2005 Financial Review
MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION
RESULTS OF OPERATIONS
Retained Liabilities and Assets of Former Operations
Executive Overview
The Company retains obligations which arose primarily as the result of its long history of operating in the coal industry. Since these obligations require significant annual cash outflows and the recording of significant annual expenses, management believes it is important to closely monitor and manage these obligations and address the related financial effects.
Of the various obligations, several have shorter terms and lesser values (reclamation, advance minimum royalties, workers’ compensation and the multi-employer pension plan withdrawal liability). The Company expects the cash payments for these obligations to be concentrated over the next few years and then end or decline significantly.
The other three obligations (retiree medical benefit plan, Health Benefit Act and Black Lung) have longer terms and have higher estimated costs. Payments associated with each liability are projected to be made over the next 60 years or more. Each liability is largely medical benefits-related, so medical inflation is an important consideration. Each obligation covers a pool of individuals that is essentially capped since the Company no longer operates within the coal industry. Further, such individuals are, for the most part, above or near normal retirement age. Accordingly, these obligations should see a steady decrease in number of participants and beneficiaries over time. The only exception to this expected decrease is the potential exposure to an increased share of the unassigned obligation under the Health Benefit Act.
The net present value of these obligations is a valuable tool for assessing their fair value as of a point in time. However, such values will fluctuate over time solely due to changes in market interest rates. The critical factor in evaluating each obligation is the cash flow needed to satisfy it.
The Company employs a team of employees, along with third parties, to monitor and control these liabilities with a primary goal of reducing future cash outflows. The primary activities of this group are to verify eligibility of participants, design and implement plans that provide the required benefits at the lowest cost, and verify costs charged to the plans.
The Company has established a VEBA to help manage the financial impact of the retiree medical benefit plan obligation. The VEBA is used as a tax-efficient way to fund this obligation. A funded VEBA would help insulate the Company’s assets, and eventually its cash flow, from the obligations. The Company contributed $225 million to the VEBA on January 31, 2006, bringing its fair market value at that time to over $400 million.
Legacy Liabilities and Assets
The Company refers to its various long-term liabilities and assets related to its former operations as its “legacy” liabilities and assets. Some of the Company’s legacy liabilities and assets are not fully recorded on the balance sheet because part of the losses have been deferred in accordance with GAAP. In addition, under GAAP, some of these liabilities are discounted to reflect a present value, while others are not.
To facilitate an understanding of the total estimated present value of these liabilities and assets as of December 31, 2005, the following table presents a Company-defined amount, a “Legacy Value,” for the Company’s legacy liabilities and assets. Some of the Legacy Values are considered non-GAAP measures because they exclude GAAP deferred loss adjustments, or reflect discounts to a present value for liabilities with extended payment dates that are not recorded at present value under GAAP. The table reconciles each non-GAAP Legacy Value to its GAAP counterpart.
The liabilities and assets in the table are based on a variety of estimates, including actuarial assumptions, as described in the Application of Critical Accounting Policies and in the notes to the consolidated financial statements. These estimated liabilities and assets will change in the future to reflect payments made, investment returns, annual actuarial revaluations, periodic revaluations of reclamation liabilities and other changes in estimates. Actual amounts could differ materially from the estimated amounts.
