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Companies are awash in cash. When will they finally start spending it?
Ronald Fink, CFO Magazine
August 1, 2004
See the 2004 Cash Management tables
Having fortified their balance sheets with cash over the past two years, one would think that CFOs would have little to worry about from investors.
At the end of 2003, cash and marketable securities constituted roughly 15 percent of the total capital employed by 1,000 companies tracked by REL Consultancy Group. That's up from 11 percent two years earlier. In terms of sales, the proportion grew from 8.5 percent to 11.5 percent. And despite a recent spate of investments and acquisitions, there's little sign that those percentages have come down significantly since then.
But equity investors have other ideas about holding so much cash. They prefer to see the money earning more than it can in bank accounts or short-term instruments. That preference often translates into pressure to buy back shares, pay dividends, or increase existing payouts if managers can't identify promising prospects for acquisitions or new capital investments.
Bondholders, on the other hand, would rather see companies maintain plenty of cash to cover their interest burdens. As for ambitious acquisitions or capital investments, fixed-income investors burned by highly leveraged undertakings during the 1990s bull market are unlikely to sit still for risky alternatives this time around — however much equity investors may clamor for them.
Ideally, all companies would keep little or no cash on hand. Yet that's not always feasible for those that have borrowed heavily, particularly in industries pounded by recession. And while finance theory offers neat formulas for choosing among different uses of cash, those formulas aren't easy to apply when economic prospects are uncertain.
That leaves CFOs of cash-rich companies caught in the middle. "Corporate cash balances have never been higher," Rizwan Hussain, an analyst for Morgan Stanley, told the annual conference of the Bond Market Association last spring. "But what are companies going to do with them?"
REL, a Purchase, New York-based consultancy that helps companies improve working-capital management, comes down squarely on one side of the issue: get rid of the excess cash. "In our view, companies are going from one extreme to another in terms of their risk assessment," says principal Bill Beech. "Most have become overly cautious." REL has helped CFO magazine develop a scorecard ranking companies within their industries on how effectively they're managing cash.
Corporate finance executives agree to some extent. "Cash is really an underperforming asset," says Elisha Finney, vice president of finance and CFO of Varian Medical Systems, a maker of medical radiation and imaging technology based in Palo Alto, California. Varian, which had revenues of $1.04 billion last year, saw its cash as a percentage of sales hit 31 percent at the end of 2003 — almost three times its industry average, according to REL. "But it's a good problem to have," maintains Finney. "We say, 'Cash is queen.' "
Finney is not alone in expressing that view. "We're carrying slightly more cash than we historically carried," says Robert Richter, CFO of Dana Corp., an auto-parts supplier whose cash grew from 1.9 percent of sales in 2001 to 9.2 percent last year, three times the industry average. While he notes that that number was inflated by the maturation of some $200 million in long-term debt and an increase in working capital, Richter says Dana has needed to keep cash levels higher since the company lost its investment-grade rating in December 2001. "It serves one well to have a little more cash on hand when one's ratings are under stress," he says.
As Finney puts it, "I would rather have too much cash than be highly leveraged any day."
Truth be told, the dramatic efforts undertaken in the past few years to improve balance sheets, whether through asset disposals or debt reduction, have created a comforting cushion at present for bondholders. As of March 31, the 374 industrial companies in the Standard & Poor's 500 stock index collectively had $555.6 billion in cash and short-term investments on their balance sheets. That's up some $56 billion, or 11 percent, since the end of 2003, and more than double what they had at the end of 1999.
How does that compare with debt levels? The top 100 investment-grade issuers at the end of 2003 collectively had cash on hand equal to 20 percent of their debt, up from 11 percent in 2000 (see "The Dough Rises," at the end of this article). Hussain says investors in high-grade corporate bonds are unlikely to grow nervous until that percentage falls back to 14 or 15 percent. He expects that cushion to shrink to such a level within a year or so.
Some companies have so much cash that they don't know what to do with it. Sears, Roebuck and Co., for instance, has bought back more than 40 percent of its shares outstanding since 1999. And in June, it announced it would pay $621 million in cash for 54 stores from bankrupt Kmart Corp. Yet the troubled retailer is still awash in cash. With its retailing business lagging, Sears's huge cash hoard makes it a likely candidate for a buyout, according to Hussain.
Not every company has such problems, of course. Memphis-based AutoZone Inc., an auto-parts retailer, has repurchased so much stock during the past five years — almost 40 percent of the total outstanding — that it has virtually no cash on its balance sheet. That has helped produce a five-year return of 200 percent for equity investors. Bond investors have less reason to be pleased, since AutoZone's leverage has climbed in the past two years, with debt now accounting for 81 percent of total capital. At year's end, the company's cash covered the interest on less than 9 percent of that.
Yet AutoZone CFO Michael Archbold has no doubt the company is doing the right thing. Its debt costs an average of 5.3 percent, and Archbold estimates the cost of its equity at roughly 15 percent; thus, he says it makes sense to buy in stock rather than pay down debt. At the same time, however, the company is determined to grow cash flow rapidly enough to maintain its target leverage ratio of 2.1 times, and with it an investment-grade rating that is rare in its industry.
