Friday, 29 November 2013

Executive Remuneration as an Investment Criterion; M&C Saatchi

And HICL Infrastructure Company Limited

The Subsidised Mineowner, Trade Union Unity Magazine 1925, courtesy Wikipedia
The bosses of the FTSE 100 have seen their remuneration increase from 11 times median wages in 1980 to 116 times median wages in 2010. But, as Brian Bell and John Van Reenen of the LSE's Centre for Economic Performance note (Firms Performance and Wages: Evidence from across the Corporate Hierarchy, Discussion Paper 1088, revised May 2012), this is in line with the phenomenal increase in the share of the UK's national income that goes to the top 1% of earners. Furthermore, they estimate that corporate executives account for only 3% of the top 1% of earners in the UK. Financial service executives with more than 40% dominate, while lawyers, accountants and management consultants are all represented in higher numbers than corporate executives are.
The question for shareholders is whether there is any relation between executive remuneration and shareholder returns. Bell and Van Reeden come up with some interesting facts based on an analysis of senior executives and employees at 400 large publicly quoted UK companies between 2001 and 2010.
·         There is a positive, statistically significant relationship between senior executive pay and shareholder returns. This is also true of lower level management and 'workers', though the relationship declines to very small numbers at the bottom of the corporate hierarchy.
·         CEO remuneration is more sensitive to increases in shareholder value than declines. Therefore, a 10% increase in shareholder returns leads to a 38% increase, on average, in a CEO's cash bonus, while a 10% decline leads to only a 7% average decline in a CEO's cash bonus. And the average cash bonus for a CEO is 31% of his or her total remuneration. 35% of a CEO's remuneration is derived from base salary and the remaining 34% comes from long-term incentive plans.
·         The relationship between executive remuneration and shareholder performance is strongest where institutional shareholders have a big share in the company.
·         They note that "Low ownership firms [where institutional shareholders are weak] strongly reward positive returns with higher pay but require no pay penalty for negative returns."
Bell and Van Reeden do not touch on the issue of criteria used by remuneration committees to set executive pay. Companies, such as Vodafone, that make large impairments for goodwill and intangibles (they often overpay for acquisitions and other intangible assets) often exclude impairment charges from their profit benchmark. In other companies, where outside shareholders are weak, senior executives sometimes help themselves to what they want irrespective of their company's performance.
The case of M&C Saatchi
After being ejected as Chairman of the advertising agency, Saatchi and Saatchi, Maurice Saatchi, his brother Charles and three other senior Saatchi executives founded a new advertising agency M&C Saatchi. The company was listed on the Alternative Investment Market and it has been a success. Maurice Saatchi left to pursue his interest in contemporary art and the remaining four executives control the company.
For the outside shareholder M&C Saatchi has an unusually problematic corporate structure. A significant rise in the company's share price leads to both a sharp reduction in its accounting profits and a large capital distribution to its four founder directors. And it is worrying that the directors focus on the company's 'Headline results' that exclude some very important accounting charges, including the perverse repercussions of its corporate structure.
In its 2012 Annual Report Charles Saatchi reports that 2012 had been the best year ever for M&C Saatchi. Then on page 10 the CFO adds:
"Non-headline results
Leaving our improved trading performance aside, the reduction in profit before tax of 38% to 9,881k pounds and basic earnings per share of 75% to 3.89p was in the most part caused by the increase in our share price from 1.165 pounds to 1.805 pounds that caused a 6.9 million pound accounting charge for minority put options (2011: 2.0m pound credit) and the 1.6 m pound write off of our Spanish associate."
This extraordinary state of affairs requires an explanation. Saatchi's 'philosophy' begins with "A federation of entrepreneurs, built through start-ups and owner managers." Saatchi puts this into financial practice in two ways:
1. Saatchi has minority shareholdings in 19 companies that own put options on Saatchi shares. These put options become ever more valuable as Saatchi's share price rises or less valuable as its share price falls. In 2012, the share price rose by 55% and the charge against profits was 6.9 million pounds. This was the main reason why earnings per share declined by 75% in 2012.
2. Saatchi awards its four founding directors ten percent of the company's increase in market capitalisation in the year, subject to certain conditions. At the beginning of 2013, this resulted in the four directors receiving shares equivalent to 5.6% of the company's outstanding shares.
As a result, the four founding directors were awarded a large bonus in a year when earnings per share declined by 75%. There is no provision for a claw back should Saatchi's share price fall.
2013 is likely to be a similar, but even more extreme story. Saatchi's share price has risen by 84% since 1 January. This suggests that the charge against profits for put options will be over 14 million pounds. Over the same period, the company's market capitalisation has increased by about 100 million pounds, suggesting a payout to the four founding directors of about 10 million pounds. In 2013, thanks to an incentive plan, the four directors paid about half the going price for Saatchi shares. It is not clear whether there is any similar plan in place for the bonus these directors are almost certain to receive in 2014.
In this scenario, Saatchi would most likely make a loss in 2013 while at the same time rewarding the four founding directors with new shares to the value of 10 million pounds.
The four founding directors currently own 27% of the company. The largest institutional shareholder, Aviva, owns 10%. Institutional shareholders are weak, and the company is run for the benefit of its owner managers. This is not in the interests of outside shareholders.

