Public Companies

But when making money in the stock market isn’t so easy, like now, investors come to see that it isn’t so much a stock market as it is a market of stocks. Selecting the right companies makes all the difference

“How’d the market do today?” people often ask. And sometimes, when stocks are moving broadly in one direction—as they did in the bull campaign of 1991-2000—such generalizations suffice.

But when making money in the stock market isn’t so easy, like now, investors come to see that it isn’t so much a stock market as it is a market of stocks. Selecting the right companies makes all the difference in investing successfully over the long haul.

The past year bears that out. While the Dow Jones Industrial Average slipped 13% and the NASDAQ composite slumped another 26%, public companies based in the Nashville area saw their shares rise an average of 6% in the 12 months ended Aug. 31, 2002. But that 6% average spans individual stock returns of –78% to +183%.

To help investors better understand the financial performance of local companies and make profitable stock selections, Nashville Post presents its 2002 Public Rankings. This year, we have devised a more sophisticated and—we believe—more useful analysis. The three-part feature reveals:

  • Which corporations are the best stewards of the capital with which they are entrusted
  • How some corporations could be vulnerable to unexpected large expenses due to overly optimistic assumptions about their pension funds’ investment performance
  • What sort of relationship exists between top executive compensation and share performance
The following report is based on data gleaned from Securities & Exchange Commission filings and stock market information. We also are grateful to Scott Burns, Dan Hall and Paul Kuhn at Woodmont Investment Counsel for helping us harness the power of their Reuters StockVal database as an aid in the compiling of this report.

Roe: It’s not just sturgeon eggs anymore
Let’s say you’ve got $10,000 burning a hole in your investment pocket. Your best friend and resident genius comes up with an idea for a business, a wonderful place for your 10 grand. His idea and your money—a perfect marriage. But before you invest, you’d want to ask some questions, best buddy or not. One of them probably would be: “How much money do you think we’ll make?” If he says, $500, you may elect to pass. A $500 profit on a $10,000 investment is just a 5% return. You can get almost that in a year on a government bond, even in this day and age of diminished interest rates. Why risk your capital for so little upside?

Accountants call this Return on Investment. For publicly held companies, the concept becomes Return on Equity (ROE). The major difference between the two is that the amount of equity, the initial amount invested (either by founders, or in an initial public offering, or some combination) is added to and subtracted from over time. While somewhat simplified, this can be summed up most simply as follows: earnings are added in; preferred dividends and depreciation are taken out.

Divide the company’s profit by its equity; you get the return on equity. It is a measure of how effectively the company uses its capital—your money. The company may make gratifyingly large profits, but does it need enormous sums of capital to do so? Is the company a good steward of your money, putting its profits to good use? Or does it invest in new ventures that don’t pay off?

For some money managers, ROE is their most important gauge of a stock’s value, the best harbinger of its future price performance. If you look at our chart, you’ll see that the four companies with high (over 20%) ROEs since Jan. 1, 2000, produced mostly good returns on their stocks. Franklin Financial did the best with a return of 122% from the first day of 2000 until the end of August 2002, followed by HCA’s 57% return. Dollar General, with its accounting problems, has an unfortunate loss of 12.5%. Genesco, well off its highs as earning growth slows, managed 17.8%. This was during the time when the market itself lost considerable ground.

A star price performer, Tractor Supply Co, where a $100 investment in its common stock on Jan. 1, 2000, would beworth roughly $415 today, sports an 11.7% ROE. With its huge expansion this year, it is just now making full use of the infrastructure it built over the past five years.

We are, of course, looking backward. Yet, the stock market is a forward-looking mechanism, and future earnings will have much to do with future ROE numbers. In fact, Paul Kuhn of Woodmont Investment Counsel thinks straight earnings are more important than Return on Equity. Nevertheless, he looks closely at ROE. “Companies with high ROEs can increase profits faster than those with low returns because they have capital with which to make investments,” he says. He also points out that ROE will differ from industry to industry. Those with high capital requirements, like manufacturing and big steel, tend to have a low ROE. “These businesses are cyclical and are suited to traders,” Kuhn says. “We are looking for growth companies.” If a company has a low ROE, it is probably better for it to pay out its earnings in dividends, allowing investors to search for more profitable investments.

Many growth companies do not require much capital, and that can mean handsome ROEs. Fortunately for area business principals and venture capitalists, Nashville-based businesses tend to be service companies, though some, like hospital chains, do involve a large amount of fixed assets.

