Since its founding in 1879, NCR Corporation has enjoyed a storied and very profitable run as one of America’s great success stories. At the beginning of the 20th century, with its powerhouse salesforce led by the legendary Thomas Watson, Sr. of IBM acclaim, National Cash Register populated our land with the mechanized cash register, a revolution in merchant trade that sticks to this day. NCR survived two world wars and entered new lines with some success and some failure. Spun out of AT&T in 1997, the modern NCR exists as one of the dominant point-of-sale players (no surprise given its cash register roots) and, more significant to the bottom line, as one of two global leaders in the manufacture of ATM machines. For we fundamental investors, NCR has maintained a pristine track record of free cash flow profitability year in and year out – this is a company we simply want to own! But there is one problem…NCR’s defined benefit pension plans are swallowing them. What is all the more shocking, however, is that their defined benefit nightmare was not always thus, and herein lies the informative story for investors as well as a sad and dire harbinger for US taxpayers.
At the end of 2007, all was well for NCR’s employee retirement plans. The benefit obligation for both the US and international plans combined was $5.219b and the plans had investments valued at $5.537b, which rendered a nice $318m overfunded cushion for the company. The funds charged a modest $44m to expense for the year and had reasonable discount rates, expected rates of return, and asset allocations. All would appear well to even the trained eye (this was, most certainly, not a General Motors 30 year bleed situation). And then came the bear market annihilation of 2008.
We would, of course, expect there to be material damage to NCR’s pension funds from the crash of 2008. We, in fact, see most pensions somewhat underfunded currently. NCR’s, however, is much, much worse. It is not somewhat underfunded, it is disasterously underfunded, especially as one considers their normalized level of earnings.
At the end of 2008, NCR’s benefit obligation (and, mind you, this is just their DBPPs and includes neither another “postretirement” plan nor their postemployment health care obligations) was $4.872b, while their plans’ assets had fallen to $3.675b, which rendered a $1.197b underfunded hole. This reads ugly enough off the page but what is truly significant is that this $1.2b hole must be filled by a company that produces, by my estimate, around $200m annually in normalized free cash flow. Foregoing compounding rates of deficit for our purposes, simple arithmetic dictates that for the next 6 years, every penny of owner earnings will need be set aside to cover pension agreements made by yesteryear’s generations.
The above arithmetic is bad enough; however, it gets worse when we read what the company estimates need be done to honor the obligations. On page 73 of the 2008 10-K, NCR surmises that for the next 10 years the company will pump approximately $360m per year into the obligation funds to make them whole. If we include what has historically been expensed into our $200m FCF estimate, maybe we can get to $360m (I honestly doubt it, for the record), but, even assuming the $360m is doable out of cash flow, the investment proposition to NCR shareholders is quite clear: own this 132 year-old company and expect zero profits to come your way for the next decade. Now, we Buffett camp fundamental investors are supposed to seek to “hold forever,” but no profits for ten years breaks me…include me out!
The NCR lesson for investors is a simple one. I have read the pension footnotes my entire career with a keen eye mainly to funding status (with return and discount assumptions to a lesser extent) as I believed it to be the main scorecard for what to expect to deduct from free cash flow for future years. The situation for NCR at 12/31/07 showed surplus, which proved to be a huge false comfort. One good bear market (and, shock of shocks, there will be others!) later and NCR is faced with pledging its foreseeable future to plug its pension shortfalls. A new, more relevant metric emerges from this tale: instead of simply looking at funding status, we should weigh the overall magnitude of the obligation (in the simple, just DBPPs, case of NCR - $5b) against the normalized free cash flow level of the company (for NCR - $200m). Now, we will have to get to know our ratios over time to learn of the danger thresholds; that being said, we do know that 25x ($5b / $200m), as in the case of NCR, is simply untenable.
The broader application of the NCR story is an obvious one: the US and state governments’ retirement/pension/postretirement health care plans. If we were simply to apply our new metric – magnitude of obligation / normalized FCF – to the US and pick-your-state (i.e. darn near every one), our ratio would yield something akin to the following:
The above ratio is, without any reach whatsoever, considerably worse than NCR’s 25x. Nevertheless, it is my opinion that the “include-me-out” option is cowardly when it comes to one’s country. As such, with the writing being so starkly on the wall, I encourage everyone to help pressure this ratio down (i.e. work to lower our governments’ obligations and/or increase our governments’ FCF) in any way that they can.
Eric Houssels is the co-founder and managing member of Houssels Capital Management, LLC, a money management firm based in Las Vegas, NV. The firm focuses on investments in the stocks of publicly-traded companies of all capitalizations that possess, preferably, significant earnings power or, alternatively, assets that can be (re)deployed to achieve significant earnings power and are trading at reasonable valuations. Houssels Capital Management was founded in 2000.