Rational Exuberance - The Equitile Blog

6th March 2019

Posted by: George Cooper

Pension deficits and dividend payments

The British Pension Regulator has just issued its latest Annual Funding Statement and the section on dividend payments relative to pension deficit repair contributions is noteworthy:  

“As the pension scheme is a key financial stakeholder, we expect to see it treated equitably with other stakeholders. In last year’s annual funding statement we highlighted our concerns about inequitable treatment of schemes relative to that of shareholders. We remain concerned about the disparity between dividend growth and stable DRCs [Deficit Repair Contributions]. Recent corporate failures have highlighted the risk of long recovery plans while payments to shareholders are excessive relative to DRCs. We are also concerned about other forms of covenant leakage which may be occurring in preference of higher DRCs and shorter recovery plans for schemes.

In 2018, we contacted a number of schemes ahead of their upcoming valuation, where we were concerned about possible inequitable treatment. The trustees of these schemes were asked a number of questions about their previous and current funding approaches and negotiations. These interventions continue and we are committed to continue our interventions on those schemes where we do not believe that their valuations reflect an equitable position relative to other stakeholders. We will continue to focus on this area when engaging with schemes in 2019. Our intention is to broaden our grip in this area to cover a larger number and greater range of schemes (regardless of covenant). We emphasise the key principles behind our expectations as follows:

Where dividends and other shareholder distributions exceed DRCs, we expect a strong funding target and recovery plans to be relatively short.

If the employer is tending to weak or weak [sic], we expect DRCs to be larger than shareholder distributions unless the recovery plan is short and the funding target is strong.

If the employer is weak and unable to support the scheme, we expect the payment of shareholder distributions to have ceased.”

Basically, the Pension Regulator is saying it is not prepared to tolerate companies paying out cash to shareholders when those payments leave the company unable to service its debt obligations. Doubtless this has been prompted by the BHS pension debacle.

The regulator is undoubtably doing the right thing here. Nevertheless, it does highlight an ongoing risk for equity investors and for how businesses deploy their capital to grow their businesses. Companies with large pension deficits are being obliged to divert their capital into pensions from where it is then invested in low-yielding government bonds.

At the aggregate level, the need to plug the hole in these pension deficits together with the fashion for pension funds to invest in low-yielding bonds risks undermining investment spending and therefore future economic growth. As we have said before, high dividend yields are often a sign of weak underlying companies (See – Depressed lobsters and the dividend yield trap).

In light of this latest warning from the pension regulator UK focussed dividend investors should tread especially carefully.

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1st March 2019

Posted by: Carsten Wilhelmsen

Organic Matters

Warren Buffett, in his ever-humble way, mused this week that he had overpaid when he teamed up with private equity firm, 3G Capital, to fund the Heinz acquisition of Kraft in 2015. The 27% fall in Kraft Heinz’ share price last Friday was a big hit for Berkshire Hathaway who, on the face of it, had found a new strategy for deploying capital - a pressing problem given its significant and growing cash pile.

In many ways the collapse is surprising.  A global player with a portfolio of leading brands should, in theory at least, offer a quiet life for long-term holders like Buffett. By selling products we consume every day into a growing population, companies with negative earnings surprises this large shouldn’t really feature.

The world is changing in all respects however and eating habits are no exception. Processed packaged food, a core segment for Kraft Heinz, no longer has the same tailwind it did. A cursory look at the global food mix brings this structural change into sharp relief. Kraft Heinz has been using old brands to roll out new products such as Mayochup, but a structural shift in the food industry indicates they might be focusing on the wrong sauce.

Figure 1 below shows the US packaged food market in structural decline relative to healthier preferences. The market has been growing at just 2% over the last few years while the organic food segment has been growing at six times that rate.

Figure 2 shows the US organic food market in dollar terms against Kraft Heinz’s stagnating revenue, we believe this is core to their challenge, and the future projections remains bleak.

Now Kraft revealed additional, more specific, problems last week. The merger hasn’t been handled well from an operational perspective, manufacturing and logistics costs are higher, goodwill write-offs were much bigger than expected and they announced a pending SEC investigation into their accounting policies. The structural shift in consumer habits, however, offers a more interesting lesson - the buy-and-hold mantra that pervades much of the investment industry is being challenged, even in traditionally stable industries.

Quickening dynamics in all markets are making business life more challenging than ever, not only for companies managing a merger on the scale of that between Kraft and Heinz, but for all companies large and small. From an investment point of view, betting on indefinite success – even in the most stable industries - is becoming a dangerous game.

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