By David Whiston, CFA, CPA, CFE
General Motors' (NYSE:GM) pension plan has been the subject of concern for investors multiple times throughout 2011. At issue is how much its underfunding will increase because of current ultra-low interest rates and lower plan assets (due mostly to the equities sell-off last summer). A lower interest rate increases the projected benefit obligation, or PBO, calculation performed by an actuary. GM's 2010 10-K filing indicates total pension underfunding of about $22.3 billion ($12.4 billion in the U.S. plan and $9.9 billion in the non-U.S. plan) as of Dec. 31, 2010.
An updated disclosure shows the Sept. 30, 2011, U.S. qualified and unqualified plan underfunding to be $9.6 billion. The decline is partially attributable to the voluntary contribution of GM common stock in January 2011 of about $2.2 billion; accounting rules required the stock not to count toward plan assets until July 2011, at which time plan assets were increased by $1.9 billion.
Over the past several years, Congress passed two significant pieces of pension legislation that affect GM's plans: the Pension Protection Act of 2006, or PPA, and the Pension Relief Act of 2010. We don't think the 2010 Act will require GM to make an additional minimum contribution. Also, we believe GM should make voluntary cash contributions to its plan in the future rather than pay a common stock dividend with its ever-growing cash hoard.
The Great Recession caused Congress to backtrack on the hard line it took in its prior attempt to mandate larger funding requirements outlined in the PPA. As such, the 2010 Act was issued to ensure many firms with defined benefit plans were not hit with large mandatory funding amounts shortly after Lehman's collapse. It is important to understand that pension funding rules and calculations are not a matter of generally accepted accounting principles. Congress passes legislation and then final pension funding rules come from the Internal Revenue Service.
According to Prudential's Pension Analyst publication, under the PPA, if a company’s plan assets are less than the funding target (100% of the present value of all benefit liabilities accrued to date), the minimum required contribution for the year is equal to the plan's target normal cost (the present value of benefit liabilities expected to accrue during the plan year, including increases in past service benefits attributable to current-year increases in compensation ) plus the annual amortization of the funding shortfall.
Extra Required Contribution Not Likely
Per its latest 10-Q, GM has opted to take the 15-year shortfall amortization provision allowed by the 2010 Act, which we think makes an additional mandatory contribution highly unlikely. We expect GM's required pension contribution to be in the low- to mid-single-digit billion-dollar range for 2012 before any installment acceleration, which we expect to be modest if anything at all. Actual contributions will probably be somewhat higher this year and next because we expect GM to make voluntary cash contributions above the minimum required funding amount.
We do not expect GM to be required to make a surprise contribution in 2012 just to satisfy minimum funding requirements. The shortfall amortization extension to 15 years gives the company plenty of time to make up the current underfunding. Furthermore, it is likely that the discount rate shown in the 10-K in early 2012 will not have declined drastically. For example, Johnson Controls filed its 10-K in November and its discount rate declined only 25 basis points for the U.S. plan and 0 basis points for the non-U.S. plan.
GM's 10-K indicates that a 25-basis-point decline would increase its U.S. plan's PBO by $2.5 billion and its non-U.S. plan's PBO by $714 million. The most recent discount rate disclosures in the 10-K are a discount rate of 5.36% for the U.S. plan and 5.19% for the non-U.S. plan. This sensitivity is not small, but implies to us that any additional funds required per the government, due to a PBO increase or a decline in plan assets, would not severely affect GM's financial health. A $2.5 billion increase to the PBO in our valuation model, all else constant, would decrease our fair value estimate by only slightly more than $1 per share.
With the pension acting as such a large overhang on GM's very cheap stock, we'd like to see GM use its excess cash to fully fund at least the U.S. pension. If this deficit is reduced, then a large risk to investing in GM is mitigated, in our opinion. Management says it will not give any more pension updates until it reports fourth-quarter results Feb. 16, but our expectation for 2012 and 2013 is for GM to make voluntary cash contributions to its plans above what the PPA already requires. We do not think more GM stock will be contributed as it was in January 2011, as tying the plan's performance to GM's stock would not be consistent with management's derisking objective.