HICL Infrastructure Company Limited


Viaduct over Kicking Horse Canyon, courtesy HICL website
Most shares have risen sharply these past five years and it is difficult to find suitable companies at a price that allows for a margin of safety. At such times, it is wise to take profits on investments where the price of a share is well in excess of one's estimate of what it is worth.  The logical asset class to park the funds is cash. However, with money market funds yielding virtually nothing and bonds still expensive, one must look for better places to invest in for the medium term.
HICL was the first investment company listed on the LSE to invest in infrastructure projects. It is incorporated in Guernsey. The company was floated in 2006 and it now has a market value of 1.55 billion pounds. HICL is 91% invested in the UK in schools, hospitals, roads and public buildings. On average, its contracts have a duration of 22 years and its income is largely indexed to inflation. HICL is unaffected by changes in GDP, though it is not entirely free of market sentiment.  Consequently, its shares (in red) were, with the exception of a brief period in late 2008, a safe haven from the consequences of the financial crisis. Its shares perform more like investment grade corporate bonds than equities:

HICL share price and shareholder return versus FTSE 250 and All Share, courtesy HICL website, click to enlarge
At the present price of 130p, the shares yield 5.4% and they are priced at an estimated premium of 9% to net asset value. Demand for HICL shares has maintained a share price premium to net asset value since 2009.

HICL share price premium to net asset value, courtesy HICL website, click to enlarge
The essence of HICL's business is:
1. To buy into completed PFI/PPP/P3 projects, currently 79. The company avoids the risks of development and construction. It prefers to own 100% of the project.
2. HICL sets an internal rate of return (IRR) of 7% per annum for each project and bids accordingly.
3. Inflation protection. Currently, the company will see an increase of 0.6% in the gross valuation of its portfolio for every 1.0% increase in the UK Retail Price Index (RPI).
4. The company leverages its equity financing, currently by 1.23 times (1.23 pounds of debt for every pound of equity). The average cost of debt is currently 5.7%. Nearly all borrowings are long term and project related.
5.  HICL issues new shares when it has exhausted its existing resources and sees an opportunity for further investments. When it does so, the share price premium falls for a short time.
6.  HICL uses Infrared Capital Partners to manage the estate. Their advisory fee in 2012 was 1.2% of gross assets. Director fees are limited to 250,000 pounds per annum.
The prudent investor will note:
 1. HICL's continuity depends upon its ability to secure new projects at its desired IRR. Of 15 bids it entered last year, it won just three.
2. The company relies entirely on the public sector and a new, Labour government could change the terms of business. However, given that the Treasury is trying to reduce the public deficit and Labour's mission is to increase capital spending, a change of government might prove to be beneficial.
3. If there is a prolonged period of RPI inflation below 2.75%, this will adversely affect the value of HICL's estate. The RPI for the year to October 2013 was 2.56%.
4. An upsurge in bond yields would depress HICL's value to investors.

