Pension longevity risk

PENSIONS MUST ACCOUNT FOR LONGEVITY RISK October 31, 2014

Will Becker

[email protected]

1

Prior to the mid-19th century, humans typically lived fewer than 40 years. By 1900, life expectancy began to rise globally, reaching 48 years in 1950, 60 years in 1980 and close to 70 by 2010, according to data by the United Nations and the International Monetary Fund (IMF). According to Institutional Investor (8/25/14), this rise in life expectancy can primarily be attributed to the decline in infant mortality, which accounted for more than 70% of improved life expectancies in the United States and Canada from 1950 to 1970. Other health care benefits aimed at people under 65 also helped and death from infections was reduced. Then, starting around 1970, a significant improvement in life expectancy for people over 65 began and this trend continues today. Although health spending accounted for approximately 16.9% of GDP in the US in 2012, the highest share among the 34 member countries in the Organization for Economic Cooperation and Development (OECD) and nearly double its average of 9.3%, the US ranked just 27th of these 34 countries in terms of life expectancy at birth. While the US has made serious progress in reducing the proportion of adults who smoke tobacco, with the rate of daily smokers coming down from 19% in 2000 to 14% in 2012, the country’s obesity rates continue to rise. Based on actual measures of height and weight, obesity rates in the US are the highest in the OECD, reaching 35.2% in 2012, up from 30.9% in 2000. Mortality from diseases, including cardiovascular diseases and many cancers, increases progressively once people become obese.

Key Points: Pension plan costs should rise materially as Americans live longer

OECD numbers show that US life expectancy rates at birth have been steadily rising for decades, increasing by approximately 2.1 years just since 2000.

The IMF has long argued that forecasters have consistently underestimated how long people will live by an average of 3 years.

The Society of Actuaries (SOA) updated their mortality estimates for the first time in 14 years, showing life expectancies for 65-year-old Americans is up more than 2 years.

Based off these longer estimated lives, the Treasury and IRS are expected to revise industry pension calculations for PBOs and minimum contributions, respectively, likely in 2016.

Aon Hewitt estimates higher lives will increase retirement liabilities by roughly 7% for most corporate plans, while the SOA sees a 4-8% rise.

Although the S&P 500 pension funded status improved significantly in 2013 off crisis levels, these levels have likely deteriorated noticeably in 2014 based off old life expectancy estimates.

We screened for companies most vulnerable to rising longevity risk

We pulled non-financial S&P 500 companies with defined benefit plans that carry a large number of employees and retirees, sorting those with largest PBOs at the top.

Leaving those whose plans were underfunded by at least $100 million over the last fiscal year and had at least 30% of plan assets in equities, we got the list down to 156 companies.

IBM has grown EPS primarily via share repurchases, but higher pension contributions could hit cash flow

Sales growth has been non-existent and IBM has taken on more debt to boost EPS through repos.

IBM carries largest combined PBO of S&P 500 at just under $100 billion.

IBM increased its employee ranks at an average annual rate of approximately 2.6% over last 20 years. However, IBM has slashed jobs in recent years, putting more pressure on its pension as its retiree base grows relative to current workers.

IBM’s women employee percentage is also rising, which could put further strain on its pension since women typically live five years longer than men.

Based off 12/31/13 numbers, should IBM’s US PBO get raised 7% based on higher longevity risk, we estimate its combined funded status goes from -$6.2 billion to -$9.8 billion.

Pension contributions, which have been lower over each of the last four years, could easily jump to nearly $1 billion from an expected $600 million for 2014. This would put a dent in IBM’s cash flow and could curb repurchases.

CAT sales to miners are down and cost cuts and repos have driven EPS gains; rising pension contributions may come at a bad time

Strong sales to North American energy and construction industries have been offset by weak mining equipment sales, forcing CAT to slash production costs involving thousands of layoffs.

CAT has been growing its employee base fast over the last decade, but has been noticeably cutting jobs since 2012 and thus putting more strain on the future funding of its pensions.

CAT’s US plans had a big equities allocation at 61% as of 12/31/13.

Based off 12/31/13 numbers, should CAT’s US PBO get raised 7% based on higher longevity risk, we estimate its combined funded status goes from -$2.7 billion to -$3.7 billion.

We believe depressed pension contributions could easily jump to over $700 million from an expected $510 million for 2014, putting a hit on cash flow.

In August 2012, CAT changed its U.S. hourly pension plan, freezing pension benefit accruals for certain hourly employees and making them eligible for company-sponsored 401(k) plans.

Pensions Must Account For Longevity Risk Behind the Numbers Will Becker October 31, 2014

2

DOW is performing well operationally, but its heavily underfunded pension remains a concern

DOW’s Performance Plastics segment has been driving solid results and should continue to benefit from low cost feedstocks in North America which result from the natural gas and liquids boom.

DOW has fewer employees today than it did 20 years ago and it is likely safe to assume that DOW’s plans cover more retirees than workers.

While still under the S&P 500 average, DOW’s women employee percentage continues to creep higher.

Based off 12/31/13 numbers, should DOW’s PBO get raised 7% based on higher longevity risk, we estimate its combined funded status quickly goes from -$6.2 billion to -$8.0 billion.

With pension contributions likely heading back up much higher, DOW may have to pare back its recently hyped share repurchase program.

APD has gotten a boost from price increases, but cash flow deficits persist and higher pension contributions won’t help

APD is a current BTN warning and dividend play that has seen its stock price rewarded after implementing new management and initiating price increases to boost sales.

APD likely cut some jobs in FY14 and its employment growth only increased by about 2.2% annually over the prior 20 fiscal years, meaning its plans likely cover more retirees than workers.

Based off 9/30/13 numbers, should APD’s US PBO get raised 7% based on higher longevity risk, we estimate its combined funded status goes from -$593 million to -$790 million.

Even a small increase in pension contributions could hurt APD, as it reported an adjusted free cash flow deficit of $125 million in FY14, even after ending its share repurchase program.

APD recently began offering certain workers lump-sum buyouts to simplify operations and perhaps unload some of the risk of running a pension.

According to the latest OECD report, U.S. life expectancy in 2012 was 78.74 years, which is nearly nine more years than it was in 1960 at 69.77 years. For U.S. men, the current average life expectancy is about 76 years, while it's 81 for U.S. women. The following table shows average US life expectancies from 1960-2012 and also breaks out gender differences over this period, according to the OECD:

U.S. Life Expectancy Table (1960-2012) United States - Life expectancy at birth

Date Life

expectancy Life expectancy

- Men Life expectancy -

Women 2012 78.74 76.40 81.20 2011 78.64 76.30 81.10 2010 78.54 76.20 81.00 2009 78.09 75.70 80.60 2008 77.94 75.50 80.50 2007 77.84 75.40 80.40 2006 77.59 75.10 80.20 2005 77.34 74.90 79.90 2004 77.34 74.90 79.90 2003 76.99 74.50 79.60 2002 76.84 74.30 79.50 2001 76.74 74.20 79.40 2000 76.64 74.10 79.30 1999 76.58 73.90 79.40 1998 76.58 73.80 79.50 1997 76.43 73.60 79.40 1996 76.00 73.06 79.08 1995 75.62 72.50 78.90 1994 75.57 72.35 78.96 1993 75.42 72.20 78.80 1992 75.64 72.33 79.12 1991 75.37 72.00 78.90 1990 75.21 71.80 78.80 1989 75.02 71.70 78.50 1988 74.77 71.40 78.30 1987 74.77 71.40 78.30 1986 74.61 71.20 78.20 1985 74.56 71.10 78.20 1984 74.56 71.10 78.20 1983 74.46 71.00 78.10 1982 74.36 70.80 78.10 1981 74.01 70.30 77.90 1980 73.66 70.00 77.50 1979 73.80 70.00 77.80 1978 73.36 69.60 77.30 1977 73.26 69.50 77.20 1976 72.86 69.10 76.80 1975 72.60 68.80 76.60 1974 71.96 68.20 75.90 1973 71.36 67.60 75.30 1972 71.16 67.40 75.10 1971 71.11 67.40 75.00 1970 70.81 67.10 74.70 1969 70.51 66.80 74.40 1968 69.95 66.00 74.10 1967 70.56 67.00 74.30 1966 70.21 66.70 73.90 1965 70.21 66.80 73.80 1964 70.17 66.80 73.70 1963 69.92 66.60 73.40 1962 70.12 66.90 73.50 1961 70.27 67.10 73.60 1960 69.77 66.60 73.10

Meanwhile, the IMF argues that forecasters have consistently underestimated how long people will live, over time and across populations, regardless of the techniques they have used. A 2000 report called Beyond Six Billion: Forecasting the World’s Population says that estimates have been too low in many countries, including the United States, by an average of three years. Giving the IMF’s estimated 3-year discrepancy some credence, we note that 2011 OECD numbers show that the average American male and female are retired for 10 and 16 years, respectively.

http://flowingdata.com/2011/04/07/who-spends-the-most-years-in-retirement/


3

So, with the average retirement age in America at 62 years according to the US Census Bureau, this means that men and women would finish their retirements at ages 72 and 78 years, respectively. However, when one goes off the OECD numbers above, we see life expectancies at 76 and 81 years for males and females. This leaves us 3-4 years short! The point we want to make is that many people think 3-4 years of additional life on a 79-year average is not a significant discrepancy. However, drilling it down in terms of years of actual retirement, 3-4 years against 10-16 years of pulling money off a pension translates to an accounting adjustment increase on the projected benefit obligation (PBO) for companies’ defined benefit plans of about 40% for males and 19% for females, respectively! So, have these longer life expectancy averages been factored into the determination of PBOs for most US company plans? Last published 14 years ago in 2000, mortality tables assembled by the nonprofit Society of Actuaries (SOA) used to measure life expectancy were finally updated on 10/27/14. This 2014 update has been heavily anticipated. In fact, according to an October 2012 Prudential report, the SOA released a draft report in March 2012 indicating that the previous mortality improvement scale it issued in 1995 for use by defined benefit plans (Scale AA) was not tracking well with recent mortality trends in the US and that a new Scale BB would be based upon research into mortality improvements by “cohort” (meaning for persons of a particular age and year of birth). This two-dimensional analytical framework is a critical advance in the measurement of U.S. longevity risk, as the current Scale AA only has one dimension – the longevity improvement of those turning a certain age (e.g., 65). Scale BB will include a 1% long-term rate of mortality improvement for all ages up to age 90. As a result, these new SOA tables show that the average 65-year-old American is living approximately 2.2 years longer than just 14 years ago. According to the WSJ (10/27/14), SOA shows the average 65-year-old U.S. woman is expected to live 88.8 years, up from 86.4 in 2000, while men age 65 are expected to live 86.6 years, up from 84.6 in 2000.

