Similarly, to add back in the presumed Intrinsic Value
of Delphi, GMAC, and even GMH is somewhat speculative.
In sum, we believe that Mr. Market is, on balance, fully
discounting GM's troubled present and future problems, but not
its substantial progress -- past, present, and future.
*********
Graham and Doddsville Revisited
Editor: Reynolds Russell, Registered Investment Advisor
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Consultants: Axel Gunderson, Wayne Crimi, Bernard F. O'Rourke,
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In addition to editing *GADR*, Reynolds Russell offers investment
advisory services. His goal is to provide clients with total
returns in excess of those produced by the S&P 500.
His investment strategy applies the principles of Value Investing
established by Benjamin Graham to the circumstances of today's
economy and securities markets.
For further information, reply via e-mail to: gadr@nyct.net
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(C) Reynolds Russell 1998. |