Friday, 8 November 2013

Why investors should be worried about company pension schemes; and BT PLC

William Hiseland, an early Chelsea pensioner, by George Alsop @1720, courtesy Wikipedia

The first English pension scheme for soldiers, who were wounded or who had completed 20 years of service, was founded by Charles II in 1682. Over three hundred years later, the public sector defined benefit pension scheme, which now includes civil servants, teachers and employees of the NHS as well as the armed forces, is unfunded to the tune of 1.2 trillion pounds. This is as big as the National Debt. But the British state will pay it off piecemeal over decades, as it is here (so it is assumed) forever.
Companies, which unlike government are assumed to have a finite life, must fund their defined benefit pension schemes (DBPS). This has become a growing burden for many companies. In April 2012, the profitable knitwear company Dawson International went into administration. The CEO announced that it was closing because it could not meet a 129-million pound demand for payment by its pension fund trustees, ". . . the deficits have widened, mainly due to changes in actuarial assumptions, and associated costs have risen significantly."
Many companies have closed their DBPS to new entrants, replacing them with defined contribution pension schemes (DCPS). As a DCPS does not guarantee a future income, it does not require the provision for future obligations that a DBPC requires.
However, closing a DBPS to new entrants only reduces the financial obligations for companies. So W S Atkins, which has closed its DPBS to new entrants, is still grappling with its obligations. See
BT warned, in its 2013 Annual Report "We have a significant funding obligation in relation to our defined benefit pension schemes. Low investment returns, high inflation, longer life expectancy and regulatory changes may result in the cost of funding BT’s main defined benefit pension scheme, the BT Pension Scheme (BTPS), becoming a significant burden on our financial resources." See more below.
In its latest pensions report (LCP Accounting for Pensions 2013) on the FTSE 100 companies, the actuaries Lake Clark & Peacock LLP (LCP) look back over 20 years. In 1994, all FTSE 100 companies had final salary DBPS open to new members. Today only one, Croda, has such a scheme open to new entrants. And 39 FTSE 100 companies have stopped accruing for present members, meaning that their employees' pension rights are frozen. Even so, the 20% excess of assets over liabilities that the companies recorded in 1994 has fallen to a 9% shortfall at June 2013.
Since 2002, FTSE 100 DBPS have been in deficit every quarter except for a short period in 2007-8.

Graph courtesy Lane Clark & Peacock LLP, click to enlarge

And the situation is deteriorating. In the past year, DBPS net liabilities have increased by 1 billion pounds to 43 billion pounds even after companies had paid 21.9 billion into their schemes. This is in spite of an 18% increase in the FTSE All Share Index that boosted pension assets in this period. There are several reasons for this deterioration: 

1. Companies have had to take a more realistic view of the future return of pension assets. But estimates vary. Resolution now expects a return on equities of 5% per annum. Babcock uses 8.4% per annum.
2. Life expectancy is increasing. LCP reckon that this has cost 40 billion pounds to FTSE 100 companies since 2005. Assumptions vary by company. So Meggitt uses 87.6 years and Standard Life 91 years as a life expectancy for a 65 year-old man. The average life expectancy for a 65 year-old man has increased by three years in the last seven years:

Graph courtesy Lane Clark & Peacock LLP, click to enlarge

3.  The discount rate that companies have used to discount future obligations is in decline. This should be based on "high quality" corporate bonds. Experian now uses 5.2% (the highest). British American Tobacco 4.1% (the lowest).

4. The regulatory burden of running pension schemes has increased six-fold since 1995, while the number of active members in a DBPS has fallen by two-thirds:

Graph courtesy Lane Clark & Peacock LLP, click to enlarge

Pension fund trustees now have great powers to protect their members, including in takeover situations. "For example, WH Smith – where the pension scheme trustees demanded that any buyer of the business would need to make a large cash injection to the scheme." (LCP)

Looking ahead, there are more changes to accounting standards and changes to pension law that will increase the burden of DBPS to companies.
·         Companies were allowed to 'smooth' their asset values over a period of time, which meant that they could overstate the actual value of their pension fund assets. Not under the new version of IAS19. One such company is Royal Dutch Shell. The adjustment to its 2012 accounts that it will have to take for this measure in 2013 is estimated at $14 billion. Management will not include this in the headline profit and loss account, although it will reduce the company's equity by that amount.

