A Citi Research investment report published March 10th suggests that improvement in the financial situation of pension funds of companies in the paper and forest products sector is leading to stronger balance sheets. Citi analysts Anthony Pettanari and William Mitchell furthermore suggest that improved balance sheets are likely to result in an increase in company share prices and more mergers and acquisition activities.

Improvements in pension funding

The Citi report highlights that almost all companies in the sector have significantly improved their pension funding over the last 12 months. Pension funding across all companies in the sector was up by a solid 12%, from 74% to 86%.

The analysts provide further details on pension funding in the report. “Pension assets grew 8% Y/Y on average for our producers while liabilities (PBO) fell 6%. Pension funding improved to 86% from 74% in 2012 & there are no producers below the critical 70% level, down from 3 companies LY. Looking at pension underfunding as a percent of market cap, RKT (12%), IP (10%) and BLL (7%) are the standouts, although IP’s funding improved $1.9 B ($4.30/sh) while RKT’s improved $490mm ($6.70/sh).”

Pension Funds

Decreasing contributions in 2014

The report also points out that the continuing improvement in pension funding means that companies can continue to decrease their contributions to pension funds. “…on average contributions were down ~30% Y/Y; only Ball Corporation (NYSE:BLL) & Avery Dennison Corp (NYSE:AVY)’s contributions were higher Y/Y.The largest declines were Rock-Tenn Company (NYSE:RKT) (- $179mm) & OI (- $115mm). 9 of 13 companies are planning to make smaller cash contributions in 2014vs. 2013 with the biggest declines at BLL (-$131 mm) & AVY (-$85mm).”

Pension Expense

Stronger balance sheets means more M&A

Pettanari and Mitchell also advance the argument that having more cash available for capital allocation is likely to mean more M&A activity. “Given the significant improvement in pension funding coupled with declining cash contributions & overall deleveraging (sector avg. 2.9x net debt/EBITDA vs. 3.2x LY), we think capital allocation will be a key driver of stock performance this year. Ball Corporation (NYSE:BLL)’s lower contributions will allow it to repurchase ~$500mm (~6% of shares) this year while Rock-Tenn Company (NYSE:RKT) & Graphic Packaging Holding Company (NYSE:GPK)’s funding improvement should allow the companies to pursue acquisitions in Paperboard.”