Note: These SOA figures are markedly higher than the OECD numbers because it only factors in deaths of Americans after they reach the age 65.

This means that the average 65-year-old will live 22.7 more years to the ripe old age of 87.7. In actuarial terms, this rising longevity means pension fund sponsors and

individuals will need to put aside a larger chunk of assets, before factoring in inflation. The new estimates released Monday—based on data from corporate pension plans—could eventually increase retirement liabilities by roughly 7% for most corporate plans, according to Aon Hewitt. Meanwhile, the SOA predicts the increases could range from 4% to 8%. In the US, using only the previous estimates of mortality, actuarial liabilities include $3.6 trillion in the 126 largest public pension funds (closer to $4 trillion when one includes local and municipal funds), $3 trillion in private defined benefit plans and $24.3 trillion in unfunded obligations to current workers and retirees within the Social Security program, according to Institutional Investor (8/25/14). Thinking about this logically, it is not surprising that living longer has a big effect on pensions. This is largely owed to the fact that the amount of income paid to pensioners is funded by working individuals. The life expectancy of a retiree has a major effect on the pension amount paid by a private pensions scheme. This is because the money that a person saves prior to retirement will have to last for a longer period of time if a retiree lives for long, unlike in a case where a person has a short life expectancy. Granted, it appears that this key longevity assumption is already being discussed in terms of its impact on state pensions. According to The News Tribune (6/22/14), in a

June presentation to the Legislature’s Select Committee on Pension Policy, Washington State Actuary Matt Smith broke the sobering news that those retiring today are living a year longer than the state’s pension model had assumed - and the life expectancy grows by another year or more for those retiring in 2034. He said men turning 65 today are estimated to live to 84.1 years under the new assumptions and women to 86.4 years. To conclude, after members thought last year that the state’s pension plans collectively had a $544 million overall surplus, Smith warned that new money needs to be paid into pension funds to erase what now amounted to $4.4 billion in underfunding across all plans over the long haul. Sen. Barbara Bailey, an Oak Harbor Republican who chairs the Legislature’s Select Committee on Pension Policy that heard Smith’s presentation, said,

“I think the general consensus on the committee was ‘wow.’ I guess we’ll have to study this for a while. I think that everyone has genuine concern. We’re trying to digest this and see how we are going to work through this, and see how it is going to affect policy work that we do.”

Smith’s outline showed employees in state and local governments would need to pony up $408 million in the next budget cycle, if the state tries to fix the problem immediately. That would drive up contribution rates in many plans - with some going up less than 1% of pay and others going up more than 2%. Local governments also would face a $556 million bill if a bite-the-bullet approach were taken. Smith said his review looked at all of the state’s pension assumptions, and of the changes he made, life expectancy had the biggest impact.

http://pensionannuity.co.uk/increase-your-pension-income


4

Longevity risk is clearly becoming a major concern for the IMF as it talked about necessary reform measures and possibly a government mandate to increase retirement ages and help stem future looming pension deficits. In an April 2012 report, the IMF concluded,

“First, governments should acknowledge the significant longevity risk the face through defined-benefit plans for their employees and through old-age social security schemes. Second, risk should be appropriately shared between individuals, pension plan sponsors and the government. An essential reform measure would allow retirement ages to increase along with expected longevity. This could be mandated by governments, but individuals could also be encouraged to delay retirement voluntarily. Better education about longevity and its financial impact would help make the consequences clearer.”

The IMF report also cautioned that if it was not feasible to increase contributions or retirement ages that benefits may have to be trimmed. Finally, the report discussed the use of risk transfer to capital markets. One can certainly suspect that longevity risk has been on the minds of some plan sponsors of private companies too. The WSJ article notes that more companies are closing

their defined benefit plans and offering defined contribution plans, such as 401(k)s, where employees are largely responsible for saving and investment choices. It also talks about how companies that are being hit with rising insurance premiums and longer-living retirees are looking to unload the risks of running a pension plan by offering workers lump-sum pension buyouts or selling those liabilities to insurance companies. Given what appears to be coming at carriers of defined benefit plans, can you blame them? Regardless, it appears that major changes in terms of accounting for higher longevity risk are coming for US plans. Under the Pension Protection Act (PPA) of 2006, it was specifically noted that defined benefit pension plans have to base the computation of their liabilities on mortality tables prescribed by the Secretary of the Treasury and that these tables must be updated at least every 10 years. As a result, the October 2012 Prudential report predicted that the SOA’s new mortality improvement scale (Scale BB) along with updated mortality base tables would be adopted by the Treasury and subsequently used by DB plan sponsors starting in 2014 or 2015. Obviously, this did not happen in 2014, but given that the SOA just updated these mortality tables on October 27th, this Treasury adoption could occur as soon as 2015. Should this adoption occur a year later, it would likely fall in line with new minimum funding calculations for corporate pension plans, which the Internal Revenue Service (IRS) is expected to consider in 2016, according to the WSJ article. What is perhaps most concerning with this looming impact from higher longevity risk is the fact that Wall Street appears to have regained a comfort level with current pension funding ratios. After all, it was only a few years ago when pension shortfalls were hitting record levels.

According to data released by S&P Dow Jones Indices, plans of S&P 500 companies were underfunded by $451.7 billion at 12/31/12, a 27% increase from year ago levels. However, according to Deutsche Bank estimates this record deficit fell basically in half to approximately $225.0 billion by 6/30/13, primarily due to higher corporate bond yields reducing PBOs rather than asset gains raising plan assets. It also helped that the S&P 500 Index surged by approximately 30% in 2013 and, by the end of the year, the funded status remained fairly level from June levels, resulting in fully-funded plans for 51 of the S&P 500 companies compared to just 18 at the end of 2012. The following table shows the funded status, funding ratio and average discount rate of defined benefit plans for the S&P 500 from 1998 to 2013:

S&P 500 Pension Status (in $bil) FYE Funded Status Funding Ratio Discount Rate 2013 ($224.5) 89.8% 4.7% 2012 ($451.7) 77.3% 3.9% 2011 ($354.7) 78.8% 4.7% 2010 ($245.0) 83.9% 5.3% 2009 ($260.7) 81.7% 5.8% 2008 ($308.4) 78.1% 6.3% 2007 $63.4 104.4% 6.1% 2006 ($40.3) 97.3% 5.8% 2005 ($140.4) 90.4% 5.1% 2004 ($164.3) 88.5% 5.8% 2003 ($164.8) 87.1% 6.1% 2002 ($218.5) 81.3% 6.6% 2001 $2.9 100.3% 7.1% 2000 $226.0 122.3% 7.4% 1999 $280.0 128.2% 7.4% 1998 $126.0 112.4% 6.7% Source: S&P Dow Jones Indices

To refresh, funding ratios measure a pension fund’s ability to meet future payment obligations to plan participants. The main factor’s impacting the funding ratio of a typical US defined benefit plan are equity market returns, which grow (or shrink) the asset pool from which plan participants are paid, and liability returns, which move inversely to interest rates. Meanwhile, the discount rate on pension funds’ liabilities is based on the yield from investment-grade corporate bonds. A higher discount rate for a stream of future payments lowers the stream’s discounted present value. At a higher interest rate, it’s possible to set aside a smaller sum to meet a future savings goal, and vice versa. However, it appears that the S&P 500 funding ratio is heading back down again in 2014 as a result of slowing growth in assets unable to keep up with liability values. Wilshire Consulting said the aggregate funding ratio for S&P 500 companies with defined benefit plans fell to 85.0% in September, down 4.8 percentage points from 89.8% at the end of 2013. According to Pension &

Investments (10/3/14), Jeff Leonard, managing director at Wilshire Consulting, said,

“(Year-to-date) I'd say it's been a surprise both from the asset and liability sides. Assets have done well, generally speaking, but the liabilities have increased in the face of declining interest rates so it's … a surprise


5

on both sides, one good surprise and one bad surprise.”

Considering that Mercer estimated that the collective deficit of the S&P 1500 was approximately $369 billion at the end of August, coupled with the fact that the last two months have been a total rollercoaster for equities, we believe the current S&P 500 deficit could be approaching $400 billion presently. (Note: Pension plan deficits for the S&P 1500 and S&P 500 closely mirror each other and were approximately $236 billion and $225 billion, respectively, as of 12/31/13.)

To summarize, we believe most pension plans carry grossly understated projected benefit obligations, while plan assets may have taken a recent hit. While most S&P 500 companies benefited from having lower required pension contributions in 2014 as their pension deficits were slashed in 2013, it appears many of these same companies will have to make much higher contributions in 2015 given the lackluster equity performance recently as these funding deficits have likely risen again in 2014. Additionally, should plan sponsors begin to factor in rising longevity risk and more accurately incorporate it into their PBO calculations, required pension contributions may need to be adjusted even higher as funding ratios fall. In turn, these higher contributions should put a further squeeze on operating cash flow and could force many of these companies to reduce share repurchases and halt dividend increases that have helped boost stock returns over the last five years.

Screening

For this exercise, we decided to look at non-financial S&P 500 companies with defined benefit pension plans that currently employ a large number of employees and also have a significant number of retirees. Obviously, these are the companies whose plans carry the largest projected benefit obligations and are the ones that could see their PBOs rise the most should longevity risk be more accurately accounted for and determined. As we laid out earlier, PBOs could potentially soar once longevity risk adjustments are made as the Treasury adopts new SOA mortality improvement tables. While we believe this adoption will likely occur in 2016 given that the SOA update came so late in 2014, plan sponsors may try to adjust for some of the impact early through higher company contributions in 2015. Additionally, the IRS is expected to consider new minimum funding calculations for plans in 2016, and we believe it is just a matter of time before most plans require higher funding. Additionally, given the generally lackluster performance of the US stock market year-to-date, we focused on S&P 500 companies whose plans carry heavy equity exposure. Not surprisingly, plans that have higher equity exposure typically assume higher expected rates of return (8%+) compared to the S&P 500 average (roughly 7%). These return assumptions affect the company’s pension expense, which ultimately impacts net income. While many of these companies saw their plans’ funded status improve markedly in 2013 following last year’s equity market surge and have thereby enjoyed much lower required employer

contributions this year, this trend may reverse for many in 2015. As a result of these impacts, we would not be surprised if employer pension contributions for some S&P 500 companies approach those made in 2013 following the height of the last pension deficit crisis. Using Bloomberg, we pulled S&P 500 non-financial companies that had plans that had at least 30% of their plan assets in equities and were underfunded by at least $100 million over the last fiscal year. We then sorted these 156 companies by projected benefit obligation from largest to smallest. For the table, we also showed companies current number of employees to get an additional sense of size and burden on these companies’ plans. We also added these plans’ most recently reported funded status compared to year ago levels, as well as the recent equity allocation as a percentage of plan assets. To determine financial health, we also included adjusted free cash flow (after covering dividends and share repurchases for the most current 12-month period to compare with the previous 12-month period, as well as a current net debt-to-EBITDA ratio.


