Credit Trends

UPS sold $2 billion in long-term bonds to fund its pensions yesterday, raising its total debt/equity to over 100%.

Although UPS is a solid and consistent generator of both free and operating cash flows, we saw that during the credit crisis of a short couple of years ago, even UPS’s fixed income securities could be impaired.

Even though the after-tax rate on the $2 billion is low, as $1.5 billion was sold at a 3.125% coupon and $500 million was sold at 4.875%, and UPS has a cash tax rate of  about 29% versus a 31.9% reported rate, it does result in lost financial flexibility for the firm. This may not appear  important during the current period of strong financial markets, but could very well change if economic conditions deteriorate or the need for capital arises. At a minimum, such cost will be higher regardless of the period in the economic and business cycle.

Despite the almost 12% rally in stocks thus far this year, pension underfunding has slightly deteriorated due to the lowering of the discount rate-that rate from which liabilities are brought to present value.

In fact, I estimate the median firm having a defined benefit plan now 22% underfunded.

Below is a list of plans with at least $1billion in reported underfunding. Bear in mind the plans at these firms utilize actuarial methods which are not borne in today’s interest rate climate, therefore their underfunded status is greater than what is being reported to shareholders, as yesterday’s action by UPS illustrates. For example, though UPS raised $2billion, I estimate, their plans are still about $600 million underfunded.

Please also bear in mind actions of the sort undertaken by UPS indicate the following:

1. Past cash flows-operating and free were overstated
2. New leverage ratio results in higher cost of capital which changes borrowing costs and any equity that needs to be raised
3. Prospective cash flows impacted by after-tax interest expense
4. Implicitly recognizes additional future cash flows impacted due to still underfunded status

I would expect many to most of the firms on this list to step up their pension contributions shortly (prior to the 10-K season). The funds will come from a combination of internally generated cash, borrowing, asset sales, or other creative financing, as with Heinz selling of receivables and swaps.

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