United Technologies Corporation (NYSE:UTX): How Pension Shift Will Drive EPS?

Pensions reversing course in 2014 will drive a cash/EPS benefit ahead for commercial aerospace sector. The pension shift will be most impactful to commercial names such as United Technologies Corporation (NYSE:UTX), Textron Inc. (NYSE:TXT), Triumph Group Inc (NYSE:TGI), and The Boeing Company (NYSE:BA).

2014 pension expense and funding should be trending in the right direction, assuming discount rates up 80 basis points (bps) since December 31, 2012 and plan returns will likely be well above the average 8 percent return on plan assets.

In most cases, the pension swing in commercial companies is not as significant as what we're seeing with the defense companies, but it will be a pleasant positive, according to Deutsche Bank analyst Myles Walton.

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Pension expense associated with defense contracting work is an allowable expense not dissimilar to other elements of a US defense company's cost structure. However, unlike most other cost elements, there is a material difference in the calculation of what pension expense is under government contracting regulations and both the funding requirements under the Pension Protection Act and the recognition of expense in GAAP.

In 2014, the discount rate used by the government to measure pension obligations (and as an input into allowable cost) will start to converge with the discount rate used for required funding.

Walton believes investors will pay for cash benefits from the turn in pension but will be less inclined to put a multiple on non-cash pension swings (unless required funding correspondingly falls).

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However, the good news for defense contractors is that the large swing in pension (2014-2017) will be driven by higher cash recoupment by the Department of Defense (DoD) contractors. In 2014, the DoD starts to fold market driven-discount rates into their modeling of pension obligations (25 percent in 2014, 50 percent in 2015, 75 percent in 2016 and 100 percent in 2017), which will drive up the government pension reimbursement by about 60 percent.

There have been some early grumblings at the DoD on the trajectory of pension expense (Jan 2013 GAO report and fiscal year 2014 National Defense Authorization Bill, Section 842). However, any changes would likely not be imparted until at least 18-24 months from now with a potential for implementation right around the time when CAS expense may be peaking.

Commercial aerospace companies on average trade at 17 times next twelve month EPS, which is 3 points higher than the 14 times the group traded at the start of 2012 and 2013. But, relative to the S&P 500, commercial aero stocks currently trade at just a 15 percent premium, versus 12 percent premium at the start of 2013 and a 20 percent premium at the beginning of 2012.

Walton says the multiple expansion relative to the overall market has not been that significant. In addition, the estimated 17 percent average earnings growth for commercial aerospace companies (followed by 13 percent average EPS growth in 2015), gives comfort that there's more equity value creation opportunity left in the group.