6

Ticker Company PBO Funded Status

Funded Status (-1) Contrib(0) Contrib(-1) Employees

Women Employee%

Adjusted FCF T12

Adjusted FCF T12(-4)

Debt-to-EBITDA

IBM IBM 99,654 -6236 -14441 449 557 431,212 30 -10,067 -1,314 1.96 GM General Motors C 99,008 -19856 -27785 1014 3275 219,000 N/A 961 -6,751 4.06 GE General Electric 71,648 -12292 -22646 898 1379 307,000 29 303 -3,096 11.95 BA Boeing Co/The 68,625 -10494 -19717 1542 1550 168,400 N/A -4,929 5,778 1 T At&T Inc 56,560 -9322 -13851 209 3 243,000 36 -1,750 -9,352 1.58 LMT Lockheed Martin 43,161 -10151 -15093 2250 3637 115,000 25 585 -1,926 1.01 UTX United Tech Corp 33,026 -1671 -5780 236 516 212,000 N/A 2,473 1,714 1.75 HPQ Hewlett-Packard 31,018 -4069 -6777 688 632 317,500 32 5,016 7,440 1.71 UPS United Parcel-B 30,584 -3429 -7215 104 442 395,000 20 -1,845 -299 1.51 DD Du Pont (Ei) 26,289 -5675 -9780 313 848 64,000 N/A -1,947 -1,580 2.32 PFE Pfizer Inc 25,633 -4514 -7915 557 585 77,700 N/A 66 -4,729 1.76 DOW Dow Chemical Co 25,027 -6200 -9115 865 903 53,000 27 -2,617 2,727 2.56 FDX Fedex Corp 24,578 -2671 -3167 727 615 300,000 N/A -4,935 1,280 0.76 VZ Verizon Communic 23,032 -5921 -8491 107 3719 176,800 37 8,998 12,532 2.17 RTN Raytheon Co 22,970 -3342 -7207 1078 1221 63,000 N/A 90 482 1.37 JNJ Johnson & Johnson 21,488 -587 -4293 565 1838 128,100 N/A 2,760 3,169 0.7 MMM 3m Co 20,313 -666 -2241 476 1079 88,667 34 -3,252 -2,033 0.84 CAT Caterpillar Inc 19,028 -2684 -6243 854 1035 118,501 N/A -715 1,454 4.41 PG Procter & Gamble 17,053 -5955 -5953 1549 391 118,000 N/A -1,276 -4,034 1.81 PEP Pepsico Inc 14,684 -445 -2394 200 1614 274,000 N/A -916 889 2.6 AA Alcoa Inc 13,730 -3150 -3708 473 571 60,000 N/A -174 290 2.95 CTL Centurylink Inc 13,401 -1055 -2560 146 32 47,000 N/A -295 647 3.64 IP Intl Paper Co 13,131 -2244 -4142 67 147 69,000 22 -331 991 2.58 MDLZ Mondelez Inter-A 11,186 -1946 -2891 528 702 107,000 N/A 99 106 3.42 GD General Dynamics 11,013 -2537 -4887 601 532 96,000 N/A 872 450 0.92 XRX Xerox Corp 10,557 -1892 -2737 230 494 143,100 N/A 194 1,982 2.65 X Us Steel Corp 10,257 -1135 -2688 226 234 N/A N/A 781 52 4.9 DIS Walt Disney Co 10,066 -1101 -3481 397 833 175,000 52 -1,813 519 1.2 LLY Eli Lilly & Co 9,976 -494.7 -2137.2 428.9 469.7 37,925 N/A 422 590 1.19 MSI Motorola Solution 9,272 -1633 -3287 182 371 21,000 30 -728 -1,341 1.97 GT Goodyear Tire 9,110 -1855 -3522 1127 647 69,000 N/A -945 -33 3.11 PM Philip Morris In 7,257 -386 -1734 150 207 91,100 N/A -3,247 -3,810 2.07 KRFT Kraft Foods 7,245 -271 -1999 616 45 22,500 N/A 272 661 2.28 TXT Textron Inc 6,544 -199 -1338 185 389 32,000 N/A 616 -332 2.68 CSC Computer Science 6,282 -195 -843 88 748 79,000 N/A 539 204 1.37 SHLD Sears Holdings 6,265 -1551 -2256 400 549 226,000 N/A -1,713 -1,324 N/A KMB Kimberly-Clark 6,164 -597 -1215 220 110 57,000 36 -445 -327 1.65 ETN Eaton Corp Plc 5,752 -1380 -1979 341 413 102,000 30 657 767 3.57 RAI Reynolds America 5,618 -398 -870 60 110 5,200 N/A -468 -993 1.83 BAX Baxter Intl Inc 5,425 -1425 -1722 67 78 61,000 50 -287 -657 2.67 PPG Ppg Inds Inc 5,240 -539 -1034 174 80 41,400 N/A -643 842 1.43 EMR Emerson Elec Co 5,132 -121 -818 160 163 131,600 N/A 393 819 1.26 CBS Cbs Corp-B 5,069 -841 -1290 203 254 19,490 N/A -2,178 -1,075 1.66 JCI Johnson Controls 4,899 -587 -587 95 95 170,000 30 -621 446 2.2 PH Parker Hannifin 4,749 -1250.173 -1285.947 146.237 291.018 57,447 N/A 673 771 1.36 HII Huntington Ingal 4,730 -420 -1316 305 239 38,000 N/A 263 -28 2 CI Cigna Corp 4,700 -611 -1602 198 253 36,500 71 516 -563 1.45 RKT Rock Tenn Co-A 4,524 -1001.5 -1493.3 188.9 367.5 25,800 N/A 364 337 2.06 APD Air Prods & Chem 4,394 -593.2 -593.2 300.8 300.8 21,600 N/A -125 -984 2.35 ASH Ashland Inc 4,307 -926 -1557 128 170 15,000 N/A 194 104 2.54 M Macy's Inc 4,243 -697 -963 0 150 172,500 N/A -213 -288 1.93

Pensions Must Account For Longevity Risk Behind the Numbers

Will Becker October 31, 2014

7



Women Employee%

Adjusted FCF T12


Debt-to-EBITDA

OI Owens-Illinois 4,141 -290 -856 104 219 22,500 N/A 190 206 2.98 TWX Time Warner Inc 3,994 -555 -835 61 47 34,000 N/A -2,657 -865 2.87 WHR Whirlpool Corp 3,985 -944 -1657 151 208 69,000 N/A -239 264 1.75 CAG Conagra Foods 3,979 -433 -474.2 18.3 19.8 32,800 40 595 117 5.65 RRD Rr Donnelley & S 3,953 -245.4 -1153.5 21.6 140.7 57,000 N/A 274 356 3.88 TAP Molson Coors-B 3,817 -220.7 -601.7 113.1 55.3 9,250 24 628 654 3.55 ROK Rockwell Automat 3,805 -437.8 -936.9 41.3 341.1 22,000 30 161 242 0.93 KR Kroger Co 3,772 -637 -918 110 82 375,000 N/A -988 308 2.41 GCI Gannett Co 3,672 -643.782 -1020.769 107.086 137.499 31,600 N/A 148 159 3.3 SYY Sysco Corp 3,672 -734.189 -571.013 24.752 93.562 50,300 N/A -30 -370 1.29 COL Rockwell Collins 3,660 -881 -1466 122 126 18,300 N/A 57 -165 2.27 DHR Danaher Corp 3,554 -792.3 -1179 57.7 108.4 66,000 N/A 2,841 2,331 0.7 IR Ingersoll-Rand 3,333 -554 -918.4 89 76.8 42,000 23 -1,349 -715 2.23 GLW Corning Inc 3,300 -404 -655 20 122 30,400 N/A -150 391 1.35 TEL Te Connectivity 3,255 -1139 -1139 116 116 84,000 38 389 203 1.43 MDT Medtronic Inc 3,234 -428 -515 136 239 49,000 49 442 892 2.18 TXN Texas Instrument 3,231 -111 -223 118 241 32,209 N/A -711 -949 0.99 ECL Ecolab Inc 3,130 -493.4 -962.9 62.3 235.2 45,415 N/A 230 292 2.6 CL Colgate-Palmoliv 2,996 -702 -1032 182 182 37,400 39 -380 -309 1.56 ATK Alliant Techsys 2,988 -562.275 -722.769 45.149 188.219 16,000 N/A 164 125 2.72 LLL L-3 Comm Hldgs 2,973 -570 -1196 105 173 48,000 N/A -164 -113 2.81 EMN Eastman Chemical 2,972 -427 -840 148 149 14,000 24 54 432 2.05 A Agilent Tech Inc 2,962 -135 -433 119 84 20,600 33 359 -112 1.67 SWK Stanley Black & 2,834 -704.7 -761.9 99.5 97.2 50,700 N/A 638 -899 2.44 INTC Intel Corp 2,832 -1178 -1632 65 52 107,600 26 -2,333 3,101 0.57 ADM Archer-Daniels 2,814 -473 -780 50 31 31,100 N/A 1,843 3,263 1.83 ATI Allegheny Tech 2,698 -368.4 -732 10.7 14 9,500 N/A -345 -229 8.6 CSX Csx Corp 2,679 -179 -660 13 13 31,000 6 -252 -106 2.06 PCP Precision Castpt 2,553 -286 -347 78 69 29,100 N/A 1,700 826 1.28 CPB Campbell Soup 2,539 -175 -214 46 87 19,400 N/A 85 163 2.68 FOXA Twenty-First Cen 2,494 -620 -438 100 95 27,000 N/A -2,278 -259 2.84 PX Praxair Inc 2,452 -281 -704 52 184 27,560 22 -104 -595 2.32 MON Monsanto Co 2,469 19 -161 57 61 22,400 N/A -5,937 102 1.63 PBI Pitney Bowes Inc 2,295 -210.607 -393.24 9.892 94.039 16,100 N/A 320 352 3.88 TGI Triumph Group 2,161 -227.439 -359.991 46.347 109.818 13,828 N/A 48 39 2.27 TYC Tyco Intl Ltd 2,159 -388 -546 56 88 70,000 N/A -421 289 0.94 FCX Freeport-Mcmoran 2,130 -656 -797 61 140 36,100 10 -1,474 -2,150 2.17 R Ryder System Inc 2,105 -272.259 -594.494 96.183 81.116 28,900 N/A -1,245 -745 2.79 BDX Becton Dickinson 2,076 -292 -734.174 174 166.367 29,979 N/A 1,221 -232 2.16 GPC Genuine Parts Co 2,035 -102.122 -570.013 74.347 16.465 37,500 N/A 198 442 0.67 SWY Safeway Inc 2,023 -379.2 -789.7 50.1 152.1 138,000 50 -1,818 741 1.93 BLL Ball Corp 1,989 -601.9 -820.2 173.8 132.9 14,600 N/A 179 -57 2.73 JOY Joy Global Inc 1,845 -153.291 -339.142 165.712 184.865 16,600 N/A -93 383 2.49 SFD Smithfield Foods 1,813 -702.6 -587.1 17.7 142.8 46,950 35 N/A 151 3.59 JEC Jacobs Engin Grp 1,776 -402.514 -463.652 62.708 90.98 49,400 21 373 472 1.19 NLSN Nielsen Holdings 1,740 -152 -245 51 64 40,000 N/A 431 593 4.16 VFC Vf Corp 1,689 -221.175 -482.917 117.591 112.892 59,000 N/A -64 598 1.04 HSH Hillshire Brands 1,685 -120 -123 8 8 9,000 N/A 1 72 2.05 FTR Frontier Communi 1,669 -452.201 -691.065 62.29 28.598 13,650 N/A 445 351 3.88 NWL Newell Rubbermaid 1,649 -286.4 -564.1 131.6 88.9 18,300 N/A -240 71 2.54



