Is This Company Sitting on a Time Bomb?

The regular "one-time, non-recurring" infusions of cash that Eastman Kodak (NYSE: EK  ) passes off each quarter as a successful turnaround strategy are bad enough, but it's getting harder to ignore the time bomb ticking away in its underfunded pension plan.

Many corporate pension plans are woefully underfunded. According to Standard & Poor's, pensions at the 500 companies comprising its market index came in $260 billion short at the end of last year, and a report from Goldman Sachs said these companies went from overfunding their plans by 8% at the end of 2007 to underfunding them by 21% the following year. Not even the market's recent gains have been enough to even out the ledger.

These aren't obscure fly-by-night companies running away from their obligations. Some of the biggest, most well-known companies around -- ExxonMobil (NYSE: XOM  ) , Disney (NYSE: DIS  ) , and Deere (NYSE: DE  ) , for example -- have massively underfunded pensions plans. You can add Eastman Kodak to the list.

Indebted to you
The fair value of Kodak's U.S. and non-U.S. pension plan assets at the end of last year totaled $7.3 billion, leaving a $1.1 billion deficit. As bad as that sounds, the situation's actually worse, because it uses imaginary numbers to pretend things are better than what they seem. Even though Kodak's accounting is perfectly legal, the bill will come due one day.

The problem stems from Kodak -- along with many other companies -- using assumptions that are simply unrealistic. The more aggressive its accounting assumptions, the less it has to set aside for pension obligations and the lower the hit to its earnings.

There are two aspects to consider: the rate of return a company earns on its investments and the discount rate, which is used to discount future obligations back to a present value. Playing with either one can allow management to massage results for greatest effect.

Easy as pie
According to its annual report, Kodak figures it can earn 8.49% on its investments here in the U.S. and 7.28% elsewhere, even though more than three-quarters of its plan assets are in non-equity investments. This suggests those assets are really more low-risk than high-return (which is appropriate for a pension plan), but that allocation also makes it extremely difficult to achieve the kind of results the pension plan needs.

The long-term rate of return on stocks is about 10%, with approximately 4.5% coming from dividends and 3% from inflation. The rest is earnings growth. Historical bond returns are much lower than that, yet almost half of Kodak's portfolio is made up of debt securities.

The other half of the equation is a company's discount rate, and until last year Kodak had been one of the worst offenders by using overly optimistic assumptions. Turning to the Goldman report again, in 2008 Kodak was tied for second place behind Allstate (NYSE: ALL  ) for companies using overly generous discount rates. Kodak used the same 7% rate that AT&T (NYSE: T  ) and First Energy (NYSE: FE  ) did.

This is gonna hurt
Yet even Kodak realized that number was a fairy tale and subsequently cut it to 5.75%. While more realistic, in a world where 10- and 30-year Treasuries go for 2.5% and 3.7%, respectively, a near-6% discount rate seems suspect. Should the company seriously be saying that it can earn well over 8% on its investments? Those assumptions project a lot of confidence in its pension managers' abilities to outperform while they're using an asset allocation that ties them heavily to historically low bond returns.

For every 25-basis-point reduction in its discount rate for U.S. pensions, Kodak's earnings will be reduced by $3 million. Decreasing the expected rate of return by a like amount for both its U.S. and non-U.S. pensions swipes $21 million from the bottom line. That certainly provides enough incentive for Kodak to be optimistic about its investing acumen.

Absent real-world numbers, pensions amount to little more than cookie-jar accounting that permits managers to dip their hands into a fund to manipulate earnings. Companies can allow these deficits to grow only so far before they have to expense them on the income statement. When that happens earnings are going to get slammed, and Kodak, with a weak business model reliant upon one-time sources of revenue, will be left overexposed.

Disney is a Motley Fool Inside Value recommendation. Disney is a Motley Fool Stock Advisor selection. The Fool owns shares of ExxonMobil. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Rich Duprey does not have a financial position in any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.


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  • Report this Comment On November 11, 2010, at 3:08 PM, khaledmrd wrote:

    Kodak Patents are huge beyond even Photography it is like Rambus in this

    Their Turnaround to Digital at it's final stage and they got Great Ranges in the Like Of Digital cameras, Camcorders, Sensor technology, New commercial Digital Inkjet technology, Digital Frames and many more

    their Consumer and office Inkjet printers and Ink biz that expected to replace the Film biz at a time.

    CEO during the CC said they are going outside US to Asia and other regions capitalizing on their Brand power and awareness, more will be announced in February as the CEO said a new Biz Model and more.

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