Companies are under intense pressure to start putting their hoards of money to work, which should fuel a surge of buybacks and increased dividend payouts
Corporations around the world responded aggressively to the global recession and financial crisis, clamping down on spending and hoarding massive piles of cash. In the United States, where cost-cutting was especially dramatic, nonfinancial firms hold close to $2 trillion in cash, equal to a record 7 percent of total assets. (See “Time to Let Go?” this page.) Meanwhile, debt burdens are smaller than they've been in decades, both in the United States and globally.
Many businesses may keep bigger cash balances for a while, as the economic recovery remains fragile. But with most of these assets parked in short-term investments earning meager returns, the pressure on management teams to put cash to work is intensifying. If companies don't start unlocking this cash value, conditions are ripe for outsiders — notably activist shareholders or acquirers — to do it for them.
The corporate cash giveback potential is enormous. We estimate that if U.S. companies pared their cash balances back to the long-term average of 5 percent of assets, it would unleash spending of more than $500 billion.
Much of this excess cash will undoubtedly be channeled into acquisitions and other capital investments aimed at improving competitiveness and productivity. But we also expect it to fuel a surge of buybacks and increased dividend payouts. In the current ultra-low interest rate environment, we expect these corporate actions to be a major catalyst driving stock prices higher.
Will Corporations Spend Wisely?
As investors, our paramount concern is that business managers put this excess cash to productive use. A value-maximizing company will always finance the highest return opportunities first. In the best of all worlds, managers would plow surplus cash into growing their businesses, organically or through acquisitions. But, as history shows, such endeavors are rife with risks and frequently end up badly for shareholders.
This is especially true for acquisitions. Business managers tend to overpay because they're too optimistic about the potential benefits and overconfident in their ability to deliver on that potential. Integrating new operations typically takes longer than expected and, in the process, diverts management attention away from other important matters. Some managers may be more interested in empire building than in maximizing shareholder wealth.
In contrast, dividends, and to a lesser degree, buybacks, are visible, verifiable ways for companies to share their profits with shareholders. Dividends are quasi-contracts that exert a discipline on business managers who may otherwise waste cash on ill-conceived growth projects. Though more discretionary than dividends, buybacks reward shareholders by reducing share count, which makes the remaining shares on the market more valuable.
Such activities are just beginning to pick up after a crisis-induced lull. (See “Cash Givebacks are on the Rise,” this page.) Though still down significantly from pre-crisis peaks, the value of announced buybacks globally have rebounded fivefold.
Cash Givebacks = Strong Returns
Dividends and buybacks have been large and reliable contributors to long-term stock returns.
Merely announcing a cash giveback can give a stock a lift. Since 2001, for example, the stocks of U.S. companies declaring a dividend hike outperformed the S&P 500 by 2.3 percent on average in the three months after the announcement, while announcing a stock buyback drove a 3.6 percent outperformance over the following three months.
There's a strong relationship between high cash payouts and stock performance. Our research shows that, over the past 30 years, the most generous cash-returning companies — as defined by total yield or the combination of dividends and buybacks divided by market capitalization — beat the market by 2.7 percent over three-year holding periods, while the stingiest firms lagged by 2.2 percent. That equates to an annual outperformance of nearly five percentage points. (See “Unlocking Value,” p. 61.)
These results illustrate how the market works to safeguard its interests. When investors sense that the goals of shareholders (the company's owners) and management (who serve as agents for shareholders) are in conflict, they discount the price they're willing to pay to assume the greater perceived risks of owning the stock. So, investors tend to reward cash-giving companies because they view them as shareholder friendly; they punish companies that spend more on other things because they doubt such efforts will be fruitful.
Look Behind the Numbers
Despite this impressive long-term record, investors can't automatically assume that cash givebacks will add value. Like everything in investing, you need to look behind the numbers for the real story. There are several factors that can influence how beneficial a cash giveback will be for shareholders:
- Lifecycle stage
The market is less receptive when a high growth company (Google, for instance) returns cash, since it's perceived as an admission that management has run out of new growth ideas on which to spend. However, investors are generally enthusiastic when stable growth or mature companies announce a dividend increase or buyback, as it signals confidence in the soundness of their cash flows.
- Intrinsic value
As with any investment, fundamentals and timing matter. For instance, repurchasing shares after a long period of outperformance will likely be a bad deal for shareholders if the shares now trade at a premium to a company's intrinsic value (or the fundamental value of its underlying assets). The risks of an eventual re-pricing overwhelm the benefits of the lower share count, diminishing long-term shareholder value. Conversely, buying back shares trading below a company's intrinsic value enables investors to enjoy any future upside in the value of the remaining shares.
- Financial leverage
If a company uses an appropriate level of debt to finance a cash giveback, it can enhance future shareholder value, because the added interest expense is tax deductible and thus adds to earnings power. The upside for shareholders is even greater if the company is repurchasing undervalued shares. However, if financial leverage is excessive, the benefits of the tax shield will be dwarfed by the greater interest expense burden and increased risk of bankruptcy. In our view, a company's cash payout plan must be assessed as part of its overall capital allocation program.
- Employee compensation
Some buybacks simply offset the dilutive effects of stock compensation packages for employees, including stock options and stock contributions to 401(k) plans. These moves don't reduce the number of outstanding shares.
Sizing Cash Return Potential
To fully exploit the potential in corporate cash, we undertake a case-by-case investigation of each company's cash-returning capacity. This analysis starts with an examination of free cash flows and considers the following factors:
- Liquidity needs
A company's giveback potential will depend on its cash needs, which in turn depend on the company's stage of development, ongoing reinvestment requirements and the cyclicality or variability of its business. Early stage growth, capital-intensive and big research and development spending companies typically need more cash than businesses without these commitments. Highly cyclical businesses also typically keep more cash on hand as a safeguard against economic downturns or unexpected events.
