Pension and Post Retirement Obligations:
Do your homework

Before you purchase that large cap stock you are interested in, do yourself a favor: delve into the readily available information regarding that companies defined benefit pension, and post retirement healthcare obligations (if applicable). For some companies, this will not change your mind, or reveal any red flags. But for others, this may(should) be the factor that scares you away from becoming an owner.

Three weeks ago, my brother in-law and I were talking about General Motors, a company near and dear to our hearts if only because three of our combined four grandfathers worked there. He remarked that his grandmother, who had never been a GM employee, received post-retirement benefits from the automaker for many years longer than her husband had actually worked for the company; not an uncommon situation these days, the result of which is bringing with it costly consequences.

Companies which have defined benefit pension and post-retirement healthcare plans made commitments to their retirees. Whether based on years of service, or other factors, these employees were promised benefits (in some cases) for life. Now, through a combination of factors which include increased life expectancy, more costly healthcare, lackluster investment returns, and challenging business conditions (among others), some companies are feeling the squeeze. Ultimately, as a shareholder, you will suffer too if companies you own need to cough up additional funds to support these plans.

Doing your homework
There is a great deal of information available to investors these days in order to assess these situations. In fact, disclosure of pension/post retirement assets, liabilities, funded status (whether the company has enough pension assets to meet liabilities, (the buzzwords are ”overfunded” or “underfunded”), assumptions about what the company believes the return on plan assets will be, as well as a current breakdown of how the money is allocated, is required by the SEC. You can find all this information, and much more, in company’s 10K(annual) filings. ( There is some data also available in the 10Q (quarterly) filings, but it is typically not as detailed.)

General Motors
Suffice it to say, that GM’s pension and postretirement liabilities are of mammoth proportions. The company lists three separate categories of obligations (all listed in the 10K): US Pensions Benefits, Non-US Pension Benefits, and Other Benefits(post-retirement healthcare).

Benefit Obligations
As of 12/31/04, GM calculated the following as the current obligation for each plan. This is often referred to as the Projected Benefit Obligation, or PBO, and represents the present value (PV) of benefits owed, for service performed in the past.
US Plan: $89.384 billion
Non US Plan: $18.056 billion
Other Benefits: $77.474 billion
While these amounts may seem staggering, they need to be taken in context. GM does have invested assets in each plan to meet liabilities, but it’s the comparison of the plan assets and benefit obligation which is meaningful.

Fair Value of Plan Assets
This represents the amount of invested assets in each plan, which is used to meet plan liabilities.
US Plan: $90.866 billion
Non US Plan: $9.023 billion
Other Benefits: $16.016 billion

Funded Status
Here is where the rubber meets (or doesn’t) the road. This is calculated by subtracting the Fair Value of Plan Assets from the Benefit Obligation. A negative number means the plan is under-funded, while positive means that its over-funded.
US Plan: $1.502 billion (over-funded)
Non US Plan: ($9.033) billion (under-funded)
Other Benefits: ($61.458) billion (way under-funded)

While the US Plan looks healthy due to the fact that it’s over-funded, it’s downhill from there. The Non US plan is significantly under-funded relative to the size of plan assets, and the Other Benefits category—in this case post-retirement healthcare—is simply in deep trouble.

General Motors must make up the difference over time—remember, the company made a promise to its retirees. The question is not whether the company can meet these obligations, but rather at whose expense. This should raise significant concerns to current and prospective shareholders, who will be footing the bill.

Health care for retirees and current employees are substantial to the point that they allegedly add more than $1500 to the cost of each vehicle produced! This at a time when GM’s market share has been dropping.

Optimistic Expectations
Perhaps the most alarming aspect of GM’s situation is the company’s own expectations for the three plans investment returns. (Expected Return On Plan Assets, 2004)
US Plan: 9.0%
Non US Plan: 8.4%
Other Benefits: 8.0%

While these projected returns seem achievable on the surface, in the context of GM’s asset allocation strategies, they are overly optimistic, at best. Typical disclosure of defined benefit asset allocations includes the past three years return assumptions, along with a breakdown of investments by Equity, Debt, Real Estate, and Other. Some companies provide more detail.

