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Companies are content to sit on their cash hoards, but investors are losing patience. What's a CFO to do?
Vincent Ryan, CFO Magazine
July 15, 2010
Even before the global financial crisis struck in 2008, corporate coffers were bulging with cash, opening companies to criticism for not putting the money to work. But following the collapse of the credit markets and the on-set of the worst recession since the Great Depression, anxious CFOs put a premium on liquidity and safety, building "fortress" balance sheets that could withstand any financial shock. It was a sensible strategy. After all, as then-president of the National Association of Corporate Treasurers Edward Liebert noted in June 2009, "You can miss your earnings targets and survive, but you can only run out of cash once."
Today, Corporate America appears in no danger of that. In fact, it has more cash on hand than ever. According to the Federal Reserve, nonfinancial companies held $1.8 trillion in cash and other short-term assets at the end of March — up 26% from a year ago, the largest increase since the Fed began keeping records in 1952. Cash now accounts for 7% of company assets, the highest level in nearly 50 years.
An analysis by CFO magazine shows that nonfinancial firms in the S&P 500 had $939 billion of cash and short-term investments at the end of 2009, also up 26% from 2008. Cash as a percentage of sales was 13%, the highest level in more than 10 years. Meanwhile, the CFO Midcap 1500 (companies with annual sales of $100 million to $1 billion) collectively held $111 billion in cash, up 15% from 2008. At the same time, year-end current liabilities fell 8% for the CFO Midcap 1500 and 9% for the S&P 500.
Now that the recession is fading, why are companies still accumulating greenbacks instead of plowing them back into the business or putting them in shareholders' pockets? "There's so much uncertainty about the value of investing, and clear and present dangers from increasing regulation and taxes," answers David Hirshleifer, professor of finance at the University of California, Irvine. "There's a high value to having financial slack so that if the firm hits bad times it will still be able to fund internal operations and take positive [net present value] projects," he adds.
At a time when suspicion of counterparties is prevalent, hoarding cash also makes commercial sense. "It helps us win deals, especially when partnerships can run as long as seven years," says Mohit Bhatia, CFO of Genpact, a finance and accounting process management firm. "Clients and prospects are very keen to deal with companies with ample liquidity."
Big cash hoards also help companies avoid having lenders peering over their shoulders and hamstringing them with covenants. Cash and a debt-free balance sheet enable Cree Inc., a maker of light-emitting diodes (LEDs), to grow without restrictions from lenders, says CFO John Kurtzweil. Without the liquidity, he says, "if I wanted to add a factory I would have to renegotiate with bank groups, and they would take a pound of flesh out of me."
Add to that the drying up of bond markets and high volatility in equities, and holding on to your cash seems highly responsible. "No one asked me once last year whether we would make it through the recession," says David Goulden, CFO of EMC, which had $10.2 billion of cash on its balance sheet against only $3.1 billion of low-interest debt at the end of its first-quarter. "The important thing is that we have lots of cash because we generate lots of cash."
The Case Against Cash
But keeping cash on the balance sheet still carries significant costs and risks. They include, for starters, extremely low returns in vehicles like money markets; less use of financial leverage, which can improve gains to shareholders; and an open invitation to leveraged-buyout practitioners.
Also, a cash-laden company runs the risk of having its investors undervaluing it. "Investors may be scared of what management is going to do with that money," says Gregory Milano, chief executive of Fortuna Advisors. "If the company has a track record of poor returns in its main business or bad and overpriced acquisitions, the market may value the cash at just 60 to 70 cents on the dollar."
A cash-heavy balance sheet also increases conflict between shareholders and management. Idle cash is an escalating issue for boards of directors, says James Ellis, managing director in the finance operations consulting group at Accenture. "There are a growing number of board-level discussions where the C-suite is being pushed," he says. Before, board members simply wanted to know whether a company had a plan for its cash; now, they want to see the actual plan, says Ellis.
But deploying cash goes beyond making a single action or deal. "CFOs have to figure out what sustainable [financial policies] work in this climate," says Eric Olsen, global leader of the shareholder-value practice at The Boston Consulting Group. "That comes back to dividends, share repurchases, mergers and acquisitions, and investing in longer-term growth."
Flexibility Versus Return
That last option, investing in growth, may be at the top of the referred list in theory, but overall capital expenditures will grow modestly this year and next, according to a May report from Fitch Ratings. Studying a universe of 308 U.S. companies, Fitch found that capital expenditure fell 16.6% in 2009. The companies plan growth of 3.1% this year, and only 1.4% in 2011. R&D projections in many industries are also paltry.
For high-growth, high-cash companies such as Cree, organic investments are eminently sensible. The market for LEDs is only 2% penetrated worldwide, says Kurtzweil, and governments are fast imposing standards that promote energy-efficient lighting using LEDs. The company received $39 million in tax credits from the American Recovery and Reinvestment Act, and raised $450 million selling common stock in late 2009. As of the first quarter, Cree had $990 million of cash and liquid investments.
