Data from Capital IQ
Other than 2009, Nucor Corporation (NYSE:NUE) has been profitable every single year of the past decade. The other two have seen their profitability plummet in the low-rate environment of the past few years. However, if rates were to rise, the glory days could return for these companies.
Pension funding in a nutshell
When you hear that a company has an “underfunded” pension plan, or is expected to have increased pension obligations going forward, what does that mean? Aren’t pension obligations predictable? Well, not really.
In general, employees contribute a certain amount of money out of their salary into a pension fund, and have a defined amount of money they can expect to receive, in perpetuity, after they retire. However, the pension benefits for the average worker are much higher that the dollar amount each worker contributes into the fund. Therefore, the company has two ways to make up the difference. They can either pay the difference out of their own pocket, or they can invest the pension contributions in order to grow the employee’s contributions enough to meet the eventual pension requirements (the more preferable option).
Why interest rates matter
Companies invest their pension funds (usually) in a low-risk portfolio of investment-grade corporate bonds. As interest rates fall, or remain at historically low levels like they have over the past few years, the higher the shortfall between the growth of the pension fund and the obligations the pension fund has to pay. When this happens (a shortfall), companies need to go into their own pockets to make up the difference.
Potential effect on profitability
As just one example, United States Steel Corporation (NYSE:X) told its shareholders that just a 1% rise in interest rates would reduce the company’s long-term total pension obligations of $11.3 billion by about $1.4 billion, a 12.4% reduction. It would also reduce the amount the company has to pay out of pocket by about $50 million annually. This would be a very big deal for a company of this size. U.S. Steel is projected to post a loss of $1.32 per share for fiscal year 2013, or a total loss of about $191 million.
In a more positive context, U.S. Steel is expected to post a profit of $0.98 per share according to the consensus; however given the recent spike in rates I think this estimate may be a little low. A 1% rise in interest rates would increase U.S. Steel’s profitability next year by more than 35%. The effect would be even more profound if the rise in rates is more than 1% (which is looking more and more probable).
The situation is the same for other companies as well. AK Steel Holding Corporation (NYSE:AKS) has estimated that for every 25 bps (0.25%) rise in interest rates, their total pension liabilities will fall by $75 million). AK Steel has other issues holding down their share price, such as higher materials and production costs than some of their bigger rivals, but having to pay less into their pension fund would certainly help.
Which to choose?
While Nucor Corporation (NYSE:NUE) is certainly the most stable and safe option, the other two stand to gain the most from a rising interest rate environment. Of the two, United States Steel Corporation (NYSE:X) is the safer option, and the effects of how much rates have risen already should be apparent on the company’s next quarterly report in late October. If you believe that the days of record low interest rates are soon to be behind us, the steel companies with pension issues may be worth a look now.
The article A Great Play on Rising Interest Rates originally appeared on Fool.com and is written by Matthew Frankel.
Matthew Frankel owns shares of AK Steel Holding (NYSE:AKS) and United States Steel (NYSE:X).. The Motley Fool recommends Nucor.
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