8



Women Employee%

Adjusted FCF T12


Debt-to-EBITDA

SON Sonoco Products 1,596 -264.524 -467.17 31.591 65.362 19,900 31 87 195 1.73 CNW Con-Way Inc 1,594 -155.48 -477.56 55.337 51.422 29,500 N/A -65 26 1.52 AVY Avery Dennison 1,577 -262.5 -397.8 105.7 77 26,000 N/A -155 -68 1.68 AVP Avon Products 1,532 -285.9 -492.7 118.7 84.7 36,700 N/A 160 102 8.91 MCK Mckesson Corp 1,474 -584 -311 24 25 42,800 N/A 1,817 1,073 3.07 IFF Intl Flvr & Frag 1,363 -114.659 -172.393 52.897 35.182 6,000 N/A 18 41 1.47 ENR Energizer Holdgs 1,308 -296 -459.7 66.1 63.2 N/A N/A 354 355 3.29 TMO Thermo Fisher 1,307 -262 -365.5 64.1 21.9 50,000 N/A 1,800 1,001 3.9 SEE Sealed Air Corp 1,263 -239.4 -260.3 3.8 7.1 25,000 N/A -503 501 5.22 BC Brunswick Corp 1,249 -293.3 N/A 53.8 N/A 15,701 N/A 105 31 1.07 CRS Carpenter Tech 1,247 -222.6 -256.5 9.8 148.2 4,900 N/A -141 -126 2.06 SNA Snap-On Inc 1,152 -136.9 -265.3 35.3 87.5 11,300 N/A 149 130 1.26 MAS Masco Corp 1,146 -487 -643 55 66 32,000 N/A 276 -89 N/A AGN Allergan Inc 1,126 -191.7 -215.3 42.3 47.1 11,400 53 625 642 0.99 CLF Cliffs Natural R 1,118 -202.7 -405.6 53.7 67.7 7,138 9 67 -328 4.05 HBI Hanesbrands Inc 1,000 -260.486 -441.409 41.177 28.175 49,700 N/A 372 414 3.83 URS Urs Corp 972 -274.1 -284.3 25.1 28.1 50,000 N/A 381 229 2.38 LIFE Life Technologies 961 -193.018 -160.408 6.259 22.176 N/A 45 454 173 1.87 DOV Dover Corp 952 -153.068 -333.047 41.045 47.677 37,000 N/A 92 80 1.66 AOS Smith (A.O.)Corp 937 -114.7 -187.2 0.6 1.2 11,400 N/A 12 45 0.77 PKG Packaging Corp 930 -157.734 -140.355 30.146 35.984 13,600 N/A 198 278 2.66 VMC Vulcan Materials 912 -155.076 -308.247 4.855 4.509 6,902 N/A 77 71 2.7 SPW Spx Corp 904 -134 -455 16.8 N/A 14,000 N/A -335 -479 3.22 VIAB Viacom Inc-B 893 -255 -563 6 34 10,000 N/A -3,526 -693 3.01 AGCO Agco Corp 851 -190.5 -265.6 41 36.1 22,100 N/A -327 461 1.4 MOG/A Moog Inc-Class A 848 -250.5 -407.596 42.661 7.957 11,152 N/A 54 139 2.5 PNR Pentair Ltd-Reg 809 -236.6 -279.971 30.8 235.186 10,900 N/A -399 -1,061 2.55 LXK Lexmark Intl-A 807 -114.5 -222.6 21.1 35.2 12,000 N/A 150 101 1.21 BF/B Brown-Forman -B 785 -180 -210 33 45 4,200 N/A 230 -631 0.98 XYL Xylem Inc 777 -253 -313 40 43 N/A N/A 47 70 2.07 BWA Borgwarner Inc 776 -157.2 -317.1 150.4 18 19,700 N/A -6 79 1.04 IDA Idacorp Inc 773 -227.774 -387.345 30 44.3 2,023 N/A 13 20 4.04 FLS Flowserve Corp 769 -163.733 -210.536 46.889 28.134 18,000 N/A 106 -534 1.33 PLL Pall Corp 723 -208.353 -237.766 47.558 27.785 10,400 N/A 42 -83 1.52 IPG Interpublic Grp 703 -194.9 -175.6 18.8 23.3 45,400 N/A -37 -606 2.06 CVS Cvs Caremark 694 -126 -231 33 36 208,000 67 -2,177 -862 1.27 RPM Rpm Intl Inc 679 -219.566 -191.663 35.4 33.969 10,848 N/A 46 -10 2.57 TEX Terex Corp 666 -398.4 -437.8 24.3 29.2 20,500 N/A -86 273 2.91 VMI Valmont Inds 652 -154.397 -112.043 17.619 N/A 10,769 N/A 95 174 1 CLX Clorox Co 641 -209 -204 15 12 8,200 39 1 118 2.02 MAT Mattel Inc 617 -160.493 -263.188 32.078 55.752 29,000 N/A -99 -92 1.91 TIF Tiffany & Co 616 -218.44 -300.357 32.767 37.043 10,600 66 -235 133 1.72 DTV Directv 568 -161 -169 7 70 16,000 N/A -508 -2,433 2.49 PKI Perkinelmer Inc 568 -174.055 -244.207 57.2 27.882 7,600 N/A 140 -114 2.3 APH Amphenol Corp-A 560 -167.532 -230.935 23.338 21.83 44,500 N/A 10 112 2.28 SJM Jm Smucker Co 542 -140.2 -165 9.4 40 4,775 N/A -122 -186 2.04 COV Covidien Plc 531 -140 -290 75 47 38,500 52 3 -447 2.01 DBD Diebold Inc 469 -122.385 -200.614 3.57 15.711 16,000 N/A -18 -12 7.2 SYK Stryker Corp 456 -175 -193 20 21 25,000 N/A 940 988 2.51 AMAT Applied Material 445 -197 -220 24 31 13,700 N/A 654 -327 1.15 MJN Mead Johnson 404 -127.9 -151.5 18.5 28.2 7,200 N/A 211 156 1.4



9



Women Employee%

Adjusted FCF T12


Debt-to-EBITDA

NDSN Nordson Corp 385 -104.675 -161.88 20.885 12.552 5,801 N/A 71 179 1.57 XRAY Dentsply Intl 359 -216.251 -230.882 12.718 12.144 11,800 N/A 274 219 2.03 TUP Tupperware Brand 246 -131.4 -147.3 14.3 16.9 13,100 N/A -36 -264 2.38 OMC Omnicom Group 186 -113.5 -125.7 5.5 9.1 71,800 N/A 291 239 2.04



10

INTERNATIONAL BUSINESS MACHINES International Business Machines (IBM) provides computer solutions through the use of advanced information technology. The company's solutions include technologies, systems, products, services, software, and financing. A

few weeks ago, IBM’s stock took a double-digit price hit after company management abandoned its long-held prediction of $20 in EPS for 2015. While IBM has been very adept at buying back shares to boost EPS in recent years, revenue growth has been non-existent. In fact, revenues for 2013 were below those of 2012, 2011, and 2010, respectively. Meanwhile, EBITDA has gone essentially nowhere from 2008 through 2013, with the small improvement attributable to margin increases. After posting five consecutive quarters of higher-than-expected EPS results, IBM badly missed EPS for its third quarter ended 9/30/14. The company reported adjusted EPS of $3.68 for 3Q14, representing an 8% decline from the $3.99 earned a year ago. Consensus estimates at Bloomberg expected EPS of $4.32 for the quarter. Revenue declined by 2% year-over-year in local currency for 3Q14, with software down, services flat, and hardware was down 15%. IBM blamed a number of factors for its poor quarterly sales result, including sales execution issues in software, below target productivity in services and adverse FX and a slowdown in the month of September. Meanwhile, gross margin was only up about 16bps year-over-year as mix was unfavorable. However, margin should get a boost soon as IBM recently agreed to sell its microelectronics business, paying GlobalFoundries an estimated $1.5 billion to take over the struggling, lower-margin business. Not surprisingly, with IBM’s sluggish operating performance and huge share buyback program, the company’s adjusted free cash flow deficits soared over the last twelve months ended 9/30/14, as the company reported a huge $10.1 billion deficit compared to a $1.3 billion deficit for the year earlier period ended September:

Adjusted Free Cash Flow Analysis (in $mil)

Twelve Months Ended:

9/14 9/13 9/12 9/11 9/10

Cash from ops before w/c

$18,247

$18,781

$20,441

$20,194

$19,518

Working capital impact

($912)

($1,477)

($104)

($649)

($314)

Cash from operations $17,335 $17,304 $20,337 $19,545 $19,204 CapEx $3,857 $3,559 $4,130 $4,027 $3,444 Free cash flow $13,478 $13,745 $16,207 $15,518 $15,760 Dividends $4,201 $3,990 $3,696 $3,401 $3,096 % FCF paid in

dividends

31.2%

29.0%

22.8%

21.9%

19.6% Share repurchases $19,344 $11,069 $12,569 $15,066 $14,838 Surplus/(Shortfall) after buyback

($10,067)

($1,314)

($58)

($2,949)

($2,174)

