Reach (RCH): PE of 3 vs Pension Deficit

Company Discussions
#1

Another useful video from PI World, this time featuring Andy Brough (AB) and Richard Leonard (RL).

RL talks about Reach (RCH) at 21m15s and mentions its ‘P/E of 3’.

Sure enough, SharePad shows a trailing P/E of 3 and the shares having traded on a single-digit multiple for at least 10 years:

RCH sharepad daily pe

The cheap rating was mentioned briefly in the video as being due to the ‘legacy’ print business and a pension deficit. Reach used to be known as Trinity Mirror and owns a number of national and local newspapers.

The pension situation is interesting. I have always viewed final-salary pension schemes as financial ‘black holes’ — they always seem to absorb more and more cash to the detriment of cash flow for shareholders.

Some extracts from the 2019 RCH annual report: https://www.reachplc.com/static-files/4af444f5-7bd1-4bd8-a533-0fb65867b208

First, confirmation of a £296m accounting scheme deficit:

RCH AR 2019 pension summary
RCH AR 2019 pension summary1214×387 121 KB

Next we discover scheme assets of £2.4b are required to pay annual benefits of £112m. The 4.7% required investment return is relatively high (at least according to my study):

RCH AR 2019 pension benefits assets
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This note reveals scheme benefit payments will rise until 2031:

RCH AR 2019 pension payments
RCH AR 2019 pension payments1192×139 77.7 KB

While this note reveals scheme benefit payments will continue beyond 2045:

RCH AR 2019 pension 2044
RCH AR 2019 pension 20441213×271 151 KB

Those dates suggest the scheme could be a burden for shareholders for some time.

This is the critical pension note:

RCH AR 2019 pension contributions
RCH AR 2019 pension contributions1215×597 347 KB

RCH is on the hook to pay deficit contributions of between £53m and £56m per annum between 2021 and 2027. I calculate the total obligation comes to £386m.

Importantly, these deficit contributions (due to accounting reasons) are not charged to earnings but are of course revealed in the cash flow statement:

RCH AR 2019 pension cash flow
RCH AR 2019 pension cash flow1207×505 140 KB

As such, calculating RCH’s P/E using reported earnings seems very optimistic to me given the obligation to pay £386m from those earnings into the pension scheme.

This chart from the results powerpoint indicates last year’s £49m deficit contribution consumed 37% of the total £133m cash flow:

RCH FY 2019 slides pension cash flow
RCH FY 2019 slides pension cash flow947×538 44 KB

If you wish to value RCH by its reported earnings, the £386m deficit-contribution obligation really needs to be added the market cap as that clears the pension worries (at least until 2027) and reported earnings then all flow to shareholders.

RCH’s market cap stated by RL in the video was £240m, so adding £386m gives £626m. If the P/E was 3 at £240m, then it is almost 8 at £626m. Still single-digit, but perhaps not offering the upside potential of a true 3x multiple share.

The annual report also reveals RCH has a £21m provision to settle claims related to phone-hacking:

RCH AR 2019 provisions
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These claims have been a notable source of exceptional items for RCH during recent years, and their regularity suggests the likelihood of RCH eventually paying these claims will be high. Arguably the market cap should be adjusted to include a phone-hacking obligation as well.

Maynard

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#2

What I find difficult for pension schemes is the actuarial variations can have a huge impact on capital requirements, which companies have to fix over a relatively short period. A small change to life expectancy or investment return (expectations) massively changes capital requirements. If RCH’s 2.4bn of assets produce 4% (96m) and its liability is 112 per year, its actually 16m/yr short which is not terribly material in a FCF of 133. Unfortunately its required to fix a long term problem in the next 6-7 years.

Obviously a decent investment return, or reduction in liabilities due to a global pandemic, would help things along nicely. In the meantime the company remains saddled with the problems of the past.

Regards
R

#3

Hi Roger,

Thanks for the reply. Yes, the actuarial variations can make a significant difference to the scheme’s funding requirements. My anecdotal experience of looking at schemes is that the variations always seem to be adverse for shareholders. I am not a pension expert, but I gather the general investment strategy is to match scheme liabilities with asset income – and the most certain of asset income comes from government bonds. Bonds have low rates at present, so I think a lot more money needs to pumped into RCH’s scheme to acquire bonds to improve the level of ‘liability matching’ and therefore appease the trustees.

I must admit returning 4% a year over time sounds achievable in an equity portfolio, but if a market slump erodes the portfolio by 15%, and then benefits of 4% have to be paid, trying then to play catch up can be hard knowing that those benefits still have to be paid next year.

Maynard
(PS yes, the global pandemic may have a bright side for actuarial valuations – life expectancy may be reduced!).

#4

My understanding is that the pension trustees agree the capital recovery plan with the company to match up assets and liabilities, so RCH should have agreed to the funding plan.
I think the biggest risk lies in the schemes’ liabilities escalating due to generous promised benefits increases. If the schemes promise a 3% p.a. rise to pensioners, that means the assets need to return 7% (say). Its hard to know the details of the multiple individual schemes. A good dose of inflation would probably help erode the liabilities (though if the investment is all in bonds that would be disastrous too!) I share your view that whatever happens it seems to work against investors.

Regards
Roger

#5

Hi Roger,

Yes, all agreed. Will be fascinating to see how RCH plays out. The pension fund is likely to act as a drag on the valuation barring something very unexpected happening with the scheme. I am not entirely convinced about Mr Leonard’s buy case and RCH making £££ from selling reader data to advertisers, but I could be wrong.

