What should I do with all that cash? With shareholders clamoring for action by the abundance of companies with currently overstuffed balance sheets, many CFOs are laboring to arrive at a logical and articulate answer to that question.
In that context, having a well-established ranking of company priorities for disbursing excess cash can be a big help – especially when times change. Thus, while Eaton Corp., a multinational power-management company based in Cleveland, has a set percentage of cash it likes to deploy in capital expenditures, it had to pull back on capex to maintain liquidity during the financial crisis, according to its CFO and chief strategist, Rick Fearon.
Now that the economy appears for now to have moved out of that crisis stage, Eaton will spend more on its plants and equipment in order to get back to its prior average spending levels, the finance chief says. In a recent interview, Fearon told CFO why Eaton values capex as the top way to deploy capital and outlined the company’s views on the wisdom of outlays for dividends, acquisitions, and share buybacks.
What’s the order of your priorities in terms of spending excess cash?
Our guidance for operating cash flow after pension contributions this year is $1.6 billion to $1.7 billion. On average, we invest about 3% of sales into capital expenditures. If we were spending exactly on average, we would be investing about $500 million. But because we were below those spending levels during the downturn, we underinvested. We’re going to spend about $600 million on capex this year. That’s the first use of cash.
The second use is our dividend, and we aim to increase it consistent with our long-term earnings growth rate. Ten percent to 15% of our investors are growth-and-income-oriented, meaning that they’re after a steadily increasing dividend. That’s an important part of what attracts them to Eaton. We think that continuing, regular dividend increases are an important part of meeting their objectives. Our dividend uses about $400 million a year of spending.
If we subtract capex and dividends from operating cash flow, we end up with $600 million to $700 million that we can spend on acquisitions and repurchases. Then we look at the relative merits of each.
Why is capex your first priority?
We start with capex because it’s fundamental to keeping the enterprise strong and competitive. You really don’t want to skimp on capex. Plus, we’ve kept our research-and-development spending relatively constant, even in the downturn.
We’ve got a lot of new products coming out, and we need to spend money to capacitize for them. A good example: we’re just opening a large new automotive engine valve facility in Jining, China, because we had run out of capacity in China, given the growth of the Chinese auto market. We have new products that we’re introducing, and most of what we’re adding [in the new facility] is new equipment. You really have to fund capex if you’re going to keep yourself vibrant and take advantage of opportunities.
Why are dividends so crucial?
You do dividend increases consistently because otherwise growth-and-income investors aren’t interested. That is a sizable pool of investment money in the United States. We decided seven or eight years ago that that was a group worth continuing to target, and hence we adopted this strategy.
Now, in all fairness, we also adopted the strategy because seven or eight years ago the tax laws changed such that it was no longer a negative for a shareholder to be paid a dividend as compared to by a share repurchase.
What do you hope to achieve with your acquisitions?
We are aiming at acquisitions that are strategic and that give us an attractive return. We define “attractive” as at least 300 basis points over our weighted average cost of capital, which we consider to be about 9%. We would not typically do acquisitions that don’t earn at least a target of 12%. Usually, as we find from studying previous acquisitions, we tend to make 14% to 15% returns.
Over the last decade, we’ve done about 55 acquisitions. About half of our revenues are from those acquisitions. We’ve used the acquisition program to change our industry mix, and now about 50% [of company revenues come from] electrical equipment. That’s almost a doubling of that participation from 10 years ago.
Fifty-five percent of our sales are outside the United States, and that’s a step-function change from where we were 10 years ago.
We’ve also really focused on trying to create a balance across economic cycles. Some businesses tend to be late-cycle; some tend to be early-cycle.
How has the economic crisis affected your pace in terms of acquisitions?
During the downturn, in ’08 and ’09, because of liquidity concerns, we really stopped doing much in the way of acquisitions. Since then, we’ve restarted significantly.
We’ve done five acquisitions thus far this year. We’ve acquired smaller companies than we do on average; companies with about $50 million of revenues each. We normally target acquisitions with $100 million to $400 million of revenues. It just so happens that this particular set of acquisitions was a little smaller than that.
But we do have a large number of transactions in the pipeline. There is a pretty reasonable chance that we’ll conclude several of those. So the program is active. Our activity levels in terms of the number of transactions we’re working on are pretty close to what they were back in 2008. We rebounded, and acquisitions continue to be an important way of growing the company and changing its complexion.
What are the relative merits of acquisitions and share buybacks?
Acquisitions and repurchases are just alternative ways of deploying the balance of capital. Not only can acquisitions give you a financial return, they can also advance the fundamental competitiveness of the company. They can get us into product lines that enable us to provide a bundle of services. They can allow us to take advantage of growth opportunities and geographies that we’re not in.
For example, two acquisitions of the five I mentioned thus far this year are in very new geographies for our electrical business. One’s in Colombia; one’s in South Africa. They’re markets that we think have good growth characteristics.
On the other hand, there are times when the financial markets misprice securities — like our stock — and that makes it awfully attractive financially to simply buy the stock back.
Let’s face it: we know our own company and our own prospects better than you’re going to know any acquisition. Shame on us if we don’t. Buybacks have the attractiveness of being pretty easy to execute. You can also make a purchase of any size as well.
The negative on repurchases is that they don’t really advance the strategic agenda of the company. They’re just a financial transaction. On the other hand, we as management are substantial shareholders, and making a smart financial move is clearly a value-creating thing.
We make it a practice to always have an outstanding repurchase authorization. That gives us some flexibility if we can’t find enough attractive acquisitions, or if we had judged that our share price is particularly inexpensive relative to our performance. Then we can step up the repurchases. And over the last decade, we’ve bought about $1.5 billion of stock back.