·         Under the new version of IAS19, companies will not be able to use estimates for equity returns of 8.4%, as Babcock does. All assets will be projected to increase by the yields available on corporate bonds.

·          LCP estimates that the new version of IAS19 will cost the FTSE 100 companies 2 billion pounds more every year. Some companies, according to LCP, will benefit (Aviva will gain a small profit) while BP, for example, will lose 500 million pounds. LCP estimates that the year-end pre-tax balance sheet charge for the 100 companies will be 20 billion pounds. Royal Dutch Shell accounts for 11.6 billion pounds of this total.

·         Companies offering a pension scheme can opt out of the Second State Pension, thereby paying less National Insurance. From 2016, the Second State Pension ceases and companies will have to pay the full quota of National Insurance.

As a result, pension contributions for companies have almost doubled in the past seven years, and their cost will continue to grow:

Graph courtesy Lane Clark & Peacock LLP, click to enlarge

Companies have found many ways to limit the risks of DBPS.

1. Moving to DCPS and freezing existing DBPS will, in the long run, eliminate the risk entirely. Many companies have already done this and more are expected to follow.

2. Some have passed some or all of the risks to insurance companies - this comes with a cost, but it reduces risk. BAE Systems took out a longevity swap to limit the risk of increasing life expectancy and so it has eliminated one variable from its DBPS.

3. Company guarantees or pledged assets can substitute cash payments. The risk is still there, but the cost is postponed. Centrica pledged its Humber power station.

4. Other companies have agreed to pay more into the pension schemes if performance, an agreed level of earnings before interest and tax (EBIT) for instance, is reached. Contributions are then spread over bumper years. ITV will pay more when EBIT exceeds 10% of revenues.

5. Companies have partnership agreements with Trustees. Company assets are transferred into jointly owned entities. Diageo transferred whisky stocks.

The State Pension will shortly be limited to a maximum flat rate of 7,500 pounds (at 2012 prices). The Joseph Rowntree Foundation found that "single people need to earn at least £16,850 a year before tax in 2013 for a minimum acceptable living standard." And many retirees will have a partner with little or no pension entitlement. Supplementary pensions are a very much-needed part of anyone's retirement. Hence pensions autoenrolment, which commenced in October 2012, with a 3% payroll charge for the company. The effect on companies will vary greatly, depending on the pension schemes they have in place. And the 3% payroll charge may well increase. In Australia, they also started with 3%, but found it inadequate. The rate there is set to rise from 9% to 12% by 2019.

The investor will separate defined contribution schemes, such as autoenrolment, which are a known cost from the uncertainties of DBPS. When reviewing a company, the cautious investor will ask:
1. Does the company operate a defined benefit pension scheme?
2. Does it remain open to new employees? Has the company stopped accruing for it, effectively freezing the benefits for employees?
3. Is the scheme in surplus or deficit?
4. If there is a DBPS deficit, do the directors address its financing in their report and propose solutions?
5. Are the assumptions for inflation, longevity, return on investment of the fund's assets and the discount rate to calculate its liabilities reasonable? Has it applied the new version of IAS19?
6. Does the company have the financial strength to comfortably pay off its future pension liabilities?

BT PLC's Defined Benefit Pension Scheme

International switchboard 1940s, courtesy Wikipedia

BT's management acknowledge in its 2013 Annual Report that its defined benefit pension scheme (DBPS) is "becoming a significant burden on our financial resources." BT's DBPS was closed to new entrants in 2001. Yet, with 44,000 contributing members, 193,000 pensioners and 80,500 deferred members, it remains one of the largest such schemes in the UK. The company has also changed the terms of its active members, so that the retirement age was raised from 60 to 65 and the pension is now based on career average earnings (adjusted for the CPI) instead of final salary. Yet BTs pension deficit continues to grow. In large part this is because BT has used more conservative assumptions to calculate its DBPS assets and liabilities:

BT DBPS assumptions
Expected return on assets per annum
Discount rate per annum for liabilities
Increase in RPI per annum
Increase in CPI per annum
Life expectancy in years from age 60*

                *For a 60 year-old 'male in a lower pay bracket'.