Cree is quickly funneling that money into capital projects. Buying buildings and equipping fabrication plants will consume $250 million both this year and next, Kurtzweil says, a level necessary to pace the market's growth and keep competitors at bay. "Time to revenue is key," says the CFO. "The flexibility I get with my cash position more than offsets the low investment returns on my cash balances."
The company's earnings aren't suffering. Its gross profit margin hit 48% in the first quarter, and even with the large cash balance, return on equity rose from 1.4% one year ago to 9.5% in the first quarter. Kurtzweil's position is a conservative one, but he says using cash instead of bank debt, preferred shares, or high-yield bonds leaves the latter avenues of financing open in the future.
Eighty percent of Cree's sales are overseas, and that will be common as U.S. companies look to emerging markets with explosive growth in gross domestic product. But BCG's Olsen says that could be a recipe for problems at cash-rich companies. Too much cash could chase fewer opportunities as economies like China, Indonesia, and India mature, Olsen explains, leading to bidding wars, overinvesting, and lower returns.
A number of multinationals hold stockpiles of cash overseas, since repatriating income earned by foreign units would incur U.S. taxes. For example, at the end of its fiscal 2010 second quarter, Cisco Systems had $39.6 billion in cash and cash equivalents, but only $8.8 billion was held within the United States.
M&A: All Talk?
By far the most common reason cited for holding cash is financial flexibility — specifically, retaining it to buy companies. After all, cash is highly attractive to a seller, allowing its owners and investors to immediately exit. In an April 2010 survey by BCG, 43% of fund managers and other investors said strategic M&A should be the highest or second-highest priority of companies with excess cash.
Indeed, many CFOs say acquisitions are on the horizon, although in June the dollar volume of deals by U.S. domestic companies was at its lowest year-to-date level since 2003, according to Thomson Reuters. "Prudence doesn't make for an exciting equity story, so many CFOs feel obliged to highlight growth strategies and make allusions to M&A opportunities — never mind that many of them don't have proven records on the M&A front," comments Justin Pettit, a partner at Booz & Co. Overall, though, Pettit thinks it's more than just talk; he's now seeing a great deal of activity on growth-strategy development, target screening, due diligence, and postmerger integrations.
Does it pay to use cash as consideration? With financing markets for deals still difficult and covenants more restrictive, tapping cash reserves is a good option. Likewise, if a buyer doesn't feel its shares are fully valued, paying in cash makes financial sense. Using cash forces more discipline around the purchase price, so it can prevent a company from overpaying. "If we can use cash we generate from the business, we're not diluting our shareholders — they wind up owning the same percentage of a bigger company," says EMC's Goulden.
One of the largest cash balances among Internet software and services firms in the CFO Midcap 1500 resides at Akamai Technologies, whose content-delivery network speeds up Web applications. The company's cash level hit $1.1 billion in the first quarter, more than 100% of annualized sales, up from $849 million in the first quarter of 2009.
Akamai acquired six companies in the past five years, spending more than $100 million in cash on its last two deals. "We made the first three [deals] in late 2006 and early 2007, when our cash balance was lower and our stock was in the 50s, so using equity made more sense," says CFO J.D. Sherman.
Akamai's transactions are "tuck-ins that grow our wallet share in our existing customer base and create new opportunities for customers in verticals like financial services and health care," says Sherman, and he plans more. That's what fund managers in the BCG survey claim to want: deals that build a moat around the core business or leverage it, not ones that are adjacencies or transformational. If companies wait too long to pull the trigger on deals, however, investors can get antsy, worried the funds will burn a hole in management's pockets.
But Akamai isn't rushing to buy. CFOs shouldn't set absolute deadlines to get deals done, advises Sherman. "If you give your corporate-development guys a hammer, everything looks like a nail," he says. "The flip side is, we don't want this kind of cash on the balance sheet earning 1% to 1.5% for shareholders."
Meanwhile, enterprise-software firm Informatica has been busy on the M&A front since last year, plunking down $470 million in cash in five deals since 2005. The company's cash and short-term investments fell to $355 million in the first quarter, but that still represented 71% of sales. "We're reinvesting in the business for the long term; these are technologies we can build around for the next 5 to 10 years," says CFO Earl Fry.
A Carrot for Investors
While the likes of Akamai and Informatica concentrate on M&A, some sectors of high tech are maturing and growing more slowly, so boards are buzzing about possibly paying dividends to attract value-type investors, says Olsen. The Duke University/CFO Magazine Global Business Outlook Survey for the second quarter of 2010 showed that CFOs across all industries expect to grow dividends 2.8% over the next 12 months, down slightly from the previous quarter.
