L.S. Starrett (SCX), a company we have previously discussed as a potential value investment, recently returned to profitability having achieved sales and gross margin growth of 65% and 80% respectively in its fiscal fourth quarter. But despite the company's strong operating performance, the value of the company continued to fall. How can this be?
This occurs because not all company losses are shown on the income statement. Changes in the funded status (i.e. the difference between the pension plan's assets and the present value of what it owes) of a company's pension plan, for example, are not required to be immediately recognized as losses on the income statement. But to shareholders, a funding shortfall in a company pension plan is a very real liability that will have to be made up by future cash payments unless positive developments (e.g. strong returns from the plan's investments) occur that reduce the shortfall. But one cannot count on such positive developments!
For some companies, pension plan shortfalls are a drop in the bucket compared to the size of the company's operations. This is not the case with Starrett, as post-retirement plan shortfalls represent more than 1/3 of the company's market cap!
In order to properly estimate the intrinsic value of companies, shareholders should be sure to consider liabilities (such as pension shortfalls) that are not fully reflected on income statements. This requires subtracting funding shortfalls from company valuations based on their balance sheet values, or by following the progress of such shortfalls on the company's statement of comprehensive income.
Disclosure: Author has a long position in shares of SCX