As one can see from above, IBM has reported combined adjusted free cash flow deficits of an astounding $16.6 billion over the last five years ended 9/30/14. To make

matters worse, excluding working capital adjustments, IBM’s cash flow from operations has been trending lower in recent years. Additionally, while capital expenditures have been held in check and dividend increases remain mild, share repurchase activity continues to jump off the ledger. As we will show later, these deficits are beginning to put some strain on IBM’s balance sheet. Next, we analyzed IBM’s pension situation. In many ways, IBM is the 800 lbs. gorilla of US-based companies, and its pension certainly qualifies for this status as the largest in the S&P 500 with a combined plan PBO of $99.7 billion as of 12/31/13. Additionally, while constantly evolving in the technology business and recently reinventing itself away from hardware to become more of a service company, IBM has maintained a huge and growing employment base over the last 20 years, as the following table shows the number of employees at the end of the most recent year as well as employment levels held 10 and 20 years ago, respectively:

Employment History - IBM

12/13 12/03 12/93 431,212 319,273 256,207

As one can see from above, IBM’s employment growth has been pretty steady over the last 20 years, growing at an average annual rate of approximately 2.6% over this period. However, IBM has actually been cutting jobs over the last few years, as IBM employed 434,246 people as of 12/31/12. Meanwhile, more jobs have been slashed so far in 2014. According to Forbes (10/23/14),

IBM is hemorrhaging talent on a global scale across all divisions. It cannot retain good people. IBMers, as they call themselves, are underpaid, neglected, and have been abused for years. Most of IBM’s 400,000+ employees are no longer working for the company. Their jobs have become nightmares. They are prevented from doing good work. They know IBM is neglecting its customers, but they are powerless to do anything. The best they can do is to try to survive until reason returns to IBM’s leadership, if ever. Every IBM staff cut now has a direct impact on revenue. After the 1Q 2014 earning miss IBM hit its sales support teams hard with layoffs, making it immediately much harder for IBM to sell products and services. Customers became frustrated and shopped elsewhere. In 3Q 2014 revenue took a big fall as a direct result of this bonehead move. Formerly growing lines of business in IBM are now declining. After 10 years of continuous layoffs, any subsequent reduction has a direct and immediate impact on business. IBM can no longer afford to cut staff.

Thus, while IBM has grown its employment ranks over the last two decades, aiding its pension plans by allowing a larger current employee base to support its growing retired employee base, we certainly are concerned about IBM’s recent job cuts. And although IBM’s plans may still cover more workers than non-workers, factoring in increased longevity risk could cause IBM’s already mammoth PBOs


11

to jump even more, making its plans even more grossly underfunded. Another factor that could potentially work against IBM’s plan sponsors in terms of their ability to fully fund its pension in the future is the fact that the company’s percentage of women employees, who typically live about five years longer than men, has been rising steadily over the last few years, as the following table shows:

Women Employee Percentage – IBM

12/13 12/12 12/11 12/10 12/09 30.1% 30.0% 28.5% 28.1% 28.7%

12/08 12/07 12/06 12/05 12/04 28.9% 28.8% 28.5% 28.4% N/A

Still, on a positive note, IBM’s current women percentage of approximately 30.1% is below the S&P 500 average of companies that carry a defined benefit plan, of roughly 34%, according to Bloomberg estimates. Looking at IBM’s recent pension performance, the combined funded status of US and non-US plans improved significantly in 2013 from year ago levels as these plans benefited from a solid performance from plan assets:

Key Pension Variables (Rounded in $mil) 12/13 12/12 12/11 12/10 12/09 Funded status ($6,236) ($14,441) ($10,366) ($7,895) ($8,088) Employer contributions

$449

$557

$728

$801

$1,195

Pension expense/ (income)

$297

$350

$345

$347

$350

Meanwhile, with IBM’s pension contributions falling to approximately $449 million in 2013, marking the fourth consecutive year they have fallen, they were not large enough to have much impact on operating cash flow, which was $17,483 million last year. Still, operating cash flow has been trending lower in recent years for IBM and contributions should head up soon and once again have some impact on cash flow. Additionally, we note that pension expense was lower by roughly $196 million in 3Q14 compared to year ago levels, even though this benefit was unable to keep IBM from posting a hefty declines in operating profits for the latest quarter. Additionally, while certainly not a huge allocation, we noticed that IBM’s US plans had increased their exposure to equities in recent years. Equity securities for US plans accounted for approximately 35% of qualified plan assets as of 12/31/13, compared to 33% and 30% at 12/31/12 and 12/31/11, respectively. Meanwhile, we also noticed that IBM had not adjusted its high 8% expected rate of return on US plan assets over the last five years. However, IBM’s sponsors made some changes to its US plan in March 2014. According to IBM’s 3Q14 10-Q,

In March 2014, the company initiated a change to the investment strategy of its U.S. defined benefit plan. The 2014 target asset allocation was modified,

primarily by reducing equity securities from 42 percent to 32 percent, and increasing debt securities from 47 percent to 57 percent of total plan assets, respectively. The asset allocation change was substantially completed by March 31, 2014. This change was designed to reduce the potential negative impact that equity markets might have on the funded status of the U.S. defined benefit plan. The change is expected to reduce the 2015 expected long-term rate of return on assets to approximately 7.75 percent.

While we certainly appreciate these sponsors’ intent to minimize losses of US plans and lower equity exposure in 2014, we hardly considered its then 35% equity allocation to be all that excessive. Meanwhile, considering that its US plans already had another 48% of their assets in extremely low-returning cash and fixed income instruments, we wonder why they needed to go even higher. Thus, even though IBM finally and rightfully lowered the assumption, we still see an expected return rate of 7.75% to be way too aggressive and should come down much more, especially given the new target allocations. The following table shows IBM’s weighted-average assumptions and allocation of plan assets for its US qualified plans, which are about 40% larger than assets for the non-US plans, over the last five years:

Weighted-Average Assumptions and Allocation of US Plan Assets

12/13 12/12 12/11 12/10 12/09 Discount rate 4.5% 3.6% 4.2% 5.0% 5.6% Expected return on plan

assets

8.0%

8.0%

8.0%

8.0%

8.0% Plan asset allocation Equity securities 35% 33% 30% 36% 35% Fixed income 44% 44% 48% 43% 45% Other 17% 17% 17% 17% 14% Cash 4% 6% 5% 4% 6%

In 2013, IBM contributed a combined $449 million towards its US and non-US plans. Meanwhile, IBM expects to contribute approximately $600 million to its non-US and multi-employer plans in 2014. However, IBM is hardly on pace, as it had only contributed $387 million to non-US plans through the first nine months ended 9/30/14. Couple these light non-US contributions with the likelihood that the PBO of its US plans will be adjusted higher soon, and we believe IBM could face much higher pension contributions soon, hurting operating cash flow. For some perspective as to how much higher IBM’s pension contributions could get, we increased the PBO of IBM’s US plans by 7% in line with Aon Hewitt’s estimates and then subtracted that increase from IBM’s combined funded status at 12/31/13 to calculate an adjusted funded status. We then took the estimated 2014 contribution divided by the 12/31/13 funded status and used that percentage off the adjusted funded status to base our projected pension contribution for the future:


12

PBO-Adjusted Impact on Funded Status and Contributions (in $mil) Combined PBO, 12/13 $99,654 US PBO, 12/13 $51,034 Reported funded status, 12/13 ($6,237) 2014 pension contribution $600 US PBO with 7% longevity adjustment $54,606 Adjusted funded status ($9,809) Projected pension contribution based off adjusted

funded status

$944

Based off these adjustments, the PBO for IBM’s US plans would have increased by nearly $3.6 billion. Considering that its US plans were considered overfunded by approximately $2.9 billion at 12/31/13, this PBO change would now make them underfunded by about $0.7 billion. Additionally, IBM’s projected pension contributions would increase by about 57% to $944 million off a still depressed $600 million that is expected for 2014. Further, considering how depressed IBM’s contribution levels have been in recent years, we believe this projected $944 million may be conservatively low. We would also add that IBM has a large PBO for its non-US plans and that these plans may be forced to account for higher longevity risk too at some point, leading to even higher pension contributions in the future. Lastly, we doubt IBM can continue posting adjusted free cash flow deficits and must become more cautious at taking on more debt. Over the last year, the company’s balance sheet has taken on more debt and expended cash, causing its net debt-to-EBITDA ratio to reach 1.55 times as of 9/30/14, compared to 1.06 a year earlier, as the following table shows:

Balance Sheet (in $mil) 9/30/14 9/30/13 Cash 9,565 10,232 Total debt 45,697 36,180 TTM EBITDA 23,327 24,457 Net debt-to-EBITDA 1.55 1.06

While IBM’s debt load has increased, it is still considered to have strong financial flexibility. In June, Fitch Ratings affirmed it’s A+ ratings on approximately $54 billion of debt, including IBM’s undrawn $10 billion credit facility. To conclude, what IBM does have to show for its heavy financial engineering and constant share repurchases is loads of debt. Operating cash flow is already heading lower and potentially much higher pension contributions certainly won’t help. It appears to be a foregone conclusion at this point that IBM will need to pull back hard on repurchases if it wants to maintain some financial flexibility in the future.

CATERPILLAR Based in Peoria, IL, Caterpillar (CAT) is a leading manufacturer of construction, mining and forest machinery. The company also manufactures engines and other related parts for its equipment, and offers financing and insurance. CAT continues to get the majority of its recent sales growth

from the North American energy and construction industries, which have been booming. However, this growth has largely been offset by continued weak sales of its earth-moving machines to the mining industry, a market CAT bet on heavily through acquisitions in 2010 and 2011 - right before a slump in commodity prices prompted resource companies to slash their investment in new equipment. Since then, CAT has focused on cutting production costs and boosting margins, a process that has involved thousands of layoffs but permitted the company to grow earnings even as sales have flattened. For the third quarter ended 9/30/14, CAT reported EPS of $1.63, representing a 7% increase from the $1.45 earned a year earlier. Consensus estimates at Bloomberg had CAT reporting EPS of just $1.36. Still, overall sales advanced by just 1% year-over-year for 3Q14, aided by a 15% increase in North American sales, driven by demand for equipment and diesel and gas engines from oil and gas companies and builders. In particular, CAT benefited from railroads buying diesel-electric locomotives ahead of tough US emissions rules that take effect in 2015. Meanwhile, CAT experienced a 21% sales decline in Latin America, a 7% sales drop in most of the Asia-Pacific region, and flat sales in China, Europe, the Middle East and Africa for the quarter. For 2015, CAT projected revenue to come in essentially flat, warning that a number of “significant risks”, including tensions in the former Soviet Union and the Middle East and slowing growth in China, could hurt business confidence and sales. Meanwhile, CAT’s free cash flow was unable to cover the dividend and share repurchases over the last twelve months ended 9/30/14, as the following table shows:


Twelve Months Ended: 9/14 9/13 9/12 9/11 9/10 Cash from ops before w/c $8,768 $8,570 $5,498 $7,745 $5,244 Working capital impact ($2) $1,007 ($785) ($53) ($316) Cash from operations $8,766 $9,577 $4,713 $7,692 $4,928 CapEx $3,665 $4,713 $4,951 $3,535 $2,639 Free cash flow $5,101 $4,864 ($238) $4,157 $2,289 Dividends $1,578 $1,410 $1,234 $1,142 $1,067 % FCF paid in dividends 30.9% 29.0% -518.5% 27.5% 46.6% Share repurchases $4,238 $2,000 $0 $0 $0 Surplus/ (Shortfall) after buyback

($715)

$1,454

($1,472)

$3,015

$1,222

To be sure, CAT’s cash flow from operations has been strong and continues to head higher, recently aided by a decline in receivable and inventory levels. However, cash commitments have been going up too. After taking a number of years off, CAT has ramped up its share buyback program over the last two years, repurchasing $4.2 billion of stock so far in 2014. Last June, the company also announced an increase of 17% in the quarterly dividend. On the plus side, capital expenditures are heading down. On the 3Q14 call, management noted that CAT generally had the capacity it needed given the current demand environment and that CapEx expectations were less than $2 billion for 2014.