GM’s Asset Allocations/b>
US Plan:
Equity: 47%
Debt: 35%
Real Estate: 8%
Other: 10%

Non US Plan:
Equity: 61%
Debt: 31%
Real Estate: 8%
Other: 0%

Other Benefits:
Equity: 41%
Debt: 48%
Real Estate: 2%
Other: 9%

Keep in mind, I have no argument with the companies asset allocations, per se. I believe they have made efforts to build better risk adjusted portfolios, and in some cases have reduced plan return expectations over the years. For instance the US Plan’s expected return is down from 2002's 10 percent, while the same for the Non US plan is down from 8.8 percent in 2002, and 8.5 percent in 2003. However, GM raised the expected return for Other Benefits from 7 percent in 2003 to 8 percent in 2004, and that’s where the trouble is.

The question is, whether its conceivable that GM’s plans can achieve the expected returns given the respective asset allocation? Can the “Other Benefits” plan realistically expect to return 8 percent with 48% of the portfolio in fixed income securities? (We are assuming that the expected return for 2005 is the same as 2004, the 2005 expected return has not yet been disclosed) An 8 percent return on a portfolio which has half it's assets in fixed income securities, given a rising interest rate environment?

Here at Cheap Stocks, we believe it will be difficult for GM to meet the expected return figure, making an already bad situation--a severely under-funded post retirement healthcare plan--even worse. GM needs to change the asset allocation, lower the expected return, or both.

We are not picking on General Motors, its simply an example. There are many other companies with pension issues. However, we are concerned about the company's future. Besides a looming pension-postretirement crisis, the companies market share is falling. They are slashing prices by offering everyone the employee discount. Surely, they will move inventory with this plan, but will lose money in the process. Several years of 0 percent financing also come with a cost, especially as rates rise. The company is also struggling to come to terms with the unions on health insurance cuts for current employees. Stay tuned

We hope you will perform similar analysis on other companies of interest that have defined benefit plans. We'll consider doing more analysis on the subject.

Postscript
Despite the negative tone of this piece, your author has a soft spot for the company. My grandfather Clyde worked for General Motors for 38 years, until 1975. During World War II, his plant in Ewing, New Jersey was transformed into an airplane manufacturing plant--they built the Avenger there, the same plane George H. W. Bush was shot down in. They, like many others, were part of the Greatest Generation, contributing to a common cause, one which helped win our freedom. Here's to you, Clyde, happy 98th birthday. We miss you dearly.

CHEAP STOCKS
Semi-Annual Review

We thought it would be interesting to take a look back at all the companies we’ve issued reports on since this site was re-launched in late fall 2004, to see how they have performed....warts and all. (See archives for company reports)

Company Ticker Report Date Report Price Current Inc(Dec)
Duckwall Alico (DUCK) 12/5/04 17.00 20.97 19%

GIII Apparel (GIII) 12/10/04 6.30 8.37 30%

Avoca Inc (AVOA) 12/22/04 2760.00 4125.00 62%

St. Joe’s (JOE) 12/29/04 63.85 82.04 29%

JG Boswell (BWEL) 01/08/05 600.00 640.00 8%

PICO Holdings (PICO) 01/25/05 20.95 27.75 33%

Hanover Foods (HNFSA) 02/22/05 90.50 118.00 31%

Tootsie Roll (TR) 01/28/05 30.99 31.03 2%

Tejon Ranch (TRC) 02/15/05 46.81 53.07 13%

Discovery Partners (DPII) 03/17/05 3.36 3.02 -11%

Nu Horizons Electric (NUHC) 03/30/05 7.03 6.40 -9%

Inforte (INFT) 04/23/05 3.33 3.53 6%

Zapata (ZAP) 05/11/05 8.42 6.20 -26%

Silverleaf Resorts (SVLF) 06/03/05 1.30 1.46 12%

Average Holding Period Return: 14.21%

The return figures presented are not scientific, they are merely the holding period returns per company; they are not annualized. One thing you will notice is that all of the companies with negative returns are from research issued within the past three months. This brings to mind one of the most important points when it comes to investing in the type of securities we follow here at Cheap Stocks: Your time horizon cannot be short. Patience is the name of the game. That does not mean that you should hold onto a losing position forever in the face of deteriorating financials or conditions. Patience should not give way to irresponsibility.

