Frontier (FTR) announced fourth quarter results and a reduction in the yearly dividend from $0.75 to $0.40. The company could not generate enough FCF (free cash flow) to support the old dividend. Additional details can be found here. Future pension funding shortfalls could affect FCF, which could have an impact on dividends.
When earnings are released we pour over the numbers to see what went right or wrong. There are some items that are not apparent when reading the earnings release, such as the pension funding. Looking for pension liabilities isn't on the radar for many. How often do we hear equity analysts grill management on pension obligations? Rarely, if ever. We'll review FTR's 2011 pension expectations vs. actual results and 2012 expectations going forward.
First a review of the 2011 pension expectations from the 10-K filing:
...Our actual return on plan assets in 2010 was 12.1%. For 2011, we will continue to assume a rate of return of 8.0%. Our pension plan assets are valued at fair value as of the measurement date. We expect that our pension and other postretirement benefit expenses for 2011 will be approximately $70 million to $80 million before amounts capitalized into the cost of capital expenditures (they were $68.4 million in 2010 before amounts capitalized into the cost of capital expenditures, including the plan expenses of the Acquired Business for the second half of 2010), and that we will make a cash contribution to our pension plan of approximately $50 million in 2011.
Two important points from the 10-K filing with dividend implications are:
- We will continue to assume a rate of return of 8.0%.
- We will make a cash contribution to our pension plan of approximately $50 million in 2011.
How did the year end?
The Company's pension plan assets have decreased from $1,290.3 million at December 31, 2010 to $1,258.0 million at December 31, 2011, a decrease of $32.3 million, or 3%. This decrease is a result of ongoing benefit payments of $128.9 million offset by $19.9 million of positive investment returns and $76.7 million of cash and real property contributions, consisting of cash payments of $18.6 million and the contribution of real property with a fair value of $58.1 million.
Adjusting for benefit payments, the $19.9 million of positive investment returns equates to a return of roughly 1.9% vs. an expected return of 8%. FTR contributed real estate to conserve cash. The Company is leasing back the properties from its pension plan for 15 years at a combined aggregate annual rent of approximately $5.8 million.
FTR had to contribute an additional $27 million above the initial estimate of $50 million. Cash flow was not meeting expectations, which led to contributing real estate, saving cash but adding a yearly lease payment. This is not a sustainable or preferred method of funding the Plan.
2011 was not a good year for pension funding, but what about 2012? For 2012, FTR assumes a rate of return of 7.75% and expects to make contributions to the plan of approximately $60 million. This is down from 8% in 2011. We think this rate is still very aggressive considering the asset allocation consists of the following.
- 35% to 55% in fixed income securities
- 35% to 55% in equity securities
- 5% to 15% in alternative investments
FTR does say, "Volatility in our asset values or returns may require us to make additional contributions in future years."
We take away the following:
- Twelve month FY2011 return of approximately 1.9%, far below management's yearly assumption of 8%.
- 2012 assumption of 7.75% appears aggressive in today's environment
FTR lowered its 2012 FCF projection by 14% from 2011 to $950 million. It's possible the company is being conservative by allowing for unforeseen problems such as additional pension contributions etc., but this is speculation on my part.
The pension plan should be monitored closely, especially if there is market turmoil caused by declining macroeconomic trends, etc., making a 7.75% return improbable. How to check? FTR gives detailed information in its 10-Q and 10-K filings.
The 2011 10-K can be found here.
Disclosure: I am long FTR.