Varian, too, has been actively repurchasing stock, spending some $75 million in the past three years on the effort (net of the proceeds it has received from employee stock-option exercise). But Finney didn't have the option to pay down some of Varian's $59 million in long-term debt, which carries a hefty 6.8 percent interest rate, because the company faces a 14 percent prepayment penalty for doing so. "We weren't in a favorable negotiating position with the banks" when the company went public in 1999, she explains.
Choosing between debt reduction and share repurchase as a use for excess cash wouldn't be a cut-and-dried matter of arithmetic even if companies didn't have to worry about bankers' conditions or credit ratings. That's because it's far more difficult to accurately estimate the cost of equity than that of debt. The appropriate risk premium to be added to the price of equity has long been subject to debate, whereas the premium for debt is widely accepted to be the spread between its current interest rate and that on comparably termed Treasuries. "The theoretical models will tell you that the optimal credit rating is right below investment grade," Dana's Richter concedes. But he notes that in reality, access to capital is more limited at that level, and such access "is worth more than a few basis points" in terms of the cost of capital. As a result, says Richter, "our objective is to get back to investment grade."
That's why Dana plans to use much if not most of the $1.1 billion it earned from its July 9 sale of its replacement- parts business to The Cypress Group, a New York-based private-equity group, to pay down debt and fund its pension plan instead of repurchasing shares. The remainder of the proceeds will be devoted to reinvestment in Dana's core manufacturing business and to "bolt-on" acquisitions.
As for spending cash on acquisitions, there's plenty of risk that a deal will produce less than what a company has earned in the past. Yet managers seem increasingly confident that they can effectively deploy excess cash in new investments. The value of M&A activities worldwide increased 37 percent during the first six months of this year, with more companies using cash rather than stock to fund the deals.
Varian, for instance, plunked down $18 million in cash last March for OpTx, a supplier of oncology-practice software, and expects the acquisition to add $9 million to its annual revenues. That deal followed by three months a $35 million cash deal for Zmed Inc., a medical-device and-software company. Finney says Varian is looking to do more such acquisitions, describing them as "our number-one priority." The trouble is, she says, it's not easy for Varian to find good acquisition opportunities in light of the 50 percentplus market shares it currently possesses in its two main markets, radiation oncology and brachytherapy.
New opportunities also seem to be appearing in the battered telecom industry. In June, SBC Communications Inc., the regional Bell giant, announced plans to spend up to $6 billion during the next five years on a new fiber-optic network. A few months earlier, in one of the biggest deals of the year, Cingular Wireless LLC, a joint venture between SBC and BellSouth Corp., acquired AT&T's wireless division for $41 billion in cash. An SBC spokes-person says such moves reflect management's recognition that SBC needs to invest in new technology to remain competitive. But the moves also reflect the fact that SBC's cash has risen from 1.5 percent of sales in 2001 to 12.7 percent in 2003 (compared with 9.7 percent for its industry average) and from 3 percent of its debt to 28 percent over the same period.
Time to Pull the Trigger?
Still, many companies remain cautious about using their cash, even as it continues to pile up. Consider Time Warner Inc., whose cash rose from 3 percent of debt in 2001 to 12 percent in 2003. Thanks to cost cuts and debt reduction, its bonds and stock have rallied strongly, after being hit hard in the wake of the disastrous merger with AOL. In the past year alone, spreads over Treasuries on Time Warner debt due in 2012 have shrunk from 300400 basis points to less than 100, while the stock price has risen by 18 percent. To sustain the stock's upward movement, however, equity investors now want management to undertake bold new moves.
Sure enough, in recent months Time Warner was rumored to be about to bid on both Metro-Goldwyn-Mayer Inc.'s movie studio and Adelphia Communications Corp.'s cable systems, which were expected to fetch as much as $4.7 billion and $20 billion, respectively. But nothing has come of those reports so far, and chairman and CEO Richard Parsons recently told Bloomberg News that the company was taking a wait-and-see approach with its cash.
True, the company's AOL unit subsequently announced a $435 million all-cash deal for Advertising.com Inc., which provides expertise in online advertising, and the price represented a steep 36 times 2003 earnings. And observers who think Time Warner is being too conservative welcomed the deal. If nothing else, the company signaled that it was willing to invest in its Internet division at a time when skeptics were predicting its spin-off.
Yet a recent research report by Morgan Stanley comparing the bond- and equity-oriented sides of the credit market suggests that bond investors in Time Warner are showing fresh concern about such moves by the company. REL's analysis may help explain why such concern exists, and why Time Warner is hesitant to pull the trigger on new blockbuster deals. The fact is, the company has a smaller proportion of excess cash to deploy than such peers as Fox Entertainment Group, and its return on capital during the past three years has been less than half of Fox's. But that also means Time Warner's potential return from using its excess cash to reduce capital would pale in comparison. So it comes as little surprise that the company seems content to let cash build further. As Parsons told Bloomberg, he would be comfortable paying down debt only "a little bit more."
That hardly sounds like a complete good-bye to excess cash. And as CFO's cash management scorecard shows, Time Warner isn't alone in keeping its balance sheet in a highly liquid state.
Ronald Fink is a deputy editor of CFO.
See the 2004 Cash Management tables
To ask questions about REL Consultancy Group's methodology, or to benchmark your own company using the REL methodology, visit www.relconsult.com.