Furthermore, BCG's survey showed that 32% of investors would prefer that companies make dividends the highest or second-highest option for excess cash, compared with 22% preferring stock buybacks. Investors are souring on share repurchases, because they see companies executing them poorly. But will dividends become more common, even at companies in early-stage markets?
The Female Health Co., manufacturer of a women's condom for disease prevention, went public just a year ago, but it adopted a quarterly dividend policy in January. The company shelled out 27% of its $5.2 million March 31, 2010, cash balance in payment of its second dividend. "We really have more cash than we need," says finance chief Donna Felch. Because Female Health sells primarily to public-sector buyers like government ministries of health, it has few marketing expenses and little need for more sales overhead as its unit sales increase. The company is also very cash efficient, manufacturing only against orders and collecting its accounts receivables promptly.
By paying the dividend, Felch says she has opened the door to another category of institutional investors. A dividend also suits Female Health because the company has significant insider ownership, which means management is strongly aligned with shareholders. "We're one and the same," Felch says.
Conventional wisdom in corporate finance, of course, argues against the example of Female Health. Developing dividend policies sends the wrong message to investors, say CFOs. Informatica posted 20%-plus revenue growth its last two quarters, and CFO Fry thinks issuing a dividend would be a mistake. "It would be signaling we don't know how to continue to grow the business," he says.
Unless economic activity falters again, many companies will continue to have the nice problem of throwing off lots of cash. Many will be increasing free cash flow, because they are only slowly ramping up hiring, while cutting discretionary costs like procurement spending and travel and entertainment. That will only increase the pressure on CFOs to put their liquidity to work.
Two wild cards in the economy complicate the question of when and where to deploy excess cash. The first is the prospect of deflation, or, less likely, inflation. The possibility of deflation increased in June, with producer and consumer prices falling. If deflation does take hold in the U.S. economy and corporate profits and asset values shrink, being in a net cash position may be beneficial. On the other hand, if inflationary pressure develops, the wisest path might be the opposite. When the value of money is deflated, companies would prefer fixed-rate debt to cash. Says Milano: "It will be better to be a debtor."
The second wild card is the direction of tax rates on dividends and capital gains. If the Obama Administration raises the tax on capital gains, ends the rate reduction on qualified dividends, or both, that will dramatically change the dilemma CFOs have regarding returning cash to investors or reinvesting it.
Regardless of what CFOs are planning, the situation is building to a point where they have to move out of fear mode. At minimum, finance chiefs need to stress to investors and other stakeholders that idle cash is a strength, not a question mark or a weakness, say experts. That means showing they are prepared to use that strength — by having a clear set of M&A policies and boundaries, for example, and articulating the opportunities.
Large cash cushions may continue to provide comfort over the next couple of years, particularly if the economic recovery fizzles. But they may also indicate to investors that management has become too comfortable. Or, worse, too uncertain about how to achieve growth or otherwise satisfy shareholders.
Vincent Ryan is senior editor for capital markets at CFO.
How Much Is Too Much?
There are plenty of ways to measure whether or not a company is holding too much cash. One way is to compare cost of capital with short-term investment yields. If a company earns 2% on cash and has a 7% cost of capital, it is destroying shareholder value, says Eric Olsen, global leader of the shareholder-value practice at The Boston Consulting Group. A high percentage of cash on the balance sheet relative to market capitalization also raises a red flag.
But some experts say measures like cost of capital are too narrow. "CFOs talk about the trade-off between optimizing the cost of capital and maintaining financial flexibility," says Gregory Milano, chief executive of Fortuna Advisors. "Most companies spend too much time optimizing cost of capital — because it's easier to quantify."
It makes just as much sense to examine cash from an operating-risk perspective. Katy Murray, CFO of talent management software firm Taleo, says she thinks about what she calls "the nuclear event": "If collections were to stop, how much cash would I need to cover operations in the next quarter and a half?" That's 6 weeks longer than the traditional rule of thumb, 12 weeks.
Other benchmarks, depending on the industry, include 2% of revenue, 6 months of fixed costs, or 12 months of research and development. If the company has debt, measures of debt-service coverage also need to be factored in. Comparing a company's cash holdings with others in its industry is also a key gauge. "In IT, where there is rapid change, volatility, and consolidation, it's difficult to define what too much cash is," says David Goulden, CFO of EMC.
The good news for CFOs holding on to liquidity is that there is evidence challenging the conventional wisdom that large cash balances depress valuations. Research by Fortuna shows that the top-quartile companies holding the largest amounts of cash as a percentage of assets actually traded at a premium in almost every quarter, dating back to 2003.
Of course, companies that don't have a lot of cash are often the ones with loads of debt and below-investment-grade credit ratings. But the results suggest that while investors may carp about cash-laden balance sheets, they behave otherwise. — V.R.