13

Next, we will give CAT’s pension a thorough look. CAT is a huge equipment manufacturer that maintains a big pension, with its combined US and non-US plans carrying PBOs of approximately $19.0 billion as of 12/31/13. Certainly, its US plans are significantly bigger and make up the majority of CAT’s total PBOs at approximately $14.4 billion. Additionally, despite downsizing its operations in recent years, CAT has maintained a hefty employment base over the last 20 years, as the following table shows the number of employees at the end of 2013 as well as employment levels held 10 and 20 years ago, respectively:

Employment History - CAT

12/13 12/03 12/93 118,501 69,169 51,250

What is somewhat concerning to us is that CAT had 125,341 employees at the end of 2012 and started to downsize in 2013, trimming its ranks by approximately 5.5% last year. Meanwhile, the company has announced thousands of layoffs for 2014 and with mining CapEx still in the doldrums we doubt many of these jobs come back any time soon. For 3Q14, CAT cut more than 6,000 jobs, roughly three quarters of them non-US employees. Still, CAT’s current employment levels are about 60% higher than they were just 10 years ago. As a result, CAT has a much larger current employee base to help support its growing number of retirees. Thus, at least for now, CAT likely has more workers helping to support its pension than retired workers depleting funds off of it. Regardless, once longevity risk is more accurately factored into the calculation of PBOs, we believe CAT’s PBOs could jump noticeably given the sheer size of CAT’s plans and its heavy retired base. Next, looking at recent performance, the combined funded status of CAT’s US and non-US plans improved significantly in 2013 from year ago levels as these plans benefited primarily from a strong performance from plan assets:


$844

$1,026

$446

$977

$1,149


$732

$723

$665

$677

$620

Meanwhile, even as the company’s pension contributions fell to approximately $854 million in 2013, they are still large enough to have some impact on operating cash flow, which was a record $10,191 million last year. Additionally, we note that pension expense has been lower by roughly $60 million over each of the last three quarters compared to year ago levels, even though this benefit was unable to prevent CAT from posting declines in operating profits for 1Q14 and 2Q14, respectively. Additionally, it should be noted that CAT’s plans had a large exposure to equities going into 2014 and we would expect that the company’s funded status might have

deteriorated some year-to-date. Of course, this could lead to even higher contributions in 2015. Equity securities for US and International plans accounted for approximately 61% and 53% of qualified plan assets, respectively, as of 12/31/13, compared to 66% and 54% at 12/31/12. Granted, it appears that CAT’s plan sponsors have prudently been lowering their equity allocations to try to minimize risk. Meanwhile, even though CAT has lowered its expected rate of return on US plan assets over the last two years down to 7.8% last year, this rate is still somewhat aggressive and we believe this assumption may need to come down even more to approach realistic levels. The following table shows CAT’s weighted-average assumptions and allocation of plan assets for its US qualified plans, which are about three times the size of its non-US plans, over the last five years:

Weighted-Average Assumptions and Allocation of US Plan Assets*

12/13 12/12 12/11 12/10 12/09 Discount rate 4.6% 3.7% 4.3% 5.1% 5.7% Expected return on plan

assets

7.8%

8.0%

8.5%

8.5%

8.5% Plan asset allocation Equity securities 61% 66% 68% 74% 72% Debt securities 34% 30% 27% 22% 24% Real estate 0% 0% 0% 0% 0% Cash and other 5% 4% 5% 4% 4%

Facing sluggish equity markets and slightly lower discount rates, it seems safe to assume that CAT’s funded status has begun to suffer again so far in 2014. We also know that CAT won’t be contributing nearly as much this year as in prior years, as the company’s 9/30/14 10-Q noted that CAT anticipated its full-year 2014 contributions would be approximately $510 million, all of which are required. This compares to the $844 million it contributed in 2013, a 40% decline. Couple CAT’s light 2014 contributions with the likelihood that the PBO of its US plans will be adjusted higher soon, and we believe CAT could face much higher pension contributions soon, hurting operating cash flow. For some perspective as to how much higher CAT’s pension contributions could go, we increased the PBO of CAT’s US plans by 7% in line with Aon Hewitt’s estimates and then subtracted that increase from CAT’s combined funded status at 12/31/13 to calculate an adjusted funded status. We then took the estimated 2014 contribution divided by the 12/31/13 funded status and used that percentage off the adjusted funded status to base our projected pension contribution for the future:

PBO-Adjusted Impact on Funded Status and Contributions

(in $mil) Combined PBO, 12/13 $19,028 US PBO, 12/13 $14,419 Reported funded status, 12/13 ($2,684) 2014 pension contribution $510 US PBO with 7% longevity adjustment $15,428 Adjusted funded status ($3,693) Projected pension contribution based off adjusted

funded status $702


14

Based off these adjustments, the PBO for CAT’s US plans would have increased by approximately $1.0 billion. Considering that its US plans were considered underfunded by approximately $2.0 billion at 12/31/13, this PBO change would now make them underfunded by about $3.0 billion, a 50% jump. Additionally, CAT’s projected pension contributions would increase by about 38% to $702 million off a very depressed $510 million that is expected for 2014. Interestingly, it appears that CAT plan sponsors are becoming more concerned about their ability to adequately fund their defined benefit plans, pushing more of its US employees into 401(k) plans. According to its 9/30/14 10-Q,

In August 2012, we announced changes to our U.S. hourly pension plan, which impacted certain hourly employees. For the impacted employees, pension benefit accruals were frozen on January 1, 2013 or will freeze January 1, 2016, at which time employees will become eligible for various provisions of company sponsored 401(k) plans including a matching contribution and an annual employer contribution. The plan changes resulted in a curtailment and required a remeasurement as of August 31, 2012.

Finally, CAT does not appear to have the financial standing to continue posting adjusted free cash flow deficits. The company’s net debt remains near peak levels, with cash and debt levels fluctuating only slightly over the last year. Meanwhile, trailing EBITDA increased by about $100 million year-over-year, allowing the company’s net debt-to-EBITDA ratio to settle at 3.73 times as of 9/30/14, little changed from 3.77 a year earlier, as the following table shows:

Balance Sheet (in $mil) 9/30/14 9/30/13 Cash $6,082 $6,357 Total debt $39,282 $39,537 TTM EBITDA $8,909 $8,800 Net debt-to-EBITDA 3.73 3.77

CAT management seems to be very comfortable with the company’s heavy debt load. On the 3Q14 call, Vice President of Strategic Services Michael Lynn DeWalt stated,

Our balance sheet remains strong, with the Machinery, Energy and Transportation debt-to-total capital ratio less than 35%, which is comfortably towards the low end of our desired range.

It currently holds an A-2 credit rating by Moody’s, so it is far from disaster. However, an upcoming rating downgrade would not shock us, as Moody’s noted in July that CAT’s $2.5 billion share repurchase announcement was credit negative. Certainly, if the company’s net debt/EBITDA ratio continues to move much higher, we would expect the credit rating to begin to suffer. To conclude, CAT does not have the operating cash flow to cover all of its cash commitments, especially its recently burgeoning share

repurchase program. Additionally, we believe CAT’s cash flow could face a major headwind from rising company contributions should the company’s underfunded pension snaps back to recent deficit levels.

DOW CHEMICAL The Dow Chemical Company (DOW) is a diversified chemical company that provides chemical, plastic and agricultural products and services to various essential consumer markets. The company serves customers in countries around the world in markets such as food, transportation, health and medicine, personal care and construction. Dow's profits are dominated by its Performance Plastics segment, which now accounts for over 45% of the company's operating segment EBITDA. Dow is one of the largest ethylene and ethylene derivative producers in the world, with roughly 70% of its cracker capacity located in the cost-advantaged Americas and Middle East. To be sure, DOW is benefiting from low cost feedstocks in North America which result from the natural gas and liquids boom. For 3Q14, DOW reported EPS from operations of 71 cents, representing a 42% jump from the 50 cents earned a year ago. This quarterly EPS result easily beat Bloomberg’s consensus estimate of 67 cents. Meanwhile, sales increased by roughly 5% year-over-year to $14.4 billion in 3Q14. This sales increase was comprised of 2% volume growth and 3% higher pricing. Margin expansion was huge, as the company's adjusted EBITDA margin improved by over 240 basis points year-over-year in 3Q14 due to higher net pricing and cost savings through productivity improvements and higher capacity utilization. Despite improved operating performance, DOW’s adjusted free cash flow was unable to cover dividends and share repurchases over the last twelve months ended 9/30/14, as the company reported a big $2.6 billion deficit:


Twelve Months Ended: 9/14 9/13 9/12 9/11 9/10 Cash from ops before w/c $5,697 $6,482 $4,719 $3,231 $4,805 Working capital impact $281 $659 ($174) $462 ($1,134) Cash from operations $5,978 $7,141 $4,545 $3,693 $3,671 CapEx $3,350 $2,427 $2,672 $2,562 $2,046

Free cash flow $2,628 $4,714 $1,873 $1,131 $1,625

Dividends $1,972 $1,853 $1,584 $1,139 $1,011

% FCF paid in dividends 75.0% 39.3% 84.6% 100.7% 62.2% Share repurchases $3,273 $134 $0 $19 $14