Such distinctions between high and low ROEs are only part of the story, though. A company’s debt-to-equity or debt-to-capital ratio is an important consideration when looking at ROE. An enterprise can hold down its equity investment by borrowing more from banks or the bond market. But this creates risk—it increases fixed overhead costs. In an economic downturn, interest payments must still be paid, even if there is little cash for capital improvement.

Or if revenues don’t rise at the projected rate, too much leverage on the balance sheet can wreck the prospects for even nicely profitable companies. On our local list, American Retirement Corp. and Shop At Home carry particularly high levels of debt as a percentage of their total capital. In both cases, revenues didn’t turn out as expected, and the debt that would have supercharged earnings on the upside have helped undermine their bottom lines.

Hospital companies, with their relatively predictable levels of revenue, typically carry a higher than average debt level. HCA, for example, has greatly deleveraged its balance sheet since the company re-emerged from a management-led buyout in the early 1990s. Even so, half of its capital is in the form of long-term debt. Fellow hospital chains Community Health Systems and Province Healthcare carry similar debt loads. Even though their revenues are relatively predictable, hospitals’ fortunes are cyclical and whenever the next round of federal health plan rate cuts arrive, these companies might be tempted to trim their debt exposure a bit.

ROE, then, is an excellent starting point for assessing how profitably a company deploys its capital. And generally, Nashville-area corporations demonstrate that good long-term ROE translates into good ROI for shareholders. But just as you would do with your buddy, the entrepreneur-to-be, before forking over 10 grand, so should you do with stocks. To identify winning stocks for the long term, you must expand the analysis and ask more questions.
---Richard Daverman

Future Imperfect
“Past performance is no guarantee of future results.”

For decades, investment professionals have stamped those words, or ones like them, onto customer correspondence and mutual fund disclosure statements. Too bad that many pension fund consultants and managers didn’t take the message to heart.

Instead, they were entranced by the siren song of outsized stock market performance in the last two decades of the 20th century. The 12% annual average returns on equities from 1980-2001 obscured the sub-10% average returns over the preceding 80 years.

Like a drying riverbed exposing the detritus below, the present bear market is revealing its own eyesores. Chief among them are unrealistic performance assumptions on the assets funding the retirement plans of some of Nashville’s and the nation’s largest employers.

But investors dare not avert their eyes. There are billions of dollars at stake. Billions of shareholder dollars. For if certain retirement plans fail to have the assets needed to meet promised pension payouts to retirees, then this money must come from the corporations themselves. That transfer of money reduces corporate earnings, which has the funny tendency to lower stock prices. So now is an excellent time to analyze these plans to see which companies remained sober in their projections and which did not.

After examining the footnotes in the Securities & Exchange Commission filings of five corporations based here or with major presences in Middle Tennessee, Nashville Post concludes that the tradition of heroic investment assumptions is alive and well. The experiences of several of the five companies–Gaylord Entertainment Co., Genesco, Caterpillar, BellSouth and Gannett Co.–bear out the price paid for propping up earnings in years past by assuming unsustainable returns in the financial markets.

Ambitious pension assumptions were popular in the 1990s bull market among well-established, older companies that maintain so-called defined-benefit pension plans for employees. Such plans require companies to assume responsibility for investing money on behalf of their employees. Through trust funds, companies attempt to manage their pension assets in a way that will allow them to cover ongoing and future pension obligations. Not surprisingly in times like the present, when many workers are seeing their self-managed 401(k) retirement plans swooning, employees love defined-benefit plans because the company is responsible for portfolio declines and must provide the guaranteed benefit regardless.

And that’s how defined-benefit plans introduce financial complications to corporations. They thrust many uncertainties into the corporate accounting picture, such as investment returns and life expectancy of retirees who are entitled to lifetime monthly income.

In 2001, Gaylord Entertainment froze its defined-benefit plans and switched most employees to a cashformula, or a defined-contribution plan. Only those staffers who were nearing retirement were allowed to continue with the defined-benefit program. The company now hopes to eventually phase out its defined-benefit pension costs.

Given the recent stock market unpleasantness, this was a savvy move as far as Gaylord’s shareholders are concerned. Up-and-coming managers wishing to be covered by the original guaranteed plan might not share that sentiment. That, or the fact that most of Gaylord’s hourly workers aren’t in the attractive defined-benefit plan, could be why Gaylord managers refused to explain to Nashville Post why the retirement plan was changed. Company spokesman Jim Brown referred all questions to the annual report, which provides information about the plans but no explanation for the change.

Gaylord’s decision to transition to a defined-contribution retirement plan is not an uncommon one. The extended bull market of 1982-2000 helped popularize defined-contribution plans, or 401(k) plans as they are better known, introduced in the early 1980s. Today, more than six in 10 U.S. workers with retirement coverage rely primarily on 401(k)s and similar plans.