Summary of Legacy Liabilities and Assets
| December 31, 2005 | |||||
| (In millions) | Legacy Value | Add Back Present-Value Effect |
Amounts Not Yet Recognized Under GAAP |
GAAP Amount | |
| Legacy liabilities: | |||||
| Company-sponsored retiree medical (a): | |||||
| Before Medicare subsidy and VEBA | $ | 695.2 | - | (366.2) | 329.0 |
| Medicare subsidy value | (62.2) | - | 50.3 | (11.9) | |
| VEBA | (185.3) | - | (2.2) | (187.5) | |
| Company-sponsored retiree medical | 447.7 | - | (318.1) | 129.6 | |
| Health Benefit Act (b) | 102.1 | 72.8 | - | 174.9 | |
| Black lung (c) | 51.7 | - | (12.2) | 39.5 | |
| Multi-employer pension plans withdrawal liability (d) | 30.5 | - | - | 30.5 | |
| Workers’ compensation | 26.0 | - | - | 26.0 | |
| Advance minimum royalties | 8.6 | - | - | 8.6 | |
| Reclamation | 5.6 | - | - | 5.6 | |
| Legacy liabilities | $ | 672.2 | 72.8 | (330.3) | 414.7 |
| Legacy assets: | |||||
| Other assets (e) | $ | 15.5 | - | - | 15.5 |
| Deferred tax assets (f) | 257.0 | 25.5 | (133.2) | 149.3 | |
- (a)
- Company-sponsored retiree medical liabilities are accounted for in accordance with Statement of Financial Accounting Standards (“SFAS”) 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.” SFAS 106 requires a liability be recorded for the present value of future obligations; however, under the provisions of SFAS 106, actuarial gains and losses are deferred. Actuarial gains and losses occur when actual events differ from assumptions (for example, when the actual health care inflation rate differs from the assumed inflation rate or when the actual return on investments is different than the estimated return) or when changes are made to assumptions used to estimate the liability, including the discount rate used to compute the present value (5.50% at December 31, 2005), expected health care inflation rates, expected life expectancy rates, asset returns and the effect of the Medicare subsidy. Actuarial gains and losses are not immediately recognized in earnings because SFAS 106 allows employers to defer these gains and losses and then amortize these gains and losses into earnings in future periods if the total unrecognized net gains and losses exceed 10% of the greater of the accumulated postretirement benefit obligation or plan assets as of the beginning of the year. As a result, the Company’s balance sheet does not reflect these liabilities at the full present value of the ultimate projected obligations at the end of the year. The Legacy Value in the table reflects the Company’s liability had the Company’s total projected obligations been fully accrued at the end of the year. The Company discloses the projected amount of its obligation before the deferral of unrecognized gains and losses as “funded status” in note 4 to the consolidated financial statements.
- In December 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”) was signed into law. The Act provides for the payment of subsidies to sponsors of retiree medical benefit plans for a portion of pharmaceutical expenses as long as the plan meets requirements of the Act. The $62.2 million Legacy Value in the table above reflects an estimate of the current value of such payments over the life of the plan.
- (b)
- Health Benefit Act liabilities are accounted for in accordance with EITF 92-13, “Accounting for Estimated Payments in Connection with the Coal Industry Retiree Health Benefit Act of 1992” and, accordingly, the Company has accrued the undiscounted estimate of its projected obligation. The Company uses various assumptions to estimate its liability to The United Mine Workers of America (“UMWA”) Combined Fund (the “Combined Fund”) for future annual premiums, including the number of assigned and unassigned beneficiaries in future periods, medical inflation, and the amount of funding of the Combined Fund premiums to be provided from the Abandoned Mine Reclamation Fund in future periods. The estimated annual payments are expected to gradually decline over time as the beneficiary population declines, and the Company expects payments will be made over the next 60 to 70 years. To determine the Legacy Value of these assets, the Company’s actuaries discounted the estimated future cash flows to a present value amount using a discount rate of 5.50%. The Company’s estimates of annual payments may change materially due to changes in future assumptions. Changes to the 1992 law under which benefits are paid also could materially affect the Company’s estimate of its liability. The estimation of the Legacy Value should not be considered a precise estimate because of the many variables that have been used to determine the estimate, including the discount rate and the amount of expected annual cash flows. There are many factors that may change and cause the amount recorded in the balance sheet to not be representative of the amount the Company may actually pay.
- (c)
- Black lung liabilities are accounted for in accordance with SFAS 106. Actuarial gains and losses resulting from changes in estimates of the Company’s black lung obligations are deferred and amortized into earnings in future periods. As a result, the Company’s balance sheet does not reflect these liabilities as if the projected obligation had been fully accrued at the end of the year. The Legacy Value in the table reflects the Company’s projected obligations had it been fully accrued at the end of the year. Of the Company’s $51.7 million of present value of self-insured black lung benefit obligations at December 31, 2005, approximately $39.5 million had been recognized on the balance sheet, with the difference relating to deferred unrecognized actuarial losses. See note 4 to the consolidated financial statements for further information.
- (d)
- Multi-employer pension plan withdrawal liabilities are accounted for in accordance with SFAS 5, “Accounting for Contingencies.” The Company withdrew from the UMWA 1950 and 1974 pension plans in June 2005 as the last employees working under UMWA labor agreements left the Company. As a result of the withdrawal from these coal-related plans, the Company expects to be obligated to pay the plans $30.5 million, which represents the Company’s portion of the unfunded status of the plans as of June 30, 2004, as determined by the plan agreements and by law.
- (e)
- “Other Assets” in the table is primarily a receivable from the state of Virginia related to tax benefits earned because of coal produced in prior years. The Company expects to receive approximately $10 million in 2006, $3 million in 2007 and $1 million in each of 2008 and 2009.
