Auto Companies Face Pension TailwindsVW Staff
Detroit is acing pension woes, but there is some good news. The city which is the home of the big auto-makers filed for bankruptcy last week. Interestingly, shortly before the news, Goldman Sachs issued a new report on problems with pensions for the big auto companies. Surprisingly, the big auto companies' conditions seem to be improving. So at least we get some good news from Detroit this week.
According to Patrick Archambault and Aditya Oberoi analysts at Goldman Sachs Goup, Inc. (NYSE:GS), if there is a positive side to higher long-term treasury rates it is that the discount rates used to calculate retiree pension and OPEB obligations will likely rise. We expect this to shrink retiree obligations and expense for the OEMs and suppliers. We see the biggest tailwinds accruing to Buy-rated auto companies as Meritor Inc (NYSE:MTOR), The Goodyear Tire & Rubber Company (NASDAQ:GT) and General Motors Company (NYSE:GM).
Use of corporate bonds to calculate discount rates
Most plans use a basket of high quality corporate bonds to calculate their discount rates. This is most easily tracked via the yield on the Moody's Corporation (NYSE:MCO) AA index shown in Exhibit 15 below. As the Exhibit outlines, on an YTD basis plans with December 31 measurement dates have discount rates that are tracking up 67bp vs. last year and plans with September measurement dates are up 81bp YTD.
While some might be tempted to dismiss the changes as “accounting” the changes are likely to be both material in terms of the core metrics the financial community uses to value auto stocks and long lasting as, according to our economists, we are likely only at the very beginning of a rising interest rate cycle.
Auto companies – Reduction in pension
The order of magnitude is clearly illustrated in Exhibit 16 below where YTD rate raises would imply an aggregate $3.4bn reduction in pension and OPEB liabilities for our covered suppliers and $15.5bn for General Motors Company (NYSE:GM) and Ford Motor Company (NYSE:F) if the plans were remeasured at current rates today. This is equivalent to 3%, and 13% of the market cap for our coverage and General Motors / Ford respectively. A lower discount rate at year end would also mean lower pension and OPEB expense for 2014, though the impact on earnings is more subdued, equivalent to a 1% EPS tailwind for suppliers and a 2% for OEMs. As we explain in more detail in the appendix of this report, this is because there are offsetting factors in Expenses with higher rates lowering service cost (a present value calculation of new benefits being accrued) but increasing interest cost (the carry cost of the existing liability).
Most impacted auto companies
As we further show below, the most impacted auto companies would be Meritor Inc (NYSE:MTOR), The Goodyear Tire & Rubber Company (NASDAQ:GT), and General Motors Company (NYSE:GM) which would stand to see their pension and OPEB PBO slashed by $282mn, $815mn, and $8.8bn respectively at year end equivalent to 38%, 20% and 16% of market cap if rates were to remain unchanged until year end. For plans like Meritor with September closing dates this could get locked in fairly soon.
We note that while the companies with the largest PBO benefits tend to also be the largest beneficiaries in terms of expense this is not always the case. For instance General Motors Company (NYSE:GM), which stands to see a big PBO reduction, would likely see expense rise because the company has so few active employees relative to the number of retirees so the rising interest cost offsets the service cost.
A couple of caveats on the methodology. We quantify the retiree expense/obligation headwind using sensitivities provided in company disclosures. We acknowledge that these sensitivities are an imperfect tool for estimating future pension expense and obligations, especially when applying 2012 sensitivities to 2013 and 2014. However, we think they are useful to scale the potential impact by company. The above calculations assume the discount rate changes by the amount by which the Moody's Corporation (NYSE:MCO) AA has changed since each company’s last measurement date.