Surplus/ (Shortfall) after buyback

($2,617)

$2,727

$289

($27)

$600

Cash flow from operations got a slight boost from lower pension contributions, yet was still noticeably lower for the twelve months ended 9/30/14 compared to the same year-ago period. Meanwhile, capital spending has been at record levels over the last twelve months, primarily due to investments to expand ethylene production capacity on the


15

US Gulf Coast. Dividend payments continue to be steadily increased and share repurchases have been stout, as the company has already spent approximately $3.3 billion on buybacks from its current program to-date. Finally, in an effort to drum up cash, DOW completed the sale of a substantial portion of its North America railcar fleet in 3Q14, raising more than $400 million in proceeds. Next, we will focus on DOW’s pension plans that cover employees in the US and a number of other countries. Not surprisingly, the US qualified plan covering the parent company is the largest plan and All Significant Plans combined carry a PBO of approximately $25.0 billion as of 12/31/13. Additionally, despite restructuring its operations in recent years, DOW has maintained a hefty employment base over the last 20 years, as the following table shows the number of employees at the end of 2013 as well as employment levels held 10 and 20 years ago, respectively:

Employment History - DOW

12/13 12/03 12/93 53,000 46,372 55,400

What is particularly interesting with DOW is that today it is actually a smaller company in terms of employment than it was 20 years ago. As of 12/31/13, DOW had approximately 53,000 employees, compared to 55,400 at 12/31/93. Additionally, only a year earlier, DOW had 54,000 employees as of 12/31/12. According to the company’s 10/23/12 press release,

Dow will shut down a high density polyethylene facility in Tessenderlo, Belgium, a sodium borohydride plant in Delfzijl, the Netherlands, as well as a number of Performance Materials manufacturing facilities, including: an Automotive Systems Diesel Particulate Filters manufacturing facility in Midland, Michigan; Formulated Systems manufacturing facilities in Ribaforada, Spain, Birch Vale, United Kingdom and Solon, Ohio; and an Epoxy resins facility in Kina Ura, Japan. Additionally, the Company will record an impairment charge related to the write-down of Dow Kokam LLC’s assets, reflecting weak global demand for lithium-ion batteries; and will consolidate certain assets in its Oxygenated Solvents business, as well as shut down a number of other small manufacturing facilities. These actions are expected to take place over the next two years.

Thus, we are somewhat concerned that DOW’s relatively stagnant employee base must continue to support a growing number of retirees. As a result, it is likely safe to assume that DOW’s plans now cover more non-workers than workers. Thus, should longevity risk become a bigger contributing factor in terms of calculating PBOs in the future, we believe DOW’s PBOs could increase significantly given its hefty retiree base relative to current employment. Another factor that could potentially work against DOW’s future pension funding is the fact that its percentage of women employees, who typically live about five years

longer than men, has been rising fairly fast over the last few years, as the following table shows:

Women Employee Percentage – DOW

12/13 12/12 12/11 12/10 12/09 27.4% 27.0% 30.0% 27.0% 26.0%

12/08 12/07 12/06 12/05 12/04 26.5% 26.0% 25.0% 24.0% N/A

Still, on a positive note, DOW’s current women percentage of approximately 27.4% is well below the S&P 500 average of companies that carry a defined benefit plan, of roughly 34%, according to Bloomberg estimates. Checking out the recent performance of DOW’s pension, the funded status of All Significant Plans improved noticeably in 2013 from year ago levels as these plans benefited from generous employer contributions and solid performance from plan assets:


$865

$903

$806

$708

$355


$1,053

$754

$561

$502

$247

Meanwhile, even as DOW’s pension contributions fell to approximately $865 million in 2013, they were still large enough to have some impact on operating cash flow, which was a record $7,823 million last year. Additionally, it is certainly worth noting that a decline in pension costs accounted for about 15% of DOW’s reported increase in operating income in the 3Q14 quarter. This impact is shown in the table below:

Pension Expense Impact on Operating Income (in $mil) 9/14 6/14 3/14 Operating income $1,359 $1,295 $1,444 Increase in operating income $571 $69 $90 Net periodic benefit cost $177 $174 $181 Decline from year ago period $84 $87 $81 % improvement in operating income 14.7% 126.1% 90.0% 9/13 6/13 3/13 Operating income $788 $1,226 $1,354 Net periodic benefit cost $261 $261 $262

Additionally, compared to recent years, DOW’s plans carried a larger exposure to equities going into 2014 and we would expect that the company’s funded status has likely deteriorated some over the year. This could lead to even higher contributions in 2015. Equity securities accounted for approximately 43% of qualified plan assets as of 12/31/13, compared to 40% at 12/31/12. Looking at target allocation percentages posted in the 2013 10-K, equity securities are targeted at 39%, while fixed income is nearly identical at 38%. Thus, DOW’s plan sponsors have clearly been taking on more equity risk over the last few years to achieve higher returns. Meanwhile, even though it


16

has been lowered in recent years, we find the 7.5% expected return for plan assets to be somewhat aggressive and we believe this assumption may need to be adjusted even lower to approach attainable levels. The following table shows DOW’s weighted-average assumptions and allocation of plan assets for its qualified plans over the last five years:

Weighted-Average Assumptions and Allocation of All Significant Plan Assets

12/13 12/12 12/11 12/10 12/09 Discount rate 4.54% 3.88% 4.93% 5.38% 5.71% Expected return on plan assets

7.47%

7.60%

7.86%

7.74%

8.03%

Plan asset allocation Equity securities 43% 40% 38% 42% 43% Fixed income 30% 36% 37% 34% 36% Alternative investments 18% 18% 18% 16% 13% Cash 7% 3% 5% 5% 6% Other investments 2% 2% 2% 3% 3%

In 2013, DOW contributed $865 million to its pension plans, including contributions to fund benefit payments for its non-qualified supplemental plans. However, DOW expects to contribute approximately $800 million to its pension plans in 2014 and is certainly on pace with $756 million in contributions through 9/30/14. Yet, with DOW’s pensions’ funded status possibly taking a hit in 2014 due to the plans’ fairly high equity exposure as well as the likelihood that the PBO of its plans will be adjusted higher soon, we believe DOW could see higher pension contributions soon, hurting operating cash flow. For perspective on how much higher DOW’s pension contributions could get, we increased the PBO of DOW’s plans (plans outside the US are not significant) by 7% in line with Aon Hewitt’s estimates and then subtracted that increase from DOW’s funded status at 12/31/13 to calculate an adjusted funded status. We then took the estimated 2014 contribution divided by the 12/31/13 funded status and used that percentage off the adjusted funded status to base our projected pension contribution for the future:

PBO-Adjusted Impact on Funded Status and Contributions (in $mil) Projected benefit obligation, 12/13 $25,027 Reported funded status, 12/13 ($6,200) 2014 pension contribution $800 PBO with 7% longevity adjustment $26,779 Adjusted funded status ($7,952) Projected pension contribution based off adjusted

funded status $1,026

Based off these adjustments, the PBO for DOW’s US plans would have increased by nearly $1.8 billion. Considering that its plans were considered overfunded by approximately $6.2 billion at 12/31/13, this PBO change would now make them underfunded by about $8.0 billion. Additionally, DOW’s projected pension contributions would increase by about 28% to just over $1 billion off a slightly depressed $800 million that is expected for 2014.

Lastly, we believe DOW cannot afford to continue posting adjusted free cash flow deficits for long and must be careful not to further compromise its already levered balance sheet. Over the last year, the company’s balance sheet has remained relatively unchanged and its net debt-to-EBITDA ratio was 1.81 times as of 9/30/14 from 1.99 a year earlier, as the following table shows:

Balance Sheet (in $mil) 9/30/14 9/30/13 Cash $5,768 $5,272 Total debt $19,782 $18,619 TTM EBITDA $7,728 $6,697 Net debt-to-EBITDA 1.81 1.99

Stemming from its $12 billion acquisition of Rohm and Haas in April 2009, DOW certainly carries some debt. Still, the company has worked it down in recent years, as debt levels have fallen from $23.8 billion at 6/30/09 to $19.8 billion at 9/30/14. In September, Fitch Ratings assigned a BBB rating to DOW’s proposed $2 billion new senior unsecured notes with 10-, 20- and 30-year maturities. The proceeds will be used to repay debt and for general corporate purposes. Looking ahead, DOW needs to continue growing its operating cash flow to cover rising cash commitments. This will need to be monitored somewhat closely, as cash flow could take a hit from rising company contributions should the company’s underfunded status deteriorate further.

AIR PRODUCTS AND CHEMICALS Air Products and Chemicals (APD) is a leading provider of atmospheric and specialty gases for industrial use as well as performance materials and equipment. The recent spike in APD’s price is a result of the announcement of its new CEO Seifollah Ghasemi in July. Mr. Ghasemi was one of three independent directors placed on the board in late 2013 at the behest of Bill Ackman whose Pershing Fund bought just shy of 10% of the company in July of 2013. Growth in the base business is less than inspiring as well. Much has been made of planned maintenance outages pulling down volumes in Tonnage Gases, but volume growth in Merchant Gases is in the low single-digits and facing tougher comps. Revenue growth for the latest fiscal fourth quarter ended 9/30/14 got a boost from one-time price increases to recoup weather-related costs from prior quarters. An increase in sweeter shale oil may stunt the demand for hydrogen among refiners. Supply and pricing in China may also be a drain on growth. However, while we believe there may be room to improve APD’s operations over the long haul, our main concern revolves around the company’s dividend. APD is a “Dividend Aristocrat” meaning it has increased its dividend every year for at least 25 years. The increases have ranged between 10-15% over the last four years and according to Bloomberg, analysts expect the dividend to grow at compound annual rate of almost 7% over the next three years. Yet, we fear that may be overly optimistic, as


17

APD’s free cash flow has been insufficient to cover its dividend over the last five fiscal years ended September:


Twelve Months Ended:

9/14

9/13

9/12

9/11

9/10

Cash from ops before w/c

$2,221

$1,514

$1,626

$1,657

($106)

Working capital impact ($34) $53 $166 $97 $892 Cash from operations $2,187 $1,567 $1,792 $1,753 $786 CapEx $1,684 $1,524 $1,514 $1,309 $779 Free cash flow $503 $43 $279 $444 $7 Dividends $628 $566 $515 $457 $476 % FCF paid in

dividends

124.8%

1309.3%

184.8%

102.9%

7213.6% Share repurchases $0 $462 $53 $649 $22 Surplus/(Shortfall) after buyback

($125)

($984)

($289)

($662)

($492)

