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Companies continue to be cautious with their cash.
Randy Myers, CFO Magazine
October 1, 2005
Our second annual cash management scorecard suggests that Corporate America continues to let cash build on its balance sheets. The 1,000 large public companies tracked by REL Consultancy Group closed 2004 with more cash relative to their annual sales than they had in the prior year. That finding follows a similar one for 2003. On average, cash plus short-term investments rose to 11.4 percent of sales, up from 11 percent in 2003 and 9.7 percent in 2002.
According to most business economists, companies shouldn't hold any more cash than they need to safely fund their operations, as equity investors bet that management will generate greater returns than those available on Treasury bills or other cash equivalents. The fact that cash is growing nonetheless means such returns are hard to come by, and that companies will face increasing pressure from those investors to return the money in the form of either higher dividends or share buy backs. Bond investors, on the other hand, may increasingly call on companies to pay down debt. REL calculates that if the average company in its 1,000-company universe had simply pared its cash levels to those in the lowest quartile of its industry sector by paying down debt, it could have boosted its return on capital employed to 15.2 percent from 14.0 percent.
That said, the overall increase in cash levels last year was moderate, and the rate of increase trended lower too. For the entire 1,000-company universe, the cash-to-sales ratio grew by only 4.1 percent from 2003 to 2004, after growing by 13.1 percent from 2002 to 2003 (see "Cash Is Still King," at the end of this article).
Still, the findings reflect continued caution despite increased profitability and higher cash flows. In 2004, cash flow for the 1,000 REL companies grew to 2.4 times capital expenditures, up from 2.1 times in 2003 and 1.8 times in 2002. That suggests that managers have drawn one or more conclusions from the current environment: they foresee insufficient returns from new investment, are guarding against a downturn in business activity, or wish to build funds for future acquisitions.
Proving the Rule
Consider the booming oil industry, where profits and cash flows have been soaring along with crude-oil prices. Among the major oil companies, the average cash-to-sales ratio doubled to 7.0 percent from 3.3 percent during the past two years. For secondary oil companies, the ratio climbed to 4.9 percent from 2.6 percent; and for oil-equipment and -services companies, it jumped to 13.3 percent from 8.6 percent.
Even the exceptions to this industry trend seem to prove the rule. For example, Dallas-based Lone Star Technologies Inc., a $967 million oil-equipment and -services firm, saw its cash-to-sales ratio slide to 7.9 percent from 23 percent during the past two years. But its total cash declined only a bit, as the principal reason for the sharp downturn in its cash-to-sales ratio was a growing denominator. The company's 2004 revenues were nearly double the $524 million it posted in 2004.
Elsewhere in the industry, 75 percent of the companies in the oil-drilling sector shrunk their cash-to-sales ratios over the past two years. The average company in the group saw its ratio fall to 11.3 percent from 22 percent. Houston-based Transocean Inc., a $2.6 billion oil-and-gas-exploration company, experienced one of the biggest declines, with its ratio falling to 17.7 percent from 45.4 percent. Yet that, too, was not an indication of a company throwing caution to the wind. Vice president and treasurer Todd Kulp explains that Transocean has been taking advantage of its strong cash flows over the past few years to dramatically reduce its debt, which now stands at about $1.6 billion after topping $5 billion as recently as 2001.
Now, says Kulp, Transocean is wrestling with a decision: Should it continue paying down debt, start stockpiling some of its cash, pay a dividend, or buy back some of its own shares? "We're focused on cash flow return on capital, and if there is not an investment out there that will produce a good positive CFROC, we have to look at other options," says Kulp. "We made a tremendous investment in assets in the late 1990s and early 2000s when we built a number of fifth-generation rigs. They're paying off for us now, and we don't feel the need to go out and build new rigs for the sake of building rigs. We're going to make sure that whatever we build will result in a good return on capital."
Kulp's views on deploying cash are hardly atypical, notes Bill Beech, a principal with Purchase, New York–based REL. "Managements are under a lot of pressure from analysts and shareholders' groups about accountability," says Beech. "Especially with the advent of the Sarbanes-Oxley Act, they're under a lot more scrutiny, which has made them more cautious about investing."
Randolph Roy, vice president and treasurer of $1.4 billion Moody's Corp., the New York–based corporate credit-rating agency, concurs. "I think managements are more aware of making sure that whatever investments they make better add to shareholder value," says Roy. "You've got to earn an appropriate rate of return, certainly one that is well above your cost of capital."
Roy also suggests that managers may be more cautious about how they deploy their cash because the penalty for messing up has gotten stiffer. "Managements are much more aware that the [career] life of the executive, if he or she doesn't perform, has gotten a lot shorter," he says. Exhibit A: former Hewlett-Packard CEO Carly Fiorina, who was unceremoniously dumped from her post at the $79.9 billion computer and printer maker early this year, in part due to lingering discontent with the 2002 purchase of Compaq Computer. HP is still trying to digest that acquisition.
Moody's itself dramatically built up its cash levels from 2002 to 2004, with its cash-to-sales ratio jumping to 42.1 percent from 3.9 percent. That put Moody's well above the 2004 year-end average of 11.0 percent for the companies in the industrial and commercial-services sector in which it competes. According to Roy, the increase was attributable primarily to Moody's being less aggressive than it typically has been about using its ample free cash flow to buy back its own shares. "We return quite a bit [of cash] through share repurchases," he says. "In the past couple of years, though, we have not been as aggressive about our buybacks."
