AT&T, Verizon pension funding issues to hurt bottom lines

The unfunded pension obligations of telecommunications giants AT&T Inc. and Verizon Communications Inc. could almost double by the end of 2011, potentially dropping the defined benefit plans below the mandated funded ratio of 80% and requiring large cash contributions in 2012.

When combined with other unfunded post-employment benefit obligations, the two companies separately have the highest unfunded liabilities of any in the Standard & Poor's 500 index, and combined represent 12% of the total unfunded liability of all companies in the index, according to a report by Bernstein Research, a unit of AllianceBernstein Holding LP, New York.

The report says that if capital markets don't improve, AT&T's 2011 unfunded pension liability will almost double to $12.5 billion from $6.3 billion in 2010, while Verizon's will increase to $6.6 billion, up from $3.4 billion.

When including other unfunded post-employment benefit obligations — such as health care — Bernstein Research estimates AT&T's liability for 2011 will jump 37.7% to $41.6 billion, up $11.4 billion from a year earlier. Verizon's liability is projected to increase 20.7% to $31.6 billion, up from $5.4 billion a year earlier.

The hit that AT&T and Verizon face is largely the result of the 2006 Pension Protection Act, which mandates that corporations make cash contributions to their defined benefit pension plans if the plan's funded ratio falls below 80%.

Some analysts say the obligations will hit the bottom line of AT&T, Verizon and other telecom companies, a setback that already is lowering the companies' target valuations in some cases.

Officials at AT&T, Dallas, and Verizon, New York, argue that their annual cash flows far exceed any annual pension or other post-employment benefit obligations and will carry them through a rough economy.

Craig Moffett, senior vice president and telecommunications, cable and satellite analyst at Bernstein Research, co-authored the report, “U.S. Telecom: Yes Virginia, Pensions Matter.” In a telephone interview, Mr. Moffett said the report is not “making a bold call that any of these companies are not going to be able to handle their pension obligations.” But he noted that “it's a glaring omission that investors too frequently ignore the pension obligations when they calculate valuations.”

The prospect of large cash contributions “is true of any company that has a large pension obligation,” Mr. Moffett said. “As it happens, they have the largest (pension and OPEB) obligations outside of the public sector and (General Motors Co.) — that's why it's particularly relevant,” he said.

As of Dec. 31, the close of AT&T's 2010 fiscal year, AT&T had a $6.3 billion unfunded liability for its U.S. and international defined benefit pension plans, making it the seventh largest unfunded pension liability of S&P 500 companies with defined benefit plans, according to Bloomberg data. Verizon's unfunded pension liability was the 15th largest at $3.4 billion.

As a result of the unfunded pension and OPEB obligations, Bernstein Research reduced its target price on the companies by $1 each, lowering AT&T to $30 and Verizon to $32. AT&T's rating was lowered to “market-perform” from “outperform,” while Verizon's “underperform” rating was unchanged, “based on its more limited dividend cushion and what we believe is a badly stretched valuation.”

Mr. Moffett said unfunded obligations should be treated as debt and considered when calculating a company's debt ratios.

AT&T stock was valued at $29.75 and Verizon at $37.62 as of the market close on Oct. 28.

Still, the Bernstein report was bullish on AT&T stock. “With strong dividend yield protection, we continue to see relatively limited downside risk in AT&T's shares,” the report noted. “For investors seeking exposure to the sector, and to the sector's attractive yields, we continue to strongly prefer AT&T, where valuations are neutral but not stretched.”

McCall Butler, an AT&T spokesman, said in an e-mail that the company generates more than enough cash to pay for its obligations. “We will make any decisions about potential pension funding at the end of the year, as we always do,” Mr. McCall said. “We anticipate that we can manage any pension funding with the cash flows that we are generating. In the third quarter, AT&T generated its best free cash flow (cash from operating activities minus capital expenditures) in two years, even with higher capital spending.”

Verizon spokesman Robert A. Varettoni, in a telephone interview, said the company generated a $34.4 billion cash flow in 2010 and contributed $400 million to the pension plan so farin 2011. “A lot of cash is generated by the business year in, year out,” he said. “That cash would help meet any funding obligations for our pension plan going forward.”

A Pensions & Investments analysis showed that among the six companies in the S&P 500 Telecom Services index that offer DB plans, Verizon was in the best position to address its unfunded pension obligations as a percentage of its annual cash flow.

Over the trailing four quarters of published quarterly financials, Verizon's unfunded U.S. and international pension liabilities represented 34.3% of the firm's free cash flow generated, whereas Frontier Communications Corp.'s was 38.8% of free cash flow; AT&T, 39.9%; Sprint Nextel Corp., 41.1%; CenturyLink Inc., 42.4%; and Windstream Corp., 46.3%.

Peter Rhamey, a managing director and telecom analyst at BMO Capital Markets, Toronto, a division of BMO Financial Group, said in a telephone interview that both AT&T and Verizon generate “a lot of free cash” and the cash funding requirement under the PPA, as a percentage of their cash flow, is relatively small.

He noted that “if current market conditions continue” for 15 years, the companies' valuations could eventually be hurt.

“Is the current interest rate environment an outlier or a permanent fixture of capital markets?” Mr. Rhamey asked.

Mr. Varettoni wrote in an e-mail that Verizon projects revenue growth of 4% to 8% and earnings growth of 5% to 8% in 2011. And with extreme market volatility, “it's impossible to predict with any level of accuracy what asset returns and discount rates will be on the last day of the year,” he said.

Mr. Moffett said his analysis aims to anticipate how much the companies will have to contribute to pensions and other obligations and how that will affect their bottom line.

“The irony here is that these (telecom) stocks tend to perform the best when the market gets defensive,” he said. “Investors flock to their dividend yields and their relative safe haven status. The irony is that it's precisely that set of characteristics that does the most damage — low interest rates and a bear market — to their pension obligations.”

Michael G. Nelson, a telecom analyst with Mizuho Securities USA Inc., New York, said he has given both AT&T and Verizon favorable outlooks because of the companies' significant cash flows and potential for growth.

“Both companies have consistently increased their dividend payments to shareholders and I would expect that to continue,” he said.

Mr. Nelson added, however, that large unfunded pension obligations will hit the companies' bottom line. “If they use that capital to fund the pension, there is a cost associated with the lost opportunity since they could be using that capital elsewhere,” he said.