February 03, 2012 - 10:19pm EST by
2012 2013
Price: 18.98 EPS $0.70 $1.23
Shares Out. (in M): 157 P/E 27.0x 15.4x
Market Cap (in $M): 2,987 P/FCF 35.0x 21.0x
Net Debt (in $M): 721 EBIT 166 251
TEV ($): 3,708 TEV/EBIT 22.3x 14.8x
Borrow Cost: NA

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  • Pension Liabilities
  • Off Balance Sheet Liabilities


Investment Thesis – Short NCR


I am recommending a short position of NCR Corporation (NCR) into their 4Q11 earnings report, to be released after the close on Monday, February 6th.  This short call is not based on operational fundamentals or expected guidance, but rather based on an expectation for a material increase in the unfunded status of NCR’s already-enormous pension liability, higher pension expense, and greater required cash contributions into the pension plan.  While it is very difficult to come up with precise estimates, I have worked closely with a sell-side pension expert who built a robust pension model specific to NCR, and based on this work I believe that the underfunded status of NCR’s pension obligation could increase by as much as $500 million, 2012 pension expense could increase by $60 million, and required cash contributions to the pension plan could be close to $200 million.  Relative to a market cap of $3 Billion, with current 2012 estimates of ~$300 million of EBIT and ~$150 million of FCF, the negative pension impact should be material.  Importantly, despite the size of NCR’s current pension problems (the gross Benefit Obligation as of December 31, 2010 was $5.5 Billion and the underfunded position was $1.4 Billion) nobody appears to be focused on this issue as management has trained investors to look at everything on an “ex-pension” basis.  Despite the material decline in the discount rate and the meager asset returns over the last year (and asset return assumptions have to come down significantly going forward since NCR is moving 100% of its plan assets into fixed income), the sell-side is not forecasting any material increase in NCR’s pension expense or the pension liability.      


While there is some risk that the company reports a strong quarter and good guidance, the 15% increase in NCR’s stock price over the last 13 days provides some comfort that expectations are high enough to prevent a big upward move in the stock based on fundamentals.  More importantly, I expect the magnitude of the pension issue to be so large as to overwhelm any potential positive business fundamentals.  Additional upside to the short position would come from fundamentals falling short of the high expectations.  There are already a couple examples of companies that have reported decent-to-great earnings only to have their stocks punished because of pension issues that caught investors by surprise.   I go into more detail on these companies below.


Pension Basics


While pension accounting is notoriously complex (and I am by no means an expert), the basic drivers of the underfunded status, income statement expense, and required cash contributions are the discount rate used to value the pension liability, the actual return on the plan assets, and the expected future return assumptions on the pension plan assets.  At the risk of oversimplifying (and I am certainly doing that), the pension obligation is a promise by the company to pay benefits far into the future, and so the present value of that obligation increases as the discount rate decreases.  The size of a company’s pension plan assets are, of course, driven by the returns generated on those assets.  When estimating potential changes to the underfunded status of a pension obligation, it is important to look not at the current net underfunded status but rather at both the size of the gross obligation and the total plan assets.  A company with a $5 Billion obligation and $5 Billion in plan assets may be fully funded one year but small moves in both the size of the obligation and the plan assets could result in a big unfunded liability seemingly coming out of nowhere.


Pension expense is driven by several factors, one of which is the assumed rate of return on the plan’s assets.  The assumed rate of return is determined by the company but is based on the asset mix within the plan asset portfolio, as well as the expected return on those asset classes.  Required cash contributions are determined by the level of underfunding, however companies are given several years to make up the shortfall with cash contributions (this period has been 7 years but, due to legislative relief, companies can choose to make up the shortfall over 15 years). 


Overview of NCR’s Pension, Postretirement, and Postemployment Obligations


As of December 31, 2010, NCR had a total pension Benefit Obligation (U.S.and International) of $5.5 Billion and an Accumulated Benefit Obligation with Plan Assets totaling $4.5 Billion.  The obligation was therefore underfunded by $997 million.  Postretirement and Postemployment liabilities are another $368 million (there are no plan assets against these liabilities) for total underfunded obligations of $1.4 Billion  (45% of NCR’s current market cap).  Pre-tax pension/postretirement expense in 2010 was $247 million and cash contributions to the pension plans totaled $105 million.  The discount rates used to determine the pension liability was 5.3% for theU.S.obligations and 4.6% for the International obligations.  Expected return on plan assets was 7.5% for theU.S.plan assets and 6.0% for the International assets.  Plan assets were allocated 60% to fixed income and 40% to equities.


