After yesterday's market reaction to Ford's (F 0.47%) 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 (GM 4.37%) 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.
