Signs that the economic recovery is sustainable are easing financial pressure on companies, with one glaring exception. The case for fat cash cushions loses urgency with each new indication that the recovery is for real. And a growing number of companies are posting robust and even record performance without burdening their balance sheets with cash. That means corporations still holding a bundle will likely face growing calls to invest it profitably or return it to shareholders. Apple Computer’s announcement on Monday that it would at long last pay a quarterly dividend and buy back shares is perhaps the most dramatic case in point.
Cash is expensive insurance against uncertainty. It weighs down earnings and forecloses chances for shareholders to invest in performing assets, even sacrifices favorable tax treatment of borrowed capital.
When recession loomed — even in rearview mirrors — extra caution was no sin. Activist investors and corporate raiders that usually lust after idle cash sat on the sidelines. More than $1.3 trillion in cash and short-term investments filled 1,100 corporate treasuries as of the end of September, according to data furnished to Institutional Investor by the Georgia Institute of Technology Financial Reporting & Analysis Lab. (The table below, developed by the lab using data provided by Cash Flow Analytics, LLC, shows the industries with the least and most cash as a proportion of their operating income. The figures are based on cash held by U.S.-listed companies in those industries in relation to income from continuing operations, a measure useful for judging how well a company is putting its cash to work. Each industry breaks out into a separate table containing the company-specific data.)
If cash as a percentage of revenue, free cash flow or income from continuing operations is high, all else equal, that means a company is not earning as much as it could on the cash it generates. Similarly, if cash as a percentage of market value is high, the cash likely isn’t producing much in the way of shareholder value. Returns must be risk-adjusted, of course, but our research suggests companies that consider cash king these days are erring on the side of caution. (The table focuses on income from continuing operations because that is closer than revenue or cash flow to earnings, which for better or worse is what investors care most about.)
The story continues below the table
|Industries with the least and most cash as a proportion of their operating income.|
|INDUSTRY 1||MARKET |
|CASH AND |
|INCOME FROM |
|CASH AND SHORT- |
TO INCOME FROM
|>> AUTOMOBILES & TRUCKS||3,761.07||1,052.50||412.35||2.51|
|>> BEER & LIQUOR||3,683.76||55.80||621.80||0.09|
|>> BUSINESS SERVICES||2,813.59||231.59||165.69||1.59|
|>> BUSINESS SUPPLIES||3,362.67||227.80||191.54||1.02|
|>> CANDY & SODA||8,298.70||651.00||652.00||1.00|
|>> COMPUTER HARDWARE||8,934.14||902.00||425.14||3.79|
|>> COMPUTER SOFTWARE||3,771.13||299.02||114.95||3.22|
|>> CONSTRUCTION MATERIALS||2,201.21||257.78||133.50||1.27|
|>> CONSUMER GOODS||6,513.06||218.80||277.00||0.91|
|>> ELECTRICAL EQUIPMENT||3,172.10||198.23||202.64||1.67|
|>> ELECTRONIC EQUIPMENT||3,734.63||633.75||171.52||3.53|
|>> FABRICATED PRODUCTS||1,575.06||243.55||110.60||1.44|
|>> FOOD PRODUCTS||4,849.68||191.55||312.06||0.86|
|>> MEASURING & |
|>> MEDICAL EQUIPMENT||6,697.13||398.48||255.07||1.76|
|>> NONMETALLIC & |
INDUSTRIAL METALS MINING
|>> PERSONAL SERVICES||2,337.67||332.86||193.66||1.46|
|>> PETROLEUM & NATURAL GAS||3,550.67||270.09||285.89||1.60|
|>> PHARMACEUTICALS PRODUCTS||8,651.85||618.91||337.34||2.45|
|>> PRECIOUS METALS||2,597.33||209.04||86.28||2.42|
|>> PRINTING & PUBLISHING||3,088.60||229.72||161.17||1.10|
|>> RESTAURANTS, |
HOTELS & MOTELS
|>> RUBBER & |
|>> SHIPBUILDING & |
|>> SHIPPING CONTAINERS||3,150.90||99.05||120.50||2.41|
|>> STEEL WORKS||7,311.75||335.35||446.06||1.09|
|Source: Georgia Institute of Technology Financial Reporting & Analysis Lab. Data from Cash Flow Analytics.|
|1 Data are based on Securities and Exchange Commission filings by publicly traded companies with market capitalization of at least $1billion and free cash flow of at least 60 percent of income from continuing operations at end of third-quarter 2011. Industries are defined by the Standard Industrial Classification codes established by the U.S. Commerce Department. Industry-level values represent medians for qualifying companies in the sectors.|
“The aggregate amount of cash is by historical standards very substantial. There’s no debating that,” says Robert Kaplan, Baker Foundation professor at Harvard Business School. At low percentages of market capital, cash is not an issue. “Where cash is 15 to 20 percent of market cap,” says Kaplan, “the strategic rationale no longer holds.”