The DBPS deficit is very sensitive to these assumptions. A 0.25% increase in the discount rate reduces it by 1.7 billion pounds. A 0.25% increase in the inflation rate increases the deficit by 1.5 billion pounds. And a year's increase in life expectancy increases the deficit by 0.9 billion pounds. BT does not provide any sensitivity analysis for a change in the expected return on assets.

In March 2012, BT and the Trustees of the DBPS announced an agreement on the triennial funding valuation as of June 2011. The substance of the agreement was:

1. The DBPS deficit was agreed, provisionally, to be 4.1 billion pounds at 30 June 2011.

2. BT will make a 2 billion pound payment into the DBPS before March 2012.

3. BT will make nine deficit payments of 325 million pounds in each year from 2013 to 2021. This is in addition to the regular payments BT makes to fund the scheme. In 2013, this amounted to 217 million pounds.

4. BT will make matching payments into the DBPS if its shareholder distributions exceed cumulative pension deficit contributions to June 2015. In 2013, BT made shareholder distributions (dividends plus net share purchases) of 876 million pounds. At this rate, the company will just about escape making matching payments into its DBPS.

5. If BT generates more than 1 billion pounds from disposals less acquisitions in a year, one-third of the net cash proceeds will be paid into the DBPS.

6. BT will consult the Trustees if it considers making acquisitions with a total cost exceeding 1 billion pounds.

7. Future creditors will not be granted superior security to the DBPS in excess of a threshold of 1.5 billion pounds until the deficit declines to less than 2 billion pounds at a subsequent funding valuation.

8. There will be new funding valuations at June 2014 and 2017.

Although BT paid 2 billion pounds to reduce the deficit in the DBPS in 2012, by September 2013 the pension scheme's deficit had climbed to 6.7 billion pounds. We are only 8 months away from another triennial valuation, and no doubt this will require BT to make further substantial payments into its DBPS. 

The strain of funding the DBPS on BT's finances will eventually disappear. But this is still many years off:

Graph from BT 2013 Annual Report
Meanwhile, actuarial losses in the DBPS have wrecked BT's balance sheet:

Pounds Mn
Sept 2013
March 2012*
March 2011
March 2010
March 2009
Net Equity
Net debt
DBPS  deficit


 There are no net assets to back BT's debts, which are currently 9.4 billion pounds. Fortunately, BT's net operating cash flow (after capital expenditure) of 9.7 billion pounds for the last five years has covered dividend payments by almost 3 times; the company slashed its dividend in 2009. But even this favourable cash flow should be qualified. The company has partly financed its activities by allowing the DBPS deficit to rise.

The company has a long-term credit rating from S & P of BBB (one notch above junk) and a short-term credit rating of  A-2.

Trading profits have been swamped by actuarial variations (mainly negative) on its DBPS:

Pounds Mn
2014 1st half
4 1/2 years
Trading post tax profit
Net DBPS (charge)/credit
Resulting profit/(loss)

Note: Assumptions on expected asset returns etc. varied considerably in past years (see above).

Taking the last 4 1/2 years, BT has made a profit of 413 million pounds, once deducting the increase in the DBPS deficit. Non-trading losses have a habit of catching up with the cash flow of a company. The DBPS deficit certainly will. Had BT applied the revised IAS19 to its accounting for its DBPS in 2013, the company would have reported a 190-million pound reduction in pre-tax profits.

It is against this background that an investor must weigh the risks associated with BTs DBPS against its undoubted trading strengths.  The company is capitalised at 29 billion pounds and its shares are priced at 371p. At this price, the shares yield 2.6% and are on a price earnings ratio of 14, if one uses trading profits as the denominator rather than the non-existent accounting profits.


Note: the next article will appear on 29 November.