- (f)
- The Company has not yet taken deductions in its tax returns for most of the retained liabilities associated with the former coal business, and has recorded a deferred tax asset for this future benefit for these temporary differences in book and tax bases. The Company’s deferred tax benefit on a Legacy Value basis is different from its GAAP counterpart because the Company’s temporary differences were based on the Legacy Values of the various coal-related liabilities and assets. In other words, if the Company had recorded the higher net Legacy Value of the liabilities on its balance sheet, it would have also recognized a larger deferred tax asset. The $133.2 million reconciling item represents the additional hypothetical tax benefit related to the Company-sponsored retiree medical and black lung obligations. The $25.5 million reconciling item represents the associated decrease to the deferred tax asset if the Health Benefit Act liability were recorded on a discounted basis.
Under the Health Benefit Act, the Company and various subsidiaries are jointly and severally liable for approximately $416 million, at Legacy Value, of postretirement medical and Health Benefit Act obligations in the above table. The purchasers of the Company’s BAX Global and natural resources assets have been indemnified by the Company for the related contingent liability.
Projected Payments and Expenses of Retained Retiree Liabilities and Administrative Costs
The following tables include the actual cash payments and expense (continuing operations only) related to the Company’s liabilities from former operations for 2003, 2004 and 2005 and as projected for the next five years.
The projected payments and expenses are estimated based on the same assumptions used in determining the estimated Legacy Value and GAAP counterparts at December 31, 2005. The actual amount of payments and expense in future periods may be materially different than amounts presented. The amounts paid or expensed in the future depends on many factors, including inflation in health care and other costs, the ultimate impact of the 2003 Medicare reform bill, discount rates the market value of postretirement benefit plan assets, the level of contributions to and the performance of the VEBA, the number of participants in various benefit programs, the amount of Combined Fund premiums for unassigned beneficiaries funded by the AML, and the level of administrative costs needed to manage the retained liabilities.
Cash Payments
| (In millions) | Actual Payments | Projected Payments | |||||||||
| Years Ending December 31, | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | |||
| Postretirement benefits other than pensions: | |||||||||||
| Company-sponsored medical plans (a): | |||||||||||
| Before Medicare subsidy | $ | 30 | 35 | 36 | $ | 42 | 45 | 47 | 50 | 51 | |
| Estimated effect of Medicare subsidy | - | - | - | (2) | (3) | (3) | (4) | (3) | |||
| Benefit payments made from VEBA (b) | - | - | - | - | - | - | - | - | |||
| Subtotal | 30 | 35 | 36 | 40 | 42 | 44 | 46 | 48 | |||
| Health Benefit Act | 8 | 9 | 8 | 9 | 12 | 11 | 11 | 10 | |||
| Black lung | 8 | 7 | 6 | 5 | 5 | 5 | 5 | 4 | |||
| Withdrawal liability | - | - | - | 31 | - | - | - | - | |||
| Workers’ compensation | 8 | 5 | 5 | 4 | 3 | 3 | 2 | 2 | |||
| Advance minimum royalties | 1 | 1 | 1 | 1 | 1 | 1 | 1 | 1 | |||
| Reclamation and inactive mine costs | 5 | 3 | 5 | 2 | 1 | 1 | 1 | 1 | |||
| Administration and other | 18 | 8 | 5 | 5 | 5 | 4 | 4 | 4 | |||
| Cash proceeds and receipts | (3) | (6) | (2) | - | - | - | - | - | |||
| Total | $ | 75 | 62 | 64 | $ | 97 | 69 | 69 | 70 | 70 | |
| VEBA contributions (a) | $ | 82 | 50 | - | $ | 225 | - | - | - | - | |
- (a)
- The Company has contributed cash to a VEBA to be used to make future payments of the Company’s retiree medical plans, including a contribution of $225 million in January 2006. The Company re-evaluates its contribution policy annually and is not obligated to fund the VEBA. The Company may elect at any time to use either these assets or its cash from operations to pay benefits for its retiree medical plans.
- (b)
- Assumes benefit payments are not made from VEBA.