Furthermore, if you believe in the NCAV philosophy, or the other deep value concepts we’ve written about, it’s very important that you not invest too much in any given name. Consider building a portfolio of companies over time. Diversification is still a prudent concept, even in our Cheap Stocks realm.

Companies are often “cheap” for good reason. Our mission here is to identify those that we believe are undervalued, and overlooked. We won’t always be right. Thanks for reading.

**The author has positions in the following stocks mentioned in this report: TR, TRC, JOE, BWEL, AVOA, PICO, ZAP. This is neither a recommendation to buy or sell this security. All information provided believed to be reliable and presented for information purposes only.

Company Update:
Avoca Inc: AVOA
Price: $4150/$5000
Current Yield: 8.43%
Shares Out: 8,057 (actual)
Market Cap: $33.4 million

Avid CHEAP STOCKS readers may recall our piece on Avoca Inc, a tiny New Orleans based company which owns 16,000 acre Avoca Island. Our 12/20/04 report Off The Beaten Path:Micro-Cap Value Strategy
Going Private: Getting Around Filing with the SEC and Avoiding Sarbanes- Oxley in the Process referred to this royalty trust, and the company's decision to initiate a reverse stock split, in order to reduce shareholder roles, and avoid filing with the SEC. Your editor went onto explain his rationale for buying a pre-split stake in this seldom traded company.

Fast forward 6 months and I am still holding Avoca. The bid ask has risen to 4150/5000, and that excludes the $350 dividend mentioned in the original report....no gloating here, mind you, this is a tiny company, which rarely trades. If I wanted to sell tomorrow, I'd have trouble finding a buyer. But still, I like this company, which derives most of it's revenue from gas leases.

My point in revisiting Avoca is because of the company's first quarter financial statements that I received in the mail last week. Hats off to Avoca. Remember, they no longer have to file with the SEC, and don't have to send shareholder's reports either. Now if only JG Boswell (ticker BWEL) would afford me, a shareholder, the same luxury. JG Boswell, which now trades at $640 per share, is a $500 million company. It is not required to file either, but getting information as a shareholder is next to impossible. But, thats my problem. I knew what I was buying into.


In case you are wondering about Avoca's results, the company generated $1.09 million in revenue, and had net income of $680 thousand, or $84.46 per share in the first quarter, down from $1.29 million, $771 thousand, and $95.63 for the same quarter last year. The shortfall was due primarily to a major gas well being offline from December until May(31 percent decrease in production). An increase in gas prices (33 percent)helped close the gap. You editor is hanging on to this one.

Silverleaf(SVLF): Part II

First of all, let’s get one thing straight. We here at Cheap Stocks are not seers, we can’t see into the future, and we don’t believe in short-term trading (or maybe we’re just not good at it). The fact that Silverleaf is up 13 percent (to $1.50) since last weeks report is a coincidence. Now that we have that out of the way, here is Part II of last weeks report.

Recent Events
• In June, 2004, the company exchanged nearly $25 million of its 6% senior subordinated debt maturing in 2007, for the same amount of 8% senior subordinated debt due in 2010, and a cash payment of $271 thousand. Conceivably, this buys the company some time to get its house in order, but if it does not, it simply delays bankruptcy.
• In July 2004, the company purchased 500 acres of land on route 7 in Berkshire County, Massachusetts. This land was formerly the Brodie Mountain ski resort, and is within 25 miles of the company’s Oak N’Spruce resort in South Lee Mass. The company estimated future development of the site would allow for up to 324 units, or the equivalent of 16,848 one-week vacations.
• Restructured loan facility in July, 2004, reducing amount from $35 million to $25 million, while extending due date to March, 2009. In same transaction, paid off $5.4 million term loan, and added $10 million revolving loan.
• In October 2004, acquired 48 two and three bedroom units on 4.8 acres in Davenport, Florida, (near Orlando, Disney World) for $6 million. Received approval from the state to sell 16 of those units.
• In March, 2005, sold the water distribution rights and waste water treatment facilities for eight of their resorts for $13.2 million.
The company has obviously been very aggressive in its efforts to restructure debt, divest of some assets, while attempting to further the core business.