With blistering stock market performance in those years, holders of traditional defined-benefit plans envied those who invested in 401(k)s because the latter plans grew more quickly into big retirement nest eggs. Employees were only too happy to contribute part of their paychecks to an investment account, traditionally matched in some degree by the employer and managed by the employee.

Two-thirds of all workers’ retirement plans in 1985 were defined benefit, but by the end of the century that figure had shrunk to less than half. Now, after a 40%+ decline in popular stock market indexes since March 2000, a swing back to traditional pensions could be in the offing.

The swing, though, is apt to be modest. Since the 1970s, when Congress required companies to beef up their plans’ funding to make them more secure, corporations have been scaling back their traditional pensions.

At that time, companies with defined-benefit plans typically maintained modest expectations on their plan assets, ranging from 5% to 7%. Oddly enough, they could then have bought long-term government bonds that paid 8%. But pension managers and advisors were still jaded by the early 1970s market collapse and were slow to make the mental adjustment to expect higher returns, says Tony Johnston, an actuary with Bryan, Pendleton, Swats and McAllister, a Nashville firm that advises pension funds.

Quoting Warren Buffett, the world’s greatest investor, Johnston says today’s pension expectations are high for the same reason: people project the market’s recent experience into the future. Looking back at the 1990s, investors had no problem achieving 9% to 10% return assumptions on their plan assets. Those levels are too heroic in view of today’s bear market in stocks and 40-year low interest rates on bonds, which tend to make up a third of retirement plan assets.

“Some financially troubled companies or companies attempting to boost their profits are pushing their rate of return to a 9% average,” Johnston says. The higher a company projects its fund returns the less money it sets aside for the plan. “That average hasn’t moved in the last five years, but my guess is that the honesty-in-accounting movement would induce the pressure to push that rate down.” A company with a 10% return rate is probably out of line, he adds.

“People are looking in the rearview mirror,” says a local money manager who wished to remain anonymous. “In general, there is fluff in the expected rate of return on plan assets. Six is a reasonable rate, but few companies maintain it.”

In fact, if the nation’s largest 50 companies decided to reduce their expected pension returns by 1%, that would have lowered their cumulative 2001 corporate earnings by $5.7 billion, according to a recent study by Milliman USA, a New York-based consulting and actuarial firm.

Milliman looked at defined-benefit accounting among 50 companies from the Fortune 100 list and uncovered some shocking numbers. For instance, surplus funding among these companies declined by $100 billion in 2001, and 90% of the surplus has disappeared since the end of 1999. Twenty-eight of 50 companies are now in a deficit position, up from eight in 1999.

While rates of expected returns for 2001 remained unjustifiably high—at 9.39% from the prior-year 9.38%—some of the biggest companies lost huge chunks of their surplus. General Motors’ $7 billion surplus in 1999 was replaced with a $9 billion deficit last year. At General Electric, surplus was down from $25 billion to $15 billion over two years; Verizon lost half of its surplus in 2001, stopping the plunge at $12 billion from $26 billion in 1999.

The study also found that at least 22 companies out of the top 50 used some sort of asset smoothing, or spreading of asset gains and losses over as much as five years. Accounting rules permit companies to smooth, or average their asset totals so that their year-to-year swings don’t create up-and-down lurches in employee benefit costs. But, on the dark side, that method allows companies to book paper gains on money-losing investments in some years, showing virtual pension fund profits and inflating net income reported to shareholders.

Smoothing of returns and exiting the defined-benefit arena are frequent corporate responses to income statement risks and volatility. Even with its recent establishment of the defined-contribution system, Gaylord’s profits were pulled down by last year’s pension obligations. At an 8% expected return rate for both 2001 and 2000, its benefit plans fell $14.5 million short of their $58.7 million retirement obligations. A year earlier, the shortfall was $5.1 million. Reflecting its need to meet the retirement plans’ minimum liabilities, the company took an $8.2 million net charge in 2001.

Nashville-based footwear maker Genesco, which froze its defined-benefit plan at the end of 1995 and added a defined-contribution plan, took an $8.3 million charge in meeting its $96.4 million defined-benefit obligation last year, after an $8.9 million charge the year before. The plan was underfunded by $17.1 million as of Feb. 2, 2002, and had cumulative losses of $32.1 million.

