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Cash may be a comfort in an uncertain economy, but it can also be a drag on shareholder value.
Randy Myers, CFO Magazine
November 1, 2007
From 1995 to 2002, Terex Corp. was a terror on the mergers-and-acquisitions scene, snapping up a string of 22 takeover targets. Since then, the Westport, Connecticut-based manufacturer of construction and mining equipment has kept its checkbook much closer to the vest, as cash-rich private-equity buyers drove prices beyond where it felt it could make disciplined acquisitions. No matter: the $8.2 billion company still managed to grow its revenues by an average of 28.8 percent each year. Shareholders responded by driving up Terex's stock price from less than $6 at the beginning of 2003 to more than $80 in late September.
Thanks to its stellar performance, Terex ranks sixth among the companies in the Standard & Poor's 500 stock index (excluding financial institutions) in terms of total shareholder return (TSR) over the past five years. That's according to a new analysis done for CFO by The Boston Consulting Group (BCG). At 49 percent, Terex's five-year TSR is well above the average for the top quartile of the S&P 500 (see "The Value Creators").
Accordingly, Terex has had the luxury of piling up cash on an underleveraged balance sheet — $453 million as of June 30 — at a time when investors are pushing many companies to make big payouts to shareholders. The company did launch a $200 million stock-buyback program last year, but against a market capitalization of $9.3 billion that's not terribly aggressive.
Terex could buy back more stock, or issue a special dividend. But it is committed to reinvesting in its business for long-term growth, according to Terex senior vice president and CFO Phillip Widman. "We consider our first priority to grow the business we have, meaning through investment in capex or acquisitions that help further our franchise," he says. "We have a return on invested capital of 40 percent the way we measure it, so investing in our own business makes sense right now."
Building for long-term growth is, of course, what business schools have been preaching for generations. But it has been surprisingly difficult to do so over the past several years, says Eric Olsen, senior partner in the Chicago office of BCG, a global business-consulting firm. What was once viewed as a strong balance sheet, BCG says, is increasingly viewed by Wall Street as a lazy balance sheet — one that underexploits a company's assets, either by holding too much cash earning low rates of return or by having too little debt. (Olsen says the credit crunch hasn't changed that perception, except perhaps in sectors directly affected by the crunch, such as mortgage lending.)
Today, firms with bulging cash coffers risk being penalized rather than praised. And the cash has been piling up. Thanks to strong balance sheets and improved cash flow return on investment, corporate profits have soared to record levels, notes BCG. What's more, given the recent upheaval in the credit markets and the growing fear of an economic slowdown, companies may not be inclined to draw down their cash reserves anytime soon.
In this environment, investors either hold back on giving a cash-rich company's stock its full due or push for a way to get that money into their own pockets, typically through a stock buyback. If management won't pull the trigger, private-equity firms and activist investors are happy to do the job. The challenge, then, is for companies to satisfy their investors' short-term expectations while retaining enough resources to execute long-term strategy — without stumbling into what BCG calls a "cash trap" (see "Avoiding Cash Traps" at the end of this article).
Ironically, the easy money of the past few years, a byproduct of rising corporate profits and stock prices, is in some ways limiting the options available to corporate managers. In too many industries, it has allowed for too much cash chasing too many growth opportunities. "There are private-equity deals getting done in industries that never would have been candidates for private equity in the past, at pricing that probably wouldn't have made sense in the past," observes J.D. Sherman, CFO of Akamai Technologies Inc., a $429 million Internet services firm in Cambridge, Massachusetts.
Still, it's not surprising that companies are trying to do something with their cash. Assuming aftertax returns on cash of 3 to 4 percent, and market-average returns of 10 percent on a stock index fund, the forgone opportunity cost for investors is 6 to 7 percent. "That opportunity cost," writes BCG in "Value Creators," "has a negative impact on annual TSR of one to two percentage points, on average, which over 10 years is equivalent to the difference between top-quartile and average performance."
Many companies have, of course, turned to stock buybacks. Through the end of last year, companies in the S&P 500 had bought back more than $100 billion in shares in each of the past five quarters, nearly double what they were paying out in dividends. There's some logic to that, says BCG, given that many companies are carrying cash and excess debt capacity equal to 20 to 30 percent of their market capitalization. Still, BCG argues that buying back stock doesn't deliver much in the way of long-term value, meaning that corporate executives must still find ways to differentiate their companies from their competitors and demonstrate that they can deliver profitable, above-average growth.
Some, like Widman and his C-suite colleagues at Terex, seem to have mastered the challenge. "Five to 10 years ago, we were a company still trying to prove ourselves," Widman says. "We had made several acquisitions, and investors were still asking themselves whether we could integrate and operate them effectively. Over the past 5 years, though, I think we've built up sufficient credibility that we have earned the right to pursue our long-term strategy. And I think that's part of what's created the increase in shareholder value that we've seen."
Cognizant Technology Solutions Corp., a software-services and data-warehousing provider in Teaneck, New Jersey, did even better with an annualized TSR of 62 percent. Over the past five years, it grew its sales from $178 million to $1.4 billion and increased earnings more than 10-fold. It has no debt on its balance sheet, only just announced its first stock-buyback program, and has limited its acquisitions in recent years to small, strategic buys — companies that could expand its geographic reach into a new niche or provide access to technologies or industry knowledge.