The NCAV Story (in millions)
Current Assets: $324.8
Current Liabilities:$11.5
Long Term Liabilities: $230
NCAV: 83.3
Market Cap: 55
NCAV/Mkt cap:1.5x

Balance Sheet Quality
While the company currently has $8.3 million in cash, the bulk of current assets is comprised of accounts receivable ($194 million) and inventory ($113 million). On the liability, side notes payable ($195 million) and Senior subordinated notes ($35 million) represent the majority. This is not a great balance sheet. In fact, in some respects, its downright scary. Why? As we’ve stated before, we prefer current assets of NCAV companies to have relatively large components of cash, and to be a little lighter on the receivable and inventory side. Receivables need to be collected in order to have true value, and inventories need to be sold. There are no guarantees either of this can be done, so we discount the stated value. On the liability side, the company is carrying a lot of debt, and as well all know, debt eventually needs to be repaid. One interesting feature of Silverleaf’s debt, however is that is “backed” by receivables from customers.

That’s right, the company offers financing to buyers of its timeshares. As of 12/31/04, the company held promissory notes from more than 34,000 customers, in the principal amount of $250 million. That portfolio of notes had an average yield of 15.1 percent, and a weighted average cost of 6.8 percent. Hence, the company makes money by borrowing money, then loaning it to customers. In 2004, the company generated $37.8 million in interest income and $17.6 million in interest expense. The company essentially backs its loans with receivables from customers. This can be risky business. Despite the fact that there is a large spread between what the company pays its lenders, and what it’s customers pay the company in terms of interest rates, this situation can go awry. Lenders have covenants on loans that companies must adhere to, and loans to customers are virtually worthless if customers can’t or won’t pay.

In 2004, the company had an allowance for doubtful accounts of 21.1 percent of the amount receivable (up from 20 percent in 2003). Essentially, that means the company expects to collect only 4 out 5 dollars it loans to customers. There is a lot of risk here, much of it driven by the fact that Silverleaf does not verify customer credit history. This explains why the average yield on the portfolio notes is 15.1 percent.

Off Balance Sheet
Silverleaf also has a wholly owned, off balance sheet subsidiary Silverleaf Finance, which had notes receivable of $84.5 million at year end 2004.

Conclusions
No doubt there is a great deal of risk here. Silverleaf is highly leveraged, and dependent on the ability to keep its lenders happy, while collecting loan payments from customers who may have terrible credit. On the positive side, the company has taken strides improve its balance sheet by restructuring debt, continues to build its core business through the acquisition of additional properties, and has been profitable for five straight quarters. First quarter 2005 sales were up 30 percent to $42.1 million from the same quarter last year, while net income was up slightly to $2.52 million from $2.34 million. I would caution readers to read the company’s most recent 10K and 10Q reports before buying shares in this company. We at Cheap Stocks are cautious on this one, but intrigued just the same. We’ll continue to follow this story.