Cash flow from operations received one-time boosts from lower pension contributions and the timing of capital lease payments. This was partly offset by lower cash restructuring costs, but this simply reminds investors of the fact that APD has been restructuring for years and cash costs are a regular drain on resources. Capital spending ramped higher in FY14, but given the rising average age and comments made by management, we would not expect much of a decline to free up cash in the future. Finally, in an effort to lower cash commitments, APD discontinued its share buyback program last year. However, this move has led to an increase in share count that not only dilutes the dividend per share, but also resulted in a 1-cent per share drain on EPS in 4Q14. Next, let’s look at APD’s pension situation. While the company is easily the smallest of our examples, APD maintains a fairly large pension, with its combined US and International plans carrying PBOs of approximately $4.4 billion as of 9/30/13. Additionally, while still growing at a decent clip, APD has had a good-sized employment base over the last 20 years, as the following table shows the number of employees at the end of the most recent fiscal year as well as employment levels held 10 and 20 years ago, respectively:

Employment History - APD

9/13 9/03 9/93 21,600 18,500 14,075

As of 9/30/13, APD had approximately 21,600 employees, compared to 18,500 employees at 9/30/03 and 14,075 employees at 9/30/93. Thus, APD’s employment growth has been pretty steady over the last 20 years, growing at an average annual rate of approximately 2.2% over this period. While it is certainly encouraging that APD has continued to grow its employment ranks over the years, allowing a larger current employee base to help support its growing retired employee base, this growth has not been significant and APD’s plans likely now cover more non-workers than workers. It should be noted that APD’s employment remained flat in FY13, as APD had 21,600

employees at 9/30/12. Additionally, while we don’t know APD’s current employment number as the company has not come out with its FY14 10-K yet, we know that new management has continued to focus on cost-cutting and on the 4Q14 call, CEO Ghasemi added,

“Our safety and financial performance in the last quarter demonstrates the power of the 20,000 people in Air Products coming together and delivering results

that exceed expectations.” While the “20,000 people” comment was likely not precise, this would indicate that APD may have lowered its employee base by roughly 7% over the last fiscal year. Thus, should longevity risk become a bigger factor in terms of calculating PBOs in the future, we believe APD’s PBOs could increase significantly given its weighty retired base relative to current employment. Looking at recent performance, the combined funded status of the company’s US and International plans improved noticeably in FY13 from year ago levels as these plans benefited from higher employer contributions and solid performance from plan assets:

Key Pension Variables (Rounded in $mil) 9/13 9/12 9/11 9/10 9/09 Funded status ($593) ($1,247) ($942) ($1,042) ($1,135) Employer

contributions

$301

$76

$241

$407

$185 Pension expense/

(income)

$170

$120

$114

$109

$110

Meanwhile, with the company’s pension contributions ramping up in FY13 to approximately $301 million, they are certainly large enough to materially impact operating cash flow, which was $1,567 million for the fiscal year. Additionally, it is certainly worth noting that a decline in pension costs accounted for about 32% of APD’s reported increase in operating income in the 3Q14 quarter. This impact is shown in the table below:

Pension Expense Impact on Operating Income (in $mil) 6/14 3/14 12/13 Operating income $413.8 $384.7 $385.6 Increase in operating income $30.7 ($5.0) $13.2 Net periodic benefit cost $32.7 $32.9 $32.5 Decline from year ago period $9.8 $3.3 $6.8 % improvement in operating income 31.9% (66.0%) 51.5% 6/13 3/13 12/12 Operating income $383.1 $389.7 $372.4 Net periodic benefit cost $42.5 $36.2 $39.3

The bulk of the decline was from a lower amortization of actuarial loss, likely related to the lowering of the discount rate. Regardless, a decline in pension expense of this magnitude cannot continue to help APD’s profits. Another major consideration is that APD’s plans had a large exposure to equities going into FY14 and we would expect that the company’s combined funded status might


18

have deteriorated some so far in FY14. This could lead to even higher contributions in FY15. Equity securities accounted for US and International plans accounted for approximately 71% and 61% of qualified plan assets, respectively, as of 9/30/13, compared to 70% and 57% at 9/30/12. Thus, it appears that APD’s plan sponsors have recently been taking on more equity risk to try to get higher returns. Even though it was lowered from 8.8% last fiscal year, we find the 8.3% expected return for US plan assets to be particularly aggressive and we believe this assumption may need to come down even more to approach more realistic levels. The following table shows APD’s weighted-average assumptions and allocation of plan assets for its US qualified plans, which are more than twice the size of its International plans, over the last five fiscal years:

Weighted-Average Assumptions and Allocation of US Plan Assets

9/13 9/12 9/11 9/10 9/09 Discount rate 4.8% 3.9% 4.9% 5.1% 5.7% Expected return on plan assets 8.3% 8.8% 8.8% 8.8% 8.8% Plan asset allocation Equity securities 71% 70% 66% 70% 68% Debt securities 23% 24% 28% 25% 26% Real estate/other 5% 5% 5% 4% 3% Cash 1% 1% 1% 1% 2%

Even though lackluster equity performance and slightly lower discount rates have likely caused APD’s funded status to deteriorate some in FY14, the company appears to be on pace to achieve its planned pension contributions of $80-100 million for FY14, a 67-73% decline from the $301 million contributed in FY13. Through nine months ended 6/30/14, APD had contributed $64.7 million to its pension plans, just a fraction of the $258.6 million it spent over the same nine-month period a year ago. Couple these tiny contributions with the likelihood that the PBO of its US plans will be adjusted higher soon, and we believe APD could see much higher pension contributions in its near future, hurting operating cash flow. For some perspective as to how much higher APD’s pension contributions could get, we increased the PBO of APD’s US plans by 7% in line with Aon Hewitt’s estimates and then subtracted that increase from IBM’s combined funded status at 9/30/13 to calculate an adjusted funded status. We then took the estimated FY14 contribution divided by the 9/30/13 funded status and used that percentage off the adjusted funded status to base our projected pension contribution for the future:

PBO-Adjusted Impact on Funded Status and Contributions (in $mil) Combined PBO, 9/13 $4,394 US PBO, 9/13 $2,809 Reported funded status, 9/13 ($593) FY14 pension contribution $90 US PBO with 7% longevity adjustment $3,006 Adjusted funded status ($790) Projected pension contribution based off adjusted

funded status

$120

Based off these adjustments, the PBO for APD’s US plans would have increased by approximately $200 million. Considering that its US plans were considered overfunded by approximately $275 million at 9/30/13, this PBO change would now make them underfunded by about $472 million. Additionally, APD’s projected pension contributions would increase by about 33% to $120 million off a very depressed $90 million that is expected for FY14. Further, considering how depressed APD’s contribution levels have been over the past fiscal year, we believe this projected $120 million may be extremely low. Interestingly, in an effort to simplify the organization and reduce costs according to management, ADP took a pension settlement loss after providing lump sum payments in 4Q14. As we noted in the introduction, more companies are trying to unload the risks of running a pension by offering workers these lump-sum buyouts. According to last week’s 4Q14 earnings release,

Our supplemental pension plan provides for a lump sum benefit payment option at the time of retirement, or for corporate officers six months after the participant’s retirement date. We recognize pension settlement losses when cash payments exceed the sum of service and interest cost components of net periodic pension cost of the plan for the fiscal year. We recorded pension settlement expense of $5.5 ($3.6 after-tax, or $.02 per share) during the fourth quarter of 2014. We expect that settlement losses will also be recognized in 2015.

Lastly, APD does not appear to have the financial standing to continue posting adjusted free cash flow deficits. The company’s net debt is now approaching all-time high levels, but EBITDA remains strong, allowing the company’s net debt-to-EBITDA ratio to settle at 2.22 times as of 9/30/14 from 2.61 a year earlier, as the following table shows:

Balance Sheet (in $mil) 9/30/14 9/30/13 Cash $337 $450 Total debt $6,119 $6,274 TTM EBITDA $2,608 $2,231 Net debt-to-EBITDA 2.22 2.61

While not crippling, APD’s debt load is substantial. Management has indicated on recent calls that it is important for it to maintain its investment grade credit rating. It is currently rated A-2 by Moody’s, so it is far from the edge. Nevertheless, if debt/EBITDA reverses back towards three, we would expect the credit rating to suffer. In addition, it is worth noting that while APD has over $300 million of cash on hand, virtually all of that is tied up overseas and cannot be tapped without paying taxes on it. Certainly, APD must continue to grow its operating cash flow and find a way to cover cash commitments. Going forward, we would not be surprised if APD’s cash flow faces a heavier burden from rising company contributions should the company’s already underfunded status worsens.


19

DISCLOSURE

Behind the Numbers is a research publication structured to

provide analytical research to the financial community.

Behind the Numbers, LLC is not rendering investment

advice based on investment portfolios and is not registered

as an investment adviser in any jurisdiction. Information

included in this report is derived from many sources

believed to be reliable (including SEC filings and other

public records) but no representation is made that it is

accurate or complete, or that errors, if discovered, will be

corrected.

The authors of this report have not audited the financial

statements of the companies discussed and do not

represent that they are serving as independent public

accountants with respect to them. They have not audited

the statements and therefore do not express an opinion on

them. Other CPAs, unaffiliated with Mr. Middleswart, may

or may not have audited the financial statements. The

authors also have not conducted a thorough "review" of the

financial statements as defined by standards established

by the AICPA.

This report is not intended, and shall not constitute, and

nothing contained herein shall be construed as, an offer to

sell or a solicitation of an offer to buy any securities

referred to in this report, or a "BUY" or "SELL"

recommendation. Rather, this research is intended to

identify issues that portfolio managers should be aware of

for them to assess their own opinion of positive or negative

potential.

Behind the Numbers, LLC, its employees, its affiliated

entities, and the accounts managed by them may have a

position in, and from time-to-time purchase or sell any of

the securities mentioned in this report. Initial positions will

not be taken by any of the aforementioned parties until

after the report is distributed to clients, unless otherwise

disclosed. It is possible that a position could be held by

Behind the Numbers, LLC, its employees, its affiliated

entities, and the accounts managed by them for stocks that

are mentioned in a "Live Update" or on the "Watch List".

Upon request we will be pleased to furnish specific

information in this regard.

Copyright 2014, Behind the Numbers, LLC

8140 Walnut Hill Lane, Suite 120

Dallas, Texas 75231-4336; 800-585-5019

All Warnings are effective until removed by our Update

Log

Jeffery B. Middleswart (214) 378-4186

Bill E. Whiteside, CFA (682) 224-5715

William N. Becker (636) 821-1319

Jeffrey N. Dalton (214) 378-4176

Rob Peebles, CFA (214) 378-4183

JR Riddlehoover, CPA (817) 447-7067

Documents

Pension longevity risk