Of course, Moody's has not had much of an opportunity. From January 2003 to the end of July 2005, its stock rose from just under $22 a share to more than $47 in virtually a straight line. Still, Roy says the company plans to become more "systematic" in its approach to buybacks, suggesting that going forward, it won't wait for a decline in price to repurchase more shares.
Looking for Bargains
The fact that Moody's had cash on hand to even consider buying back stock indicates that it wasn't having much luck finding external investments at good prices. It has been hardly alone in that situation; from year-end 2002 to year-end 2004, the Standard & Poor's 500 stock index rose 37.9 percent. Yet the stock of an acquirer no longer represents as valuable a currency as it did when pooling-of-interest accounting was easily available, so higher prices make acquisitions more expensive. That's held back such companies as West Greenwich, Rhode Island–based Gtech Holdings Corp., a $1.3 billion provider of lottery and gaming technology solutions. "Public-company valuations are fairly high in the industries we're looking at for acquisition opportunities," says Gtech CFO Jaymin Patel. The company saw its cash-to-sales ratio jump to 33.4 percent from 3.6 percent over the two years ended February 28, 2004 (Gtech's fiscal year-end). "As a fairly conservatively run business, we're simply not prepared to pay up at the kinds of market values these assets are commanding," says Patel. "We're a patient company, and we're prepared to wait if necessary."
And despite strong cash flows in recent years, Gtech has seen fit to borrow to bolster its reserves. The firm sold $250 million in senior notes in October 2003 and another $300 million in 2004, taking advantage of what it considered attractive long-term rates for investment-grade debt. Although it is conserving some of that firepower for future acquisitions, last December the firm announced an agreement to purchase a 50 percent controlling equity interest in Atronic, the leading video-slot-machine maker in Europe, Russia, and Latin America. However, that deal will not close until December 2006.
Phoenix-based regional airline operator Mesa Air Group Inc. also built up its cash reserves over the past two years by way of debt offerings — two convertible-bond issues of $100 million each — but not necessarily to fund future acquisitions. "This is a very capital-intensive industry, and capital is not always readily available," observes CFO George Murnane. "Just when you need it is probably when you don't have access to it. We felt very strongly that given the turmoil in our industry, we needed to have more liquidity." By year-end 2004, Mesa's cash-to-sales ratio stood at 26.6 percent, more than double its level of 10.9 percent two years earlier and well above the industry average, which rose to 17.8 percent from 17.6 percent during the same time period. "For an airline," says Murnane, "more cash is better than less."
That point has been driven home over the past five years. Murnane notes that the airline business was already starting to soften when terrorists attacked the United States on September 11, 2001, exacerbating the industry's problems and helping to drive two of Mesa's partner airlines into Chapter 11 bankruptcy protection. But thus far, he says, Mesa has been able to operate without tapping into its recently plumped cash stockpile, leaving it open to the possibility of making an acquisition should a good opportunity present itself. In the meantime, he says Mesa's cash position is expected to continue to swell. "We have said publicly that at the end of our fiscal year (September 30), we expect our cash levels to be about $275 million [versus $221 million at the end of fiscal 2004], and we are exploring some other liquidity-generating measures that would get our cash levels to $300 million," he says. Since then, Mesa has monetized its regional jet spare-parts inventory by allowing a third party to purchase and manage it on its behalf.
If the trends of the past two years continue, corporate cash-to-sales ratios will continue to grow in 2005, though at a slower pace. That would make perfect sense to all those finance executives who agree that absent extenuating circumstances such as the need to fund an acquisition or carry the company through a business downturn, holding excess cash is a drag on performance. Too bad those circumstances are so hard to predict.
Randy Myers is a contributing editor of CFO.
Calculating Excess Cash
The Cash Management Scorecard prepared for CFO magazine by REL Consultancy Group uses public information reported by 1,000 U.S. companies to calculate the returns that companies would generate by paying down capital employed with the excess amount of cash on their balance sheets. For this purpose, cash is defined as cash + cash equivalents + marketable securities, and capital employed as short-term debt including notes payable + long-term debt + equity.
To calculate the opportunity cost of excess cash, REL first figures out how much of a company's cash exceeds its industry benchmark, which REL determines to be the lowest quartile in a given industry as a percentage of sales. Then it subtracts that excess from the amount of capital a company employs. The company's return on capital employed (ROCE), based on 2004 pretax operating profits, is then compared with what the return would be after excess cash is used to reduce the amount of capital employed. The comparison is not made for companies with excess cash that have negative ROCE.
Cash Is Still King
Companies continue to let cash grow, albeit more slowly.
While cash on corporate balance sheets continued to grow last year, it did so at a slower pace than during 2003, according to CFO's second annual Cash Management Scorecard. And the breadth of the increase narrowed, as the number of industry sectors experiencing gains fell to 47 out of 78 in 2004, down from 58 in 2003. Leverage levels also have been trending lower over the past two years. The debt-to-total-capital ratio for the universe of companies fell to 43 percent in 2004, down from 46 percent in 2003 and 49 percent in 2002. Still, as the main story notes, finance executives show no sign of abandoning their caution when it comes to cash.