Expenses in Continuing Operations
| (In millions) | Actual Expense | Projected Expense | |||||||||
| Years Ending December 31, | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | |||
| Postretirement benefits other than pensions: | |||||||||||
| Company-sponsored medical plans (a): | |||||||||||
| Before Medicare subsidy and VEBA | $ | 50 | 52 | 54 | $ | 58 | 58 | 57 | 56 | 55 | |
| Estimated effect of Medicare subsidy | - | (6) | (6) | (7) | (7) | (7) | (7) | (7) | |||
| Estimated investment income in VEBA (a) | - | (9) | (13) | (34) | (39) | (42) | (46) | (50) | |||
| Subtotal | 50 | 37 | 35 | 17 | 12 | 8 | 3 | (2) | |||
| Black lung | 6 | 5 | 4 | 4 | 4 | 3 | 3 | 3 | |||
| Pension (b) | (1) | 2 | 5 | 3 | 1 | (3) | (5) | (7) | |||
| Administrative, legal and other coal expenses, net | 18 | 9 | 7 | 6 | 6 | 5 | 5 | 5 | |||
| Other income, net | (3) | (7) | (12) | - | - | - | - | - | |||
| Total | $ | 70 | 46 | 39 | $ | 30 | 23 | 13 | 6 | (1) | |
- (a)
- Beginning in 2004, the Company accounted for the VEBA as a plan asset of Company-sponsored medical plans in accordance with SFAS 106 and has recognized a lower amount of amortization of previously unrecognized losses due to the effects of the 2003 medical subsidy legislation. The above projection includes the contribution of $225 million to the VEBA in January 2006 but assumes that there will be no further contributions made to the VEBA. To the extent contributions are made, projected investment income will be increased to reflect the long-term rate of return on such contributions.
- (b)
- Includes U.S. pension costs (credits) for BAX Global in the projection period. The above projection does not assume that any pension contributions will be made. If voluntary or required contributions are made, projected expenses from that year forward would be reduced by the expected long-term return on those contributions.
Following are comments covering the more significant legacy liabilities in the above tables. For additional information, please see note 4 to the consolidated financial statements. Each of these liabilities and assets is affected by estimates and judgments. More information is available at “Application of Critical Accounting Policies” later in Management’s Discussion and Analysis.
Company-Sponsored Retiree Medical Benefits Obligations and VEBA
The Company provides postretirement health care benefits to eligible former coal miners and their dependents. With the assistance of actuaries, the Company annually reevaluates the estimated future cash flows, expenses and current values of the obligations. Projected payments are expected to increase each year for the next five years as a result of medical inflation and as eligible participants attain retirement age. This increase will be partially offset by reductions in the number of participants through mortality.
The Legacy Value, which equals the funded status at December 31, 2005, increased to $448 million from $445 million at December 31, 2004 primarily due to a decrease in the discount rate by 25 basis points to 5.50% and an increase in the assumed medical inflation rate partially offset by the effects of converting to an updated mortality table.
A VEBA has been established by the Company under Internal Revenue Code Section 501(c)(9). In general, a contribution made to the VEBA becomes deductible for federal income tax purposes in the year in which it is made. Investment earnings within the VEBA and distributions from the VEBA to pay designated benefits or to reimburse the Company for designated benefit payments are not subject to federal income tax from the Company’s perspective. The Company can determine the timing and size of any payment from the VEBA to cover expenses of eligible participants.
The following table summarizes the activity in the VEBA for the last three years:
| (In millions) | Balance at January 1, |
Contributions | Earnings | Benefit Payments |
Balance at December 31, |
|
| 2003 | $ | 18 | 82 | 5 | - | 105 |
| 2004 | 105 | 50 | 17 | - | 172 | |
| 2005 | 172 | - | 13 | - | 185 | |
In January 2006, the Company contributed $225 million to the VEBA upon completion of the sale of BAX Global. The VEBA’s assets are allocated among active investment managers of equities and fixed income securities. Approximately 70% of the trust assets are invested in equities, and 30% are invested in fixed income securities. The VEBA’s assets are being invested in a similar fashion to the Company’s primary U.S. pension plan and the Company has estimated the same expected long-term rate of return of 8.75% per year.
Health Benefit Act Obligations
In October 1992, The Coal Industry Retiree Health Benefit Act of 1992 (the “Health Benefit Act”) was enacted as part of the Energy Policy Act of 1992. The Health Benefit Act established rules for the payment of future health care benefits for thousands of retired union mine workers and their dependents. The Health Benefit Act established a trust fund, The United Mine Workers of America Combined Benefit Fund (the “Combined Fund”), to which “signatory operators” and “related persons,” including The Brink’s Company and some of its subsidiaries and former subsidiaries (collectively, the “Brink’s Companies”), are jointly and severally liable to pay annual premiums for those beneficiaries directly assigned to a signatory operator and its related persons, on the basis set forth in the Health Benefit Act.
In addition, the Health Benefit Act provides that assigned companies, including the Brink’s Companies, are required to fund, pro rata according to the total number of assigned beneficiaries, a portion of the health benefits for unassigned beneficiaries if these benefits are not funded from other designated sources. To date, almost all of the funding for unassigned beneficiaries has been provided from transfers from the Abandoned Mine Reclamation Fund (the “AML Fund”) or other government sources.