Last year, Genesco cut its expected return on plan assets from 9.5% to 8.5%, but its plan sustained an actual 2.3% loss, missing the return target by nearly 11%. With total benefit obligations rising to $104 million in the fiscal year ending February 2003, and with stock prices sharply lower year-to-date, the risks to Genesco’s profitability from its defined-benefit plan are even greater. Given these pressures, it will be interesting to see what future return assumptions the shoe retailer uses.

For Caterpillar, the worldwide construction equipment manufacturing giant whose Caterpillar Financial unit is based in Nashville, its 9.7% expected rate of return on defined-benefit assets also resulted in major losses. At the end of 2001, the company’s $8.6 billion obligation was $130 million under-funded. The difference between the company’s expected and actual returns was a negative $1.3 billion in 2001 and a negative $377 million in 2000. If the expected return rate had been set 100 basis points lower at 8.7%, Caterpillar’s corporate earnings would have been reduced 11.5% in 2001, according to Milliman.

In the case of BellSouth, which has not changed its 9% assumed rate of return during the past three years, corporate earnings would have been reduced 7.2% if it had lowered its expected rate of return on plan assets to 8%. Bel South’s difference between expected and actual returns was a negative $2.85 billion in 2001, negative $934 million in 2000 and $2 billion in 1999.

Gannett Co., the McLean, Va.-based owner of The Tennessean, warned that its pension expense will rise $50 million this year due to investment declines in 2001. The company’s $2.3 billion in retirement plan assets at the beginning of 2001 cratered $511 million last year due to big investment declines. What had been a $264 million over-funded plan reversed to $192 million under-funded last year. And that was a year in which the publisher employed an eye-popping 10% assumed rate of return on plan assets, one of the highest in corporate America.

As these experiences attest, investors are well advised to be mindful of defined-benefit plan return assumptions. Even though shareholders do not reap direct benefits from the income generated by pension plans, they feel it when performance targets are not met.

Companies do not tout their pension assumptions in press releases. Even corporate boards pay the matter little attention, as investor Buffett attested in a 2001 Fortune article: “I myself have been on 19 boards, and I’ve never heard a serious discussion of this subject.”

That’s all the more reason for individual shareholders to troll through SEC filings and the notes attached to the primary reports. Even so, the data is provided only once a year since the SEC doesn’t require quarterly updates.

While defined-benefit pension plans can provide employees a more predictable future than 401(k) plans, in today’s market they can resemble ticking bombs lodged inside companies’ financial statements. By looking out for pension managers who, in Buffett’s words, made their return assumptions “with all eyes looking backward at the glories of the 1990s,” investors might avoid a nasty surprise.
---Alexei Smirnov

Compensation Issues
A falling stock market and spectacular accounting scandals did nothing to hold back the seemingly inexorable rise in executive compensation in 2001. The buoyancy of CEO pay was even better demonstrated in Nashville than for the country as a whole.

Thanks to lucrative stock option grants, chief executives of 18 local publicly traded companies received average total compensation of $2.4 million last year (versus $7 million nationally), up from $1.5 million the year before, according to the recently compiled annual survey from Mercer Human Resource Consulting. By combing through public company annual reports, 10-K filings and proxy statements, the consultant also found that even the salary and bonus component of executive pay rose an average 9.2% here, while the average of 350 corporations nationally slipped 2.8%.

In 2001, the average CEO of a Nashville-based publicly traded company received a salary of $446,501, a bonus of $220,680, and long-term incentives of $1.8 million. These long-term incentives consist mostly of stock options, though 17% of local execs received restricted stock as well.

Only 30% of Nashville CEOs received a smaller bonus in 2001 than in 2000, versus 62% of CEOs nationwide whose bonuses shrank in 2001. Some of this resiliency no doubt stems from the fact that Middle Tennessee, with its relatively small technology community, missed much of the spirited increase in tech-related pay in the late 1990s and now is dodging the worst of the technology wipeout.

As figures from the Nashville Post public company report attest, more than two-thirds of Nashville-based public companies are enjoying larger per-share profits this year than the year before, and more than half have share prices above year-ago levels. Such strength in share prices has been a tempting inducement for many area executives who own large numbers of stock options.

In 2001, six execs realized gains in excess of $1 million upon the exercise of company stock options. Renal Care Group Chief Executive Sam Brooks realized gains of $12.7 million, while AmSurg development chief David Manning had gains of $3.7 million and Renal Care Group Chief Medical Officer Raymond Hakim took home $2.2 million. As Mercer notes however, attributing the gain from option exercises to a single year is a bit misleading since the value of options can derive from a period as long as 10 years.

The sample of 18 Nashville companies surveyed by Mercer had median revenues of $586 million. HCA was excluded again this year because of its considerably larger size.
---David A. Fox