- Future capital investment
A critical part of our analysis is determining whether reinvesting existing cash in the business or using it to fund acquisitions would generate a bigger return to investors than a cash giveback. We view management's past track record in generating attractive returns on equity as a reasonable indicator of future success.
- Financial leverage
A firm with minimal debt can raise debt to maximize the benefits of cash givebacks to shareholders. A heavily indebted firm would be better off conserving cash by easing up on cash givebacks (or acquisitions and capital investments) or by using cash to pay down debt.
“Evaluating Cash Return Capacity,” p. 62, presents a simplified view of how this assessment works. This matrix essentially compares free cash flow available to shareholders (labeled “Free cash flow in excess” or “Free cash flow in shortage,” with the return potential of current and planned capital investments (labeled “Good projects” and “Bad projects”).
Consider, for instance, a company that generates surplus cash even after some combination of paying out dividends and buying back shares. In that case, there's excess free cash flow. But let's say that its industry is mature and has minimal reinvestment needs. That would put it in the “Bad projects” category. We would conclude that the company should curb its capital spending and use surplus cash to increase its cash payouts. However, if that same company had found good investment opportunities and had a strong record of success with such initiatives, we would want it to use excess cash to fund the highest returning projects — and deploy any additional cash to boost cash payouts. If the firm is underlevered, it would have even greater capacity to raise its cash givebacks; if it's overlevered, it should decrease them.
A Cash Return Success Story
Time Warner Cable (TWC) serves as a role model for how to get the maximum reward from a cash return program. The company is the second largest cable operator in the United States, serving more than 14 million homes. The cable business has matured, requiring far less reinvestment. As a result, free cash flow has increased significantly. Since 2008, TWC shares have returned more than 100 percent, while industry peers rose 32 percent and the S&P 500 index fell. TWC accomplished this feat despite operating results that were largely in line with those of its peers and even a bit below initial expectations. We attribute this strong stock performance to the company's disciplined capital allocation approach and steadfast commitment to returning cash to shareholders.
Soon after the stock began trading publicly, TWC established a strategy for capital allocation and financial leverage. Beginning in early 2007, the company committed to reaching and maintaining leverage of 3.25 times net debt to EBITDA (earnings before interest, taxes, depreciation and amortization), or roughly the middle of the range for U.S. cable operators. The objective was to set leverage at a level that wouldn't endanger its investment grade credit rating, while providing maximum flexibility to deploy excess cash, mostly through dividends and stock buybacks. By preserving its investment-grade status without “gold plating” its credit rating, it was able to lower its cost of capital and free up significant cash for dividends and buybacks. The company delivered on its promise, starting with a special dividend in 2009.
Since 2008, TWC has led the U.S. cable industry in returning cash to shareholders. Dividends and stock buybacks have totaled roughly 44 percent of its initial 2008 market capitalization, versus 12 percent for its peer group. We expect the company to maintain a high payout ratio going forward, as it remains committed to keeping leverage at the targeted level.
Meanwhile, the company has also maintained strict criteria for alternative uses of excess cash, such as acquisitions and new business initiatives, which require that the return from any new investment must exceed the return from buying back stock on a risk-adjusted basis. For example, it took into account the empirically high uncertainty of an acquisition versus the relatively risk-free opportunity to buy back stock. As a result, no major merger and acquisition has been pursued over the past three years.
As EBITDA and free cash generation grew, the company took on more debt and increased its payout to maintain its optimal leverage target, building investor confidence that management would stick to its plan to return excess cash to shareholders.
Dividends or Buybacks?
The choice of whether to initiate or increase a dividend, repurchase shares or pay a special dividend depends on the stability of a firm's expected future cash flows, recent stock performance, employee stock option activities and shareholder tax considerations.
As noted earlier, a firm should be reluctant to use a share repurchase as a means of distributing excess cash following an unwarranted run-up in the share price above its intrinsic value. In that case, it's better to return cash as dividends. If a firm deems it necessary to attract or retain talent by issuing employee stock options, it would be more inclined to conduct buybacks.
Taxes on dividend income and capital gains vary significantly by country and by type of investor. In the United States, rates vary from zero for tax-exempt pension funds to 15 percent for both dividends and capital gains for individuals. With the extension of the Jobs and Growth Tax Relief Reconciliation Act of 2003, dividend income and capital gains will continue to be taxed at current rates through 2012, both lower than they've been historically. Uncertainty about tax policy prompted a handful of companies to pay onetime, special dividends in 2010.
Spread the Green
We don't expect companies to let their huge cash hoards sit idle forever, and this is promising for shareholders. Eventually, they'll stop hoarding cash and start putting it to better use — or risk that outsiders will do it for them. Once the spending spigots open, we expect buyback and dividend activity to accelerate, adding powerfully to equity returns.
The attractive opportunity in cash-rich companies is a major theme across our U.S. and global value portfolios. Because of our value mindset, we prefer the “bird in hand” aspect of dividends and stock buybacks over riskier investments, and, when appropriate will share those preferences with management.
It takes rigorous research to be able to tell whether a cash giveback is likely to enhance or damage shareholder value — and to know when a company is able to return even more cash. We believe that actively managed equity strategies are well positioned to capitalize on this large, differentiating investment opportunity.
Brian F. Lomax, far left, is a portfolio manager for Bernstein Value Equities, based in New York. Gregory D. Singer is the director of research for Bernstein's Wealth Management Group, based in New York
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