Maynard

#6

As the pension elements are so large (£2.7bn actuarial liabilities versus £2.4bn assets) and so long term (to 2045 and beyond), the key investment consideration is not the quality of the business but the potential movement in pension liaility.

The liabilities are largely a function of mortality assumptions. These change every so often but have been fairly flat over the last decade or so. The assets reflect return assumptions. In a world of low or negative risk free rates, these can differ from historical norms.

I am not sure the accounts give the information required to take a view on the liability. Even if they did, I doubt private investors are equipped to take a view. The accounts provide an actuarial view. The are other important perspectives. For example, what are assets on “risk free” basis (i.e. matched to government bonds). Significantly lower. What would be the “buyout” valuation where a third party (insurer) would take on the risk and expect a profit. I suspect such a buyer would require at least £1bn (and possibly more) to take on this scheme (given the scale and longevity).

I also suspect the market has and will continue to put this into the “too difficult box”. There is a significant risk that the pension may last longer than the underlying business.

Having dealt with them in a private capacity, I am amazed at how sanguine public institutional investors are generally in relation to defined pension liabilities. In my view, your intial instinct is absolutely right: cash “black hole”.

#7

Yes, good point. Reminds me of Rolls-Royce last year:

“The deal will see Rolls-Royce make an exceptional cash contribution of around £30m. Free cash flow guidance for the Full Year remains unchanged. Alongside the transfer of around £4.1bn of liabilities to Legal & General, the Rolls-Royce trustee will also transfer around £4.6bn of assets. This results in a reduction in net assets of around £0.5bn though funding levels remain unchanged.”

The scheme transfer had an accounting surplus of £0.5bn, yet RR paid £30m to get rid of it and kept its funding levels unchanged for the remaining scheme(s).

The subject is complicated, which I think is why many investors just overlook the small-print and wonder why they end up with a ‘value trap’. I had a go at looking at pension deficits here, which at least helped me think more about the subject. Anyway, I was surprised RCH was presented in such a positive light in the video without any discussion about the pension situation.

Maynard

#8

Thank your for the useful link. I had not read that previously and it was interesting.

My rule would be to avoid DB schemes. I might break that rule where the total liabilities were low re the EV or profits. Often the focus is on the deficit or permium, but I focus on the liablity.

Assume a £5m EBIT business: I would not invest if it had a scheme with £100m liabilities even if it had a £5m surplus, but I might invest if it had a £2m deficit if the liabities were £10m.

Understanding the number and nature of the beneficiaries is helpful. If you have a smaller number with a greater proportion drawing a pension, the liability is less likely to move badly against you.

#9

I agree with Maynard’s PS - yes, the global pandemic may have a bright side for actuarial valuations – life expectancy may be reduced!

Does anybody have any thoughts on when such a reduction might begin to become apparent?

#10

Must admit my PS was a tad flippant! I suspect actuarial tables will be slow to alter if they do. The pandemic is likely to subside at some point and actuaries may argue the effect was temporary and life-expectancy forecasts may not change at all (I am not an actuary!). I think if there is going to be a benefit to Reach, it is more likely to involve (sadly) a few more of the scheme participants dying this year than would otherwise have been the case. So the liabilities could be reduced that way.

Maynard

#11

Thanks Maynard, your view seems reasonable

#12

Back on the pensions theme for a moment, I’d be interested in views following the chancellor’s recent announcement that the government is effectively scrapping RPI and replacing it with CPIH, a lower measure of inflation (c 0.8% lower on average. This should lower pension plan liabilities where these included an RPI escalators. I have seen comment that some funds have tried to cover liabilities with index linked bonds, so the change is a negative for those. In the case of Reach, they mention making up some of the pension shortfall with investment performance so it suggests that the fund isn’t bond-heavy, so I interpret the change as a positive, though noting the change doesn’t come in for quite a while (2030).

R

#13

I am not a pension expert and I admit this is the first I have heard of this change. The following articles suggest some consternation within the industry:

I think the change will lower liabilities, as pensioners from 2030 will not see their pensions rise as much as they had expected. But the value of RPI-linked gilts in pension schemes ought to fall as well. One of those articles includes a good quote:

“This is expected to reduce the future change in RPI from 2030 onwards by 1% per annum, effectively transferring around £100bn of value from index-linked gilt holders (largely pension funds) to the government.”

The risk I guess for shareholders is that the £100bn transfer is not funded entirely by pensioners taking a lower-than-expected income post-2030, but the schemes having to fund greater contributions and share some of the hit.

Reach’s pension assets from the 2019 annual report are below:

RCH AR 2019 pension assets
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Not too much in the way of index-linked gilts, which I think will be the most affected by the change.

Pension obligations was already a complicated subject, and has now become even more complicated! I maintain for most long-term investors, staying away from complex/significant pension burdens is the best course of action.

Maynard

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#14

Hi

Assuming longevity is constant, if interest rates ever go up again would this reduce any pension related liability? I am not suggesting this is (ever!) going to happen in this new world - I just wanted to clarify the relationship.

Thanks,
Ben

#15

Hi Ben

Yes, if rates go up then pension liabilities should reduce. The liabilities are calculated as the net present value of estimated future payments, so the higher the interest (or discount) rate applied, the lower the liability.

Mind you, if rates go up, then equity prices ought to fall as their theoretical value is based on the future value of cash flows – which will now be lower with the higher rate applied.

So the pension scheme should see liabilities reduce, but also see some investment values reduce as well. The overall effect may therefore not be so pronounced on any reported deficit.

Maynard