Trading Below Net Current Asset Value, and real estate related? A CHEAP STOCKS Dream (Or Nightmare)?
Part I of II
Silverleaf Resorts
Ticker: SVLF
Price: $1.30
Market Cap: $48 million
Average Daily Volume: 52000
P/E: 4
NCAV: $77.2 million

It sounds too good to be true. A company trading below its net current asset value, with real estate exposure. Avid readers of our research know from past postings that if there’s one thing we like better than NCAV companies, it’s companies with exposure to land. Here at Cheap Stocks, we were excited upon discovering this tiny timeshare developer. But the more research we did, the more wary we became. Caution is the name of the game with this company we decided….But isn’t it always with NCAV companies?
Silverleaf, a Dallas Texas based company, owns 12 timeshare resorts in Texas, Missouri, Illionos, Georgia, Massachusetts, and Florida. This company has seen it’s share of tough times in recent years; at one point, it had more than 20 timeshare resorts.(More on that later)

For an overview of the company, the following is taken directly from the company’s 2004 10K report:

The principal business of Silverleaf Resorts, Inc. (“Silverleaf,” the “Company,” or “we”) is the development, marketing, and operation of “drive-to” and “destination” timeshare resorts. As of December 31, 2004, we own eight “drive-to resorts” in Texas, Missouri, Illinois, and Georgia (the “Drive-to Resorts”). We also own four “destination resorts” in Texas, Missouri, and Massachusetts (the “Destination Resorts”). In February 2005, we obtained approval to operate a fifth destination resort in Florida, which was acquired in October 2004. Also in 2005, we reclassified one of our Drive-to Resorts in Texas to a Destination Resort.
The Drive-to Resorts are designed to appeal to vacationers seeking comfortable and affordable accommodations in locations convenient to their residences and are located near major metropolitan areas. Our Drive-to Resorts are located close to principal market areas to facilitate more frequent “short-stay” getaways. We believe such short-stay getaways are growing in popularity as a vacation trend. Our Destination Resorts are located in or near areas with national tourist appeal and offer our customers the opportunity to upgrade into a more upscale resort area as their lifestyles and travel budgets permit. Both the Drive-to Resorts and the Destination Resorts (collectively, the “Existing Resorts”) provide a quiet, relaxing vacation environment. We believe our resorts offer our customers an economical alternative to commercial vacation lodging. The average price for an annual one-week vacation ownership (“Vacation Interval”) for a two-bedroom unit at the Existing Resorts was $9,671 for 2004 and $9,510 for 2003.
Owners of Silverleaf Vacation Intervals at the Existing Resorts (“Silverleaf Owners”) enjoy certain distinct benefits. These benefits include (i) use of vacant lodging facilities at the Existing Resorts through our “Bonus Time” Program; (ii) year-round access to the Existing Resorts’ non-lodging amenities such as fishing, boating, horseback riding, tennis, or golf on a daily basis for little or no additional charge; and (iii) the right to exchange a Vacation Interval for a different time period at a different Existing Resort through our internal exchange program. These benefits are subject to availability and other limitations. Most Silverleaf Owners may also enroll in the Vacation Interval exchange network operated by Resort Condominiums International (“RCI”). Our new destination resort in Florida is not under contract with RCI; however it is under contract with Interval International, Inc., a competitor of RCI.

Silverleaf traded as high as $29 1/8 back in 1998, but has since fallen on hard times. In 2000, losses started mounting, and the company’s credit rating was slashed. In 2001 the company cut back sales and marketing efforts, and had to negotiate extensions of its credit facilities. Amid a cash crunch, there were doubts that the company could continue as a going concern. In June 2001, Silverleaf's common stock was delisted from the NYSE and it began trading on the OTC market. In May, 2002, the company exchanged nearly $57 million of its 10 ½ percent senior subordinated notes for $28.5 million in 6 percent senior subordinated notes, and 65 percent of the company’s outstanding stock. Clearly, a company in deep trouble. In May, 2004 Silverleaf was off the OTC, and onto the OTC Bulletin Board. This does not sound like a great story; sounds more like a company on the road to bankruptcy.

Fast forward to 2005, and Silverleaf is showing signs of life, having turned a profit for 5 straight quarters (note the current P/E ratio of 4). Silverleaf has shed some assets, but picked up some new ones as well (mainly land). Stay tuned for Part II of this report which we’ll run next week. We'll explore some of the more recent events, go into detail about the risks inherrent in this company, as well as get into the NCAV components and calculation.

*The author does not have a position in this stock. This is neither a recommendation to buy or sell this security. All information provided believed to be reliable and presented for information purposes only.