For 2011, the company has stated that it will use discount rates of 5.25% and 4.25%, respectively, for itsU.S.and International plans and an expected return on plan assets of 6.75% for itsU.S.plan.  The company estimated having to make $125mm of cash contributions into their pension plans for the year.  Mix of plan assets were expected to shift to 80% fixed income and 20% equities by the end of 2011 and by the end of 2012 they would get to 100% fixed income.


Potential Impact of a Lower Discount Rate and Lower Expected Return on Plan Assets


My short thesis is based on the belief that lower discount rates, lower than expected return on plan assets in 2011, and a significantly lower expected return on plan assets in 2012 and beyond will materially increase the underfunded pension status, increase pension expense for 2012 and beyond, and result in significant required cash contributions to the pension plan.  For a company with a market cap of only $3 Billion that already has $700 million of net debt and is anticipating generating only $75-$100mm of FCF in 2011, the negative impact of the pension should be material enough to result in a permanent impairment to the value of the equity and a reduction in the stock price.


It is impossible to know what assumptions management will use, but based on my conversations with a well-regarded pension expert on the sell-side I believe that the discount rate assumptions for 2011 could be as much as 100 bps lower than 2010 – in my model I assume management decreases the discount rate by 75 bps.  I assume that the actual return on theU.S.assets in 2011 was 3.4% and I assume the expected return on plan assets decreases to 5% for theU.S.assets and 4% for International assets.  It is important to note that in early 2010 NCR management made the decision to shift its mix of pension assets to 100% fixed income by year-end 2012 in order to “substantially reduce future volatility in the value of the plan assets held by itsU.S.pension plan.”  The trade off to get this reduced volatility is to accept lower returns, which has the impact of increasing the pension expense. 


Based on these assumptions, I estimate that the underfunded status of just the pension liability (i.e., not including postretirement and postemployment benefits) could increase to $1.5 Billion – a $500 million increase from 2010 (representing 17% of NCR’s market cap).  Pension expense would increase to $280 million from an estimated $202 million in 2011 (relative to an estimated $300 million of EBIT in 2011).  Cash contributions would increase to $187 million from $125 million (relative to FCF guidance for 2011 of $75-$100 million).


Using more conservative assumptions (from the perspective of this short thesis), assuming only a 50 bps decline in the discount rate and an expected return of 5.5% on U.S. plan assets and a 4.5% return on International plan assets (pretty aggressive assumption given the shift to fixed income), I get to an unfunded status of just over $1.3 Billion (a $300mm increase – 10% of market cap).  Pension expense would be $247 million and the cash contribution would be $188 million.


Investor Expectations and Potential Stock Reaction


I believe that the stock reaction news to this pension impact could be exacerbated by the fact that nobody is paying attention to the looming problem.  The stock is up over 20% since the end of 2010 (vs. a 7% increase for the S&P 500), including a 15% increase in the last 13 trading days ending on February 3rd (vs. a 4% increase for the S&P 500).  By constantly using and emphasizing non-GAAP, ex-pension earnings numbers, management seems to have lulled investors into a false sense of comfort with the enormous pension liability.  JPM and Morgan Stanley, for example, both forecast the underfunded pension liability decreasing in 2011 vs. 2010 and forecast that pension expense will decrease in 2012.  This just simply isn’t realistic.


There are two recent examples of companies reporting pension issues and having their stocks punished as a result.  Unisys Corp (UIS) reported generally in-line numbers after the close on January 31 but shocked investors with its pension disclosure.  The underfunded status of its pension increased from $963 million in 2010 to $1.6 Billion in 2011 (relative to a market cap of ~$900 million).  Pension expense increased by $37 million in 2011 vs. 2010.  Cash contributions were projected to increase from $87 million in 2011 to $240 million in 2012 and management indicated that cash contributions would remain at this level going forward.  The stock ended the day down 14.1% vs. a 0.9% gain for the S&P 500.


On January 25th, Motorola Solutions (MSI) reported outstanding numbers and gave strong guidance (ex-pension).  However they also reported that the unfunded status of their U.S. pension plan increased by $380 million (relative to a market cap of ~$15 Billion), that they had to make an incremental $250 million cash contribution to the plan (total contribution was $480 million), and that 2012 pension expense would increase by $60 million (relative to total EBIT of $1.5 Billion).  Despite great fundamental numbers and a seemingly minor pension impact, investors had not been paying attention to this issue and the stock traded down 6.1% on the day versus a 0.9% increase in the S&P.


 I believe these two examples give a pretty good indication of how investors react to pension surprises and makes for a good risk-reward on a short position of NCR heading into the quarter.


4th Quarter earnings announcement and pension disclosure / guidance.
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