"Because we've been delivering strong results, we haven't had a whole lot of pressure to pop margins up for short-term benefit," says Cognizant CFO Gordon Coburn, who is also the company's chief operating officer and treasurer. "We tell our investors we're in this for the long term, and the vast majority of our institutional base understands that our strategy is paying off."
BCG readily concedes that finding the right balance between delivering results over the short term while retaining the financial flexibility to invest for the long haul is a tricky undertaking — one that will require different approaches from different companies in different industries. But it also offers clues as to which factors managers should focus on.
Those factors aren't always intuitive. For example, many executives tend to focus on revenue growth — growth that generates returns above the company's cost of capital — as a major driver of shareholder returns. Indeed, over the long term it is the key driver. But when it comes to near-term returns, growth's contribution to shareholder returns is secondary to improvements in the company's valuation multiple — market value divided by earnings before interest, taxes, depreciation, and amortization.
A relatively small number of factors explain as much as 80 to 90 percent of the differences in valuation multiples among peers, BCG says. Those factors tend to cluster into four broad categories: revenue growth, profitability, risk, and "fade" (BCG's term for the confidence investors have that current levels of growth or profitability can be sustained). Which factor plays the greater role in determining a company's valuation multiple depends on its business. Revenue growth can be a key differentiator in high-growth industries such as software, for example, but a secondary factor in, say, pharmaceuticals, where the research-and-development spend relative to revenue is a better indicator of long-term prospects.
On the other hand, BCG argues that a number of broad trends are today affecting valuation multiples across many industries. Most strikingly, it says concerns that companies will poorly deploy accumulated cash have made investors sensitive to any signs of either fade in a company's current profitability or increased risk relating to its growth strategy.
To invest for long-term growth without alienating investors, BCG says companies should reexamine how their investments align with investor expectations. Growth companies might weed out businesses that operate with a value proposition; value companies might temper risky growth plans and pay more attention to increasing the dividend. At the same time, BCG urges companies to look for new opportunities for growth, whether through innovation or by leveraging what it calls "megatrends," such as the rise of China as a major industrial power or the increasing scarcity of energy resources. MEMC Electronic Materials Inc., a $1.5 billion maker of silicon wafers that shared the top spot in BCG's ranking with an annualized TSR of 62 percent, has done that by beginning to sell its wafers not just to the computer industry but also to the solar-energy industry, where they are used in solar panels.
Finally, BCG suggests that companies make their strategy as transparent as possible. Doing that is something Gordon Coburn credits for helping Cognizant, which presents at more than 30 investor conferences a year, earn a higher multiple than its peers.
The ultimate reward for all that hard work should be an investor base that believes in the company's long-term potential. "There's a lot to be said for getting a base of investors that really understands and appreciates long-term results," comments MEMC senior vice president and CFO Ken Hannah. "They're not the ones calling you every time your numbers are plus or minus some minute amount."
Randy Myers is a contributing editor of CFO.
Avoiding Cash Traps
In their efforts to balance short-term investor expectations with long-term strategic goals, The Boston Consulting Group (BCG) warns companies to avoid four cash traps that can have a negative impact on their near-term shareholder returns.
1. The Lazy-Balance-Sheet Trap
Companies that ignore investor pressure for near-term returns run the risk of reducing their valuation multiple and jeopardizing their independence. While public companies probably can't get away with leveraging their balance sheets as highly as a private-equity owner would, many will find they can squeeze out cash for stock buybacks or dividends without jeopardizing their long-term goals. Some, of course, will be able to justify holding a bigger cash cushion than others. MEMC Electronic Materials Inc., a $1.5 billion maker of silicon wafers that delivered an annualized TSR of 62 percent over the past five years, announced a $500 million stock-buyback program in June but remained committed to maintaining a strong balance sheet. At the end of June it had $996 million in cash and short-term investments on hand, and just $26 million in long-term debt.
"I don't consider that to be a lazy balance sheet," says MEMC senior vice president and CFO Ken Hannah. "We're in an industry that tends to be very cyclical, and I consider our position to be prudent."
2. The Reinvestment Trap
Beyond deciding how much to reinvest in their business and how much to return to shareholders, companies also need to be smart about how they reinvest for long-term growth. Companies fall into a reinvestment trap, BCG says, when management misallocates resources across the business portfolio — either by feeding all businesses at the same rate despite their differing growth prospects or contributions to shareholder return, or by allocating too much capital to problem businesses.
3. The M&A Trap
Acquisitions are highly appealing, especially when they are immediately accretive to earnings. But an accretive deal won't necessarily boost shareholder returns if, as is possible, it also reduces the acquirer's multiple. BCG cites the example of a consumer-brands company whose CEO engineered the purchase of numerous low-tier, low-margin brands. The acquisitions boosted earnings in the first year but diluted the company's average organic growth rate and margins, causing investors to drive down the multiple on the company's stock and ultimately yielding no improvement in shareholder return.
4. The Stock-Buyback Trap
BCG doesn't discount the role that stock buybacks can play in boosting near-term returns for some companies. But the firm's research indicates that buybacks do not change investors' estimates for long-term earnings-per-share growth, or induce them to accord a company a higher valuation multiple. By contrast, it says, dividends have a far more positive long-term impact. In a study of 107 companies that boosted their dividend, and another 100 that announced an increase in share repurchases, the dividend payers saw their multiples go up over the next two quarters by an average of 28 percent, and the top-quartile performers by an average of 46 percent. In comparison, the buyback companies saw their valuation multiples erode on average, and top-quartile improvements averaged only 16 percent. — R.M.