A large pension liability ought to act as a warning signal for value investors
In in a pickle, we flagged up the plight of premier foods, which as a consequence of having high levels of debt, has been run more for the benefit of its banks than its shareholders in recent years. a different slant on this situation – and indeed one that can even give the banks sleepless nights – is when a company is being run primarily for its pension fund, which brings us to the case of UK coal.
UK coal, which acquired many of the mining assets of British coal when it was privatised by the UK government in 1994, enjoyed a new lease of life during the property boom of the mid-2000s. As the company owned significant amounts of land - either surrounding existing coalmines or earmarked for future mining projects – it was seen as an exciting, hitherto undiscovered property development opportunity. The shares performed strongly.
In their rush to snap up the shares, however, some investors may have overlooked that, in common with other former public-sector, labour-intensive businesses, the company had quite a large pension fund associated with it – one that today is £450m in deficit. Furthermore, in pursuit of some of its property development goals, UK coal also took on a lot of debt and, in a story we have heard many times before, that did not end well.
Early in December 2012, UK coal completed a complicated restructuring that saw the business split into two new companies, with one focusing on its coal assets and the other on its property assets. Having previously owned 100% of both, the company’s shareholders have been left owning 90% of the economic rights of the coal business and just 33% of the voting rights – so they still benefit from most of the cash flows generated by the mines, but don’t have control over how they are run. Existing shareholders also see their interest in UK coal’s property assets – in terms of both economic and voting rights – fall to 25%.
The other 75% of the property company and the balance of the coal company rights are now owned by either a newly formed ‘employee benefit trust’ or the pension scheme. While the mining deal may appear more generous than the property deal, outstanding amounts owed to the pension fund mean, to quote the management, “all the surplus cash flow from the mines will go into the pension fund deficit for the foreseeable future”.
That really is not something any shareholder wants to hear because, if the theoretical value of a company is linked to the cash it generates for shareholders over time and not much cash flow is going to generated for shareholders “for the foreseeable future”, then this has a big impact on what shares in a business are worth.
At best and in essence, equity investors in UK coal have been left with a small stake in a property business, which may or may not turn out to be good news, and an option on one day getting some money out of a collection of UK-based coal assets, which – as we saw in Old King Coal – may not be the greatest cause for celebration.
One of the cautionary tales we highlight from time to time is that it pays to be wary of investments in businesses where large obligations are owed to stakeholders that rank ahead of equity shareholders. In the UK, pension funds usually rank before everyone else and, while that does not always turn out badly, when it does go wrong, it can go very wrong indeed.
Fund Manager, Equity Value
I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.
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