An exact contribution amount is hard to estimate, but at least $5 billion in voluntary contributions over the next couple of years would not be unrealistic, in our opinion. We believe the pension, government ownership, and European debt worries are by far the biggest contributors to GM's depressed stock price. Pension contribution is the one item of these issues over which management has total control, so we would like to see the deficit addressed in 2012 with voluntary cash contributions.
Our next preference for GM's use of its cash would be for the firm to buy back its common shares, as the stock trades well below our estimate of its intrinsic value. GM has plenty of cash on hand to do this, and we expect it to remain comfortably free cash flow positive, thanks to its low break-even point and our expectation for the U.S. seasonally adjusted annualized selling rate to increase dramatically over the next few years. A buyback may not occur in 2012, however, as we view 2012 as another transition year toward getting new GM up to full speed.
GM has some pressing needs this year (fixing Europe and investing in full-size pickups) that will require cash that otherwise could be used for share repurchases. GM's unique ownership situation means the company could pursue a buyback the traditional way in the open market, or it could do a tender offer for the U.S., Canadian, and Ontario governments' stakes in order to relieve this overhang. We expect the Canadian entities not to sell until the U.S. Treasury sells, which should allow Canadian politicians to justify the timing of their sale despite the capital loss of taxpayer funds.
However, a buyback of the U.S. Treasury's stake is complicated. We suspect that the Obama administration wants to have at least the majority of the government's stake sold before the summer campaign season begins, but on Dec. 22, 2011, Bloomberg reported that the Treasury prefers to sell for at least $30 and ideally above the $33 initial public offering price. It may be difficult for GM's board to agree to offer the government $30 a share if the listed quote remains well below that.
Once most of the Treasury's stock is sold either back to GM or in the market, we suspect the shares will enjoy a strong rally as investors will no longer fear the Treasury's dumping of about 500 million shares on the open market all at once. We calculate that the Treasury owns 32% of GM's common stock and the Canadian entities own 9%.
Now that rival Ford Motor Company (NYSE:F) has announced a resumption of its dividend, it is possible GM's board will feel that it must do the same (though we think the CFO's comments at the Deutsche Bank auto conference in January imply no common dividend is likely soon). GM has 1.565 billion shares actually outstanding as of Oct. 31, 2011, so for it to match Ford's 1.6% yield would mean an annual dividend of about $0.38 per share, or about $594.5 million. Although this annual payout is probably affordable for GM, even if it funds its pension voluntarily, we would rather see the cash redeployed into the business and would be very disappointed if GM announced a dividend without first dealing with the pension.
Even then, our preference for excess capital allocation would be a share repurchase before a dividend. We do not see a need for GM to pay a common stock dividend at this time. The cash can clearly be better spent on funding the pension, buying back shares, new vehicle programs, and fixing GM Europe. Furthermore, yield-focused investors who want GM exposure can buy the mandatory convertible Series B preferred shares. These shares have a $50 par value and pay a 4.75% dividend.
The shares must be converted on Dec. 1, 2013, but can be converted at any time before then for 1.2626 common shares. We view the common shares as more attractive than the Series B preferred shares because of the Series B's premium to the conversion value of 31%, which limits the preferred's upside relative to the common shares. In other words, the premium should decline to zero between now and Dec. 1, 2013, so the capital appreciation of the Series B is less attractive than the common shares.
GM's pension is an important issue, but we think it's critical to remember that the entire obligation comes due over the course of decades rather than all at once. Last year's low rates combined with falling plan asset values after the European debt crisis have created more risk for the plan, but we believe GM's balance sheet and continued strong free cash flow will allow the firm to weather any storm. It is also important to remember that even if the Fed keeps rates low into 2014, it is likely that all the stimulus since Lehman's collapse may result in inflationary pressure at some point, which will eventually lead to an increase in long-term interest rates. When rates go up, the PBO will shrink.
Owning GM's stock carries a large amount of volatility, along with more macro and company-specific concerns than other large caps have. Although 2012 will see GM continue to deal with its shortcomings (in particular in Europe and trucks), we continue to see tremendous upside to the common stock from its current price. We think it is ridiculous for GM to be trading at about 1.5 times trailing-12-month EBITDA and 3.6 times 2012 consensus earnings (excluding cash) when it has more than $10.50 per share of net cash on its balance sheet and its key U.S. market has probably entered the early stages of a large increase in annual vehicle sales.
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