10-K SEASON
Eric J. Fry
"10-K Season" has arrived on Wall Street...and this year's
10-K season promises to be more exciting than ever! This is
the time of year when most of America's largest public
companies release their 10-Ks, also known as annual reports.
Lending drama to the 2002 vintage of 10-Ks is the fact that
pension plan liabilities are skyrocketing to become a very
serious problem for many companies...and the annual 10-K
filing is the only public document in which companies must fess
up to these ugly truths.
Several well-known corporations, like General Electric and
Berkshire Hathaway, have already dispatched their 10-Ks. But
many more of these revealing annual filings are yet to emerge.
Traditionally, many of the most disturbing K's arrive on, or
immediately prior, to March 31st, the final due date. While
there is no automatic connection between corporate
shenanigans and a late-arriving 10-K, it's true that "cooking the
books" requires more time and creativity than merely reporting
the unvarnished truth.
This year, however, even the varnished truth may be unsightly
to investors. That's because many corporate pension plans are
racking up titanic liabilities.
Normally, pension plan health doesn't change very materially
over a 12-month span. But 2002 wasn't "normal" - the stock
market tumbled and health care costs soared, which means that
many pensions suffered a wicked double- whammy.
Ron Ryan, president of a New York-based pension plan
consultancy, calls 2002 "the worst year in pension history". His
firm, Ryan Labs Inc., estimates pension assets dropped 11%,
as pension liabilities soared 19%. GE, as a case in point,
divulged in its latest 10-K that its pension plan's surplus
declined a whopping $10 billion last year. The industrial giant's
surplus shriveled from $14.5 billion at the end of 2001 to a
mere $4.5 billion on Dec. 31, 2002. Thanks to the
long-running bull market of the 1990s, GE hasn't made
contributions to its pension plan since 1987. The company
optimistically states that no future contributions will be needed,
as long as expected rates of return are achieved. But that's a
significant caveat. GE's management expects its pension plan's
investments to earn about 8.5% per year.
We are skeptical. And so is Warren Buffett, who recently
cautioned companies to lower their annual pension income
estimates to 6.5%, as he did with his Berkshire Hathaway Inc.
Not surprisingly, his cautions have largely been ignored.
Another fly in the ointment is that, even if GE achieves its
unrealistic investment-return bogey of 8.5%, health- care costs
are soaring out of control. That's a particularly acute problem
for a company like GE, where nearly three quarters of pension
plan participants are retired personnel and therefore, more
likely to require medical care than current employees.
The bad news for corporate America, and by extension, the
stock market, is that GE's pension plan is fairly typical of
established U.S. companies in that the lion's share of the plan's
participants are retired, which makes any retroactive benefit
reduction nearly impossible. In other words, there's no easy
way to get rid of these nasty liabilities! Net-net, GE may find
itself functionally working for its pensioners rather than its
shareholders.
The good news is that GE's pension plan remains in
surplus...for now. Many other companies are not so fortunate.
Apogee Research (a company from which I draw a paycheck)
has been prospecting for short-sale candidates among the
companies with large, and growing, pension liabilities. Late last
year, for example, Apogee identified a metasticizing liability on
the books of Deere Corp. The tractor company's pension
liabilities had soared more than 70%, from $3.2 billion to $5.5
billion. "Put another way," said Apogee, "$5.5 billion is
equivalent to almost 10 times Deere's estimated earnings for all
of 2003."
More recently, the gang at Apogee has been sniffing around the
financial statements of a few other American companies. In
fact, Apogee's latest short-sale recommendation is a
well-known American company that's saddled with a
spectacular $76 billion liability - a number four times larger than
the company's market capitalization! In other words, every
dollar an investor spends buying the stock also buys about $4
worth of pension liability. Most folks would not knowingly
make such an investment, if they thought about it in those
terms.
It's true, of course, that pension plan liabilities are "soft
liabilities": they are based upon unknowable, long- term
assumptions, like rates of return on investment, future benefit
costs and discount rates. Even so, these "soft liabilities" can
create some very hard costs in the here and now - costs that
can take a huge bit out of the shareholder's equity.
Deere, for example, reduced its shareholder equity by $1
billion to account for its pension losses in 2002. That
represents a sizeable hit to the company's $3.26 billion book
value. In and of itself, a large pension plan liability does not
make a given stock a great short-sale candidate. But since
massive pension liabilities can create a substantial headwind to
profitability, stocks like these are likely good ones to avoid.
Unfortunately, an investor has to do some serious digging to
uncover the facts about a company's pension liability. GE, for
example, buried its pension plan disclosures in the footnotes of
its recent 10-K filing.
Furthermore, Financial Accounting Standards Board (FASB)
accounting rules help to obscure the truth. The full magnitude of
pension fund losses hasn't shown up on many corporate
financial statements, because FASB rules allow companies to
allocate estimated pension investment gains to net income,
rather than actual investment losses.
"Companies in the Standard & Poor's 500 Index lost more
than $200 billion in the past two years in pension investments
without clearly disclosing those losses in SEC filings,"
Bloomberg News reports. "12 companies, including General
Motors Corp. and International Business Machines Corp., said
they had reduced shareholder equity by $40 billion to account
for pension deficits." This too, is real money!
"IBM, for example, using an estimated rate of 10 percent,
reported assumed pension gains totaling $12.2 billion for 2000
and 2001 in its SEC filings, following FASB rules," Bloomberg
continues. "IBM's annual reports showed in footnotes that the
world's largest computer maker actually lost $2.8 billion in its
pension fund for those two years - a disparity of $15 billion.
On Dec. 31, IBM said it put $3.95 billion in cash and stock
into its U.S. pension fund to make it fully funded."
Don't blame IBM; it's legal!
CFOs become addicted to booking illusory pension "gains" as
profits, says Ron Ryan, even when their plans produced losses.
"Some [people] get addicted to heroin and cocaine. They got
addicted to pension earnings."
A prediction: De-tox will be a painful experience. |
