QUALIPORT
Spotting Pension Black Holes

By Maynard Paton (TMFMayn)
July 27, 2004

Pension deficits matter. City analysts believe the FTSE 100's aggregate pension scheme shortfall is around the £60b mark and according to Company Reporting, only 4% of FTSE 350 firms enjoy a scheme surplus. Indeed, the shortfalls have prompted some high-profile investors to double-check their research. Potential offers for Marks & Spencer (LSE: MKS) and WH Smith (LSE: SMWH) for example were called off recently as sizeable pension gaps scuppered negotiations.

Furthermore, no longer will FRS17 allow firms to hide away all their pension bad news in an accounting footnote. New international accounting standards to be introduced in 2005 will bring all the deficits and associated costs to the main profit and loss and balance sheet statements. Shareholders had better be prepared!

What to spot

So what can investors do now to spot a pension 'black hole'? The best starting point is to compare the reported FRS17 position to underlying earnings. Clearly a relatively large shortfall could mean a reduction in future profits as the company's contributions are hiked to plug the gap. This is how the Qualiport's watch list matches up:

Company	Year end	FRS17 pre-tax surplus/(deficit) (£m)	Surplus/(deficit) as a % of underlying earnings
Associated British Ports (LSE: ABP)	Dec 2003	34	34
Vodafone (LSE: VOD)	Mar 2004	(165)	(3)
Emap (LSE: EMA)	Mar 2004	(29)	(20)
Gallaher (LSE: GLH)	Dec 2003	(80)	(22)
London Stock Exchange (LSE: LSE)	Mar 2004	(18)	(29)
Capital Radio (LSE: CAP)	Sep 2003	(6)	(37)
GlaxoSmithKline (LSE: GSK)	Dec 2003	(1,895)	(40)
Imperial Tobacco (LSE: IMT)	Sep 2003	(407)	(62)
Johnston Press (LSE: JPR)	Dec 2003	(65)	(71)
Ulster Television (LSE: UTV)	Dec 2003	(8)	(80)
Renishaw (LSE: RSW)	Jun 2003	(12)	(86)
Rotork (LSE: ROR)	Dec 2003	(20)	(98)
Halma (LSE: HLMA)	Mar 2004	(41)	(118)

The list can be divided broadly into three groups:

* Safe: Associated British Ports (with a surplus) and Vodafone (with a minor deficit) should not worry shareholders.

* No immediate worries: Emap, Gallaher, London Stock Exchange, Capital Radio and GlaxoSmithKline appear to have manageable deficits.

* Further attention required: Imperial Tobacco, Johnston Press, Ulster Television, Renishaw, Rotork and Halma.

With any relatively large deficit, it's worth considering if temporarily depressed profits are giving a misleading impression of the shortfall. Sadly, this is not the case with the six watch list shares in the latter group.

(For the record, the figures for Renishaw relate to the year ended June 2003. Renishaw's 2004 results were published earlier this month and showed a small reduction to the scheme deficit and underlying earnings 12% higher. The full 2004 annual report, which contains the full pension details, has yet to be published.)

So the next step then is to assess the make-up of the pension scheme and the assumptions used. Unfortunately, directors and their advisers are at liberty to apply aggressive growth rates in order to present a more favourable pension position and lower the associated funding charge within the profit and loss account (which will be levied when the new international accounting standards are introduced in 2005). One of the main areas for flexibility concerns future stock market returns. This table lists the equity proportion of each watch list scheme, and the accompanying equity growth rate:

Company	Year end	Percentage in equities	Assumed growth rate (%)
Renishaw	Jun 2003	97	8
Ulster Television	Dec 2003	84	7.5
Halma	Mar 2004	84	7.75
GlaxoSmithKline	Dec 2003	75	7.75-8.5
Rotork	Dec 2003	70	8.2
Johnston Press	Dec 2003	69	7.3
Vodafone	Mar 2004	67	4-7.5
Gallaher	Dec 2003	64	7.5
Imperial Tobacco	Sep 2003	60	6.9-8.3
Emap	Mar 2004	49	7.7
Associated British Ports	Dec 2003	49	7.5
Capital Radio	Sep 2003	46	7
London Stock Exchange	Mar 2004	26	8.2

A study by Company Reporting discovered the average equity growth rate used by FTSE 350 firms was 7.69% (the average pension equity weighting was 62%). So it's interestingly to note the assumed future funding requirements at Renishaw, Halma, Rotork and Imperial Tobacco (8.1% for UK equities) are calculated using above-average growth rates on what are their largest scheme asset. These higher rates reduce the associated accounting funding charge in their respective profit and loss accounts and may in time understate the actual funding requirements.

Tellingly, two of the firms with larger funding gaps have recently made special pension payments. Johnston Press ploughed in £12m during September last year, while Rotork pumped in a further £5m this March. Still, the companies possessing the three biggest deficits when compared to profits aren't in any immediate danger. From their latest set of results, net cash at Renishaw was £33m, net cash at Rotork was £32m and net cash at Halma was £22m. If worst came to worst, the cash hoards could be used to reduce or even eliminate the current shortfalls.

Summary

It should be remembered that pension funding is a long-term commitment and that scheme assets are subject to short-term fluctuations. Given the relatively low level of the stock market, it's fair to say many of today's pension deficits will reduce in the years ahead. However, the deficits are an economic reality and a statement today from WH Smith highlights the investor dangers.

Alongside various strategic measures, the stationer announced it is to borrow £120m to help shore up its pension fund. Clearly earnings will suffer from the additional interest payments -- and there will be no direct operational gain to compensate.

Notably, Smith's 2003 accounts showed a pension deficit before tax of a £215m -- three times that year's earnings of £71m. Given the events at Smiths, it would be understandable to view pension deficits as debt -- a balance sheet item that few investors ignore. Thankfully, none of the Qualiport's watch list members have a pension situation anywhere near as bad as Smith's.

Perhaps the easiest way to deal with an onerous pension scheme is to factor the deficit into the valuation calculations. Halma's shortfall for instance equates to around 11p per share and its 129p Qualiport buy price would therefore have to drop to 118p. Such an adjustment may be too conservative in practice, given the deficit should reduce in time, but it will minimise the downside should the burden prove troublesome in future.

Of course, the best route to sidestep pension black holes is to select firms that have no retirement obligations whatsoever. Eagle-eyed readers will have spotted a lack of reference to Games Workshop (LSE: GAW) within the earlier tables; it's the only watch list company that does not operate a defined benefit scheme for its workforce.

Where next? Company Reporting | Why Pension Deficits Matter | What FRS17 Means For Your Shares

Maynard owns shares in Associated British Ports, Games Workshop, GlaxoSmithKline, Halma, Johnston Press and London Stock Exchange.

Portfolio value

Holding	Number of shares	Closing price 26/07/04 (p)	Value (£)
Associated British Ports	681	397.5	2,706.98
Emap	372	722	2,685.84
Halma	1,920	145.25	2,788.80
Johnston Press	1,608	513	8,249.04
London Stock Exchange	1,669	363	6,058.47
Cash			2.16
Total			22,491.29