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As the Ford Sell-Off Continues, What Are Investors Missing?

After yesterday's market reaction to Ford's (NYSE: F  ) 2014 guidance -- a plunge of 6.3% followed by today's 2.5% additional drop -- it's hard to remember that this year's projected pre-tax earnings will become one of the best annual performances in the automaker's history. While Ford's margins and profit may slightly decline next year it's because the company is launching 23 new or refreshed vehicles, compared to 11 in 2013, which will provide long-term growth at the cost of short-term profitability. That aside, there's a huge aspect that was overlooked in Ford's announcement: impressive progress on its underfunded pension plan.

Hidden problem
A huge problem facing many large corporations is their massively underfunded pension plans. Rather than simply throwing numbers at you (I'll do that shortly), I'll explain the details and why this matters first.

There are two major types of pension plans, the defined benefit pension plan and the defined contribution plan such as a 401(k). The difference between the two for large corporations is substantial. For the contribution plan, the company bears no risk; it just matches employee inputs to a certain percentage.

A defined benefit pension plan means that the company agrees to pay retirees based on length of service and salary at the time of retirement. To do this, companies invest in a pension fund that is invested in bonds, equities, or other securities -- essentially taking on more risk during the length of investment.

Thus, the company pension funding status is equal to its investment in plan assets minus its projected benefit obligation. If you put less into your pension plan than you are projected to owe employees, you're underfunded and have a potential problem. Here's where it gets a bit tricky. A company's benefit obligation is based on discount rates, which have been sitting very low, and that means a company's obligation on paper is much higher.

As obligations rise due to low discount rates, these massive corporations are left with largely underfunded pensions. How large are these underfunded pension obligations?

Ford's pension plans were underfunded by a whopping $18.7 billion at the end of last year. That number doesn't fully show up on balance sheets and is essentially a debt or obligation greater than Ford's automotive debt of $15.8 billion. It's even worse for General Motors (NYSE: GM  ) which ended 2012 with a staggering $27.8 billion underfunded pension plan. 

As discount rates rise, which they are expected to do slowly, obligations will shrink for corporations. Until then, Ford and others will be throwing large sums of money at their pension plans. Ford expects to drop $5 billion this year alone into its plan -- that's cash the automaker could spend next year to help fund its 23 vehicle launches. Such a large obligation is something that could drag its profits down, and likely contributed to the nearly 9% plunge in its share price since yesterday.

Now for the good news.

Most people are overlooking the substantial progress Ford has made on its massive $18.7 billion underfunded pension plan. Ford announced it cut its underfunded status nearly in half this year -- perhaps to around the $10 billion mark. That's a difference of roughly $8.7 billion in obligations that disappeared this year. Compare that to the difference in Ford's 2014 pre-tax earnings projections and you'll wonder why its share price didn't move higher. Ford estimates this year's pre-tax earnings to hit $8.5 billion -- one of its best years in history -- and it expects 2014 to bring in between $7 billion and $8 billion. That is not a devastating earnings decline, particularly when you consider that Ford has beat expectations six out of the last seven quarters and met expectations once. 

Foolish takeaway
Sure, there will be a drop in 2014 pre-tax earnings compared to one of the company's best years ever. Sure, margins will feel pressure while the company unleashes a plethora of new vehicles to sustain its market share and revenue growth well into the back half of the decade. However, how can that outweigh the substantial progress made on its pension plans? How can a speed bump in next year's earnings outweigh its potential growth for the rest of the decade? As a longtime Ford investor, I won't let a short-term speed bump derail my long-term focus. I believe Ford's core business is still on track, doing well, and that its future is still very bright -- the market's reaction to Ford's 2014 guidance was looking at all the wrong information.

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 19, 2013, at 2:13 PM, SkepikI wrote:

    <Ford expects to drop $5 billion this year alone into its plan>

    Daniel. You don't have to be so vauge about this. Ford was quite specific about what CASH contributions it made to the pension plan in previous quarters. If you want to do your readers some good, you should be reporting this number because its hard to fuzz.

    We should all be watching the 4th quarter numbers for the Ford CASH contribution, which I expect will be substantial and I would not be surprised in the least if the total exceeds $5 B for the year.

    Finally you should be reporting as did John R earlier in the year that the increased performance of pension fund assets will further erase the amount of the deficit. Reporting the current "shrinkage" would be useful. Speculating on where the actual short fall (significantly less than 18 B) will end up would be useful. Not mentioning it at all is a serious deficiency- the sort of thing I've not seen often in your articles...

  • Report this Comment On December 19, 2013, at 2:18 PM, SkepikI wrote:

    Oh, and by comparison, you might also report that GM's CASH contribution this year (which you dont mention) to its enormously underfunded pension plan (which to your credit you report as a number) was pitiful by comparison and will likely drag on earnings for years to come... something GM shareholders don't seem to be holding against GM....

  • Report this Comment On December 19, 2013, at 2:23 PM, TMFTwoCoins wrote:

    I understand your point, but sometimes it can be difficult to balance how much an article should cover. I think you're more aware and knowledgeable about Ford than the average reader and might have more expectations. However, some might enjoy more explanations of the different pension funds and what it means to Ford. This is me guessing, I have no answers and only your opinion saying the opposite!

    That said, the plan was to write a secondary piece that dives deeper and discusses how a 70-80 basis point increase in the discount rate could drop Ford's obligation by ~40%. As well as discussing the facts behind its voluntary lump sum program that is eroding risk from Ford's end. I made the decision that was too much, to explain properly and do the topic justice, to add into this piece that I believe covered the overall points well.

    Thanks for reading, and I respect your points/opinion.


  • Report this Comment On December 19, 2013, at 2:27 PM, TMFTwoCoins wrote:

    Yes, I considered also pointing out GM's weak contribution, as I have in the past. Though I'd really like to know more about what GM plans to do with its ~$27 billion cash pile before speculating its contribution -- albeit to this point weak -- will drag on earnings for years. I think that huge cash pile could be used for various things, and a large chunk might end up in its pension plans, soon. I hope GM adds more color on its intentions for the cash pile, sooner rather than later.

  • Report this Comment On December 21, 2013, at 11:43 AM, observerbob2013 wrote:

    I would have thought that the potential loss of the company's stunningly successful CEO may have played a little on the minds of the sellers.

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