The Company’s liability for Health Benefit Act obligations is equal to the undiscounted estimated amount of future annual premiums the Company expects to pay to the Combined Fund. The Company’s estimated annual premium is equal to the total number of beneficiaries (including assigned beneficiaries and an allocated percentage of the total unassigned beneficiaries) at October 1, the beginning of the plan year, multiplied by the premium per beneficiary for that year. The Company expects to pay annual premiums over the next 60 to 70 years, but it expects these annual premiums to gradually decline over time as the number of beneficiaries decreases.
Since the passing of the Health Benefit Act, the vast majority of the costs for unassigned beneficiaries have been paid with transfers of cash from the AML Fund or other government sources. From the inception of the Combined Fund through December 31, 2005, the Company has paid only $1.1 million to the Combined Benefit Fund for premiums related to the unassigned pool, including $0.5 million in 2005.
In 2005, the authority for continued transfers from the AML Fund was extended for another year, but this authority may expire in 2006. Since the continued transfers of funds are not sufficiently assured, the Company’s estimate of its obligation assumes that no transfers beyond the current plan year will be available to offset future Company payments. There may be a legislative or regulatory extension to the transfer authority. If the transfer authority is extended, the Company may decrease its estimate of the probable liability for future premiums payments by a material amount.
Moreover, the Company’s estimate of its contingent liability for unassigned beneficiaries could increase materially in the future if other responsible coal operators become insolvent. This liability could also change materially if the percentage of unassigned beneficiaries that are allocated to the Company changes due to relative mortality rates of the Company’s assigned beneficiaries compared to the total assigned beneficiaries.
The Company uses Legacy Value, a non-GAAP value, to assess the fair value of obligations under the Health Benefit Act. The Company believes that Legacy Value information is useful to investors and creditors as an estimate of the fair value of a series of payments to be made over an extended period of time for these obligations.
| Legacy Value (discounted) |
Add-Back Present-Value Effect |
GAAP basis (undiscounted) |
|||||||
| (In millions) | 2005 | 2004 | 2005 | 2004 | 2005 | 2004 | |||
| Assigned and other | $ | 65 | 67 | 45 | 53 | 110 | 120 | ||
| Unassigned | 37 | 37 | 28 | 29 | 65 | 66 | |||
| Total | $ | 102 | 104 | 73 | 82 | 175 | 186 | ||
The Legacy Value (representing the present value of the obligation) of the Company’s Health Benefit Act obligations at December 31, 2005, was slightly lower than the $104 million of a year earlier. The Company made $8 million of payments in 2005. In addition, a slightly lower number of beneficiaries were assigned to the Brink’s Companies in 2005 than was projected last year. Both of these factors also explain the decrease in the GAAP basis measurement, which is undiscounted. In addition, the Legacy Value increased from the prior year due to the reduction in the discount rate used by 25 basis points to 5.50%, and the accretion of interest for 2005.
Payments related to the Health Benefit Act are projected to rise in 2007 to reflect the current assumption that the previous sources of funding for the unassigned pool will not continue beyond 2006. If future funding of all of the unassigned benefits becomes available through the AML Fund or other sources, projections for 2007 and later years may be reduced by up to $4 million per year.
Any changes to expected future obligations determined during annual reevaluations are recorded as expenses or benefits within discontinued operations.
Black Lung Obligation
The Company makes payments to former miners who have been determined to have pneumoconiosis (black lung disease). Such payments primarily cover disability payments and condition-related medical expenses. These payments stretch out over many years and have been discounted to a net present value. Actuarial gains and losses are deferred and amortized into continuing expense over the average remaining life expectancy of all participants (approximately 10 years).
The Legacy Value, which equals the accumulated projected benefit obligation, of the black lung obligations decreased to $51.7 million in 2005 from $55.2 million in 2004 largely due to $6.1 million of cash benefit payments made in 2005. This decrease was partially offset by the effect of reducing the discount rate by 25 basis points to 5.50% as of December 31, 2005.
Future cash payments are expected to gradually decline as the number of participants declines through mortality. Future expense levels are also expected to decline as the remaining value of the obligation declines.
Withdrawal Liabilities
The Company withdrew from the UMWA 1950 and 1974 pension plans in June 2005 as the last employees working under UMWA labor agreements left the Company. As a result of the withdrawal from these coal-related plans, the Company expects to be obligated to pay the plans $30.5 million, which represents the Company’s portion of the unfunded status of the plans as of June 30, 2004, as determined by the plan agreements and by law.