Before the recent run-up in stock prices, that notch was easy to beat. Cash and short-term investments exceeded 20 percent of market capitalization at more than 170 of those 1,100 companies near the end of 2011. Another 97 companies reported cash and short-term investments of over 15 percent of market cap. Stock market gains would tend to shrink cash relative to market capital — if cash accounts were static. But prodigious free cash flow pumps new cash into coffers every day.
Portfolio managers’ patience with overflowing treasuries has started to fray. “We understand in this environment the cautious mentality,” says investment strategist James Russell of Minneapolis-based U.S. Bank Wealth Management. “But the fuse has been lit on cash balances. The absolute level is on the high side of any reasonable expectation.”
Apart from calling for tax legislation aimed at repatriating billions of dollars abroad, U.S. legislators have been mute on cash accumulating while unemployment languishes above 8 percent. What could make it an issue in fall election campaigns is hard to predict. As for stakeholders that want to pry cash loose, it’s not a proxy issue that has come to the attention of Institutional Shareholder Services, which tracks initiatives in proxy season. Companies can thank the Securities and Exchange Commission for keeping cash off the table, says Charles (Ted) Allen III, governance counsel at ISS in Washington. A long-standing SEC rule bars proxy proposals governing cash or stock dividends.
Absent regulatory action, impetus for change would come from managers armed with evidence that lean cash profiles accompany record financial performance.
To their credit, many companies have returned some idle cash to shareholders. Stock buybacks in 2011 stemmed the rising tide of corporate cash but didn’t drain it. Nearly 350 Standard & Poor’s 500 index companies bought back common and preferred shares in 2011, worth about $400 billion, according to S&P. American International Group, infamously bailed out by U.S. taxpayers, grabbed first place in the repurchase sweepstakes. It reclaimed shares worth $37 billion, followed by Exxon Mobil Corp., Intel Corp., Hewlett-Packard Co., Pfizer and Procter & Gamble Co. Ten companies that top the list accounted for $100 billion in buybacks. Science Applications International Corp. marked the median by spending $470 million on buybacks.
With balance sheets elsewhere awash in cash but outcry scarce, observers have begun to wonder whether cash floors have risen to new levels as permanent insurance against economic upheaval. The recession depleted treasuries at alarming rates, as severe downturns do, with cash the best bulwark when banks get nervous about lending.
Yet there’s a growing roster of flourishing companies that operate with lean cash. Their market caps exceed $1 billion, and sturdy free cash flow can replenish at least 60 percent of their annual income from continuing operations. CACI International, Cooper Cos., Danaher Corp., Group 1 Automotive, Heico Corp., Monro Muffler Brake and Polaris Industries all had the lowest cash in proportion to income from continuing operations in their industries, yet each posted record sales, earnings or cash flow in late calendar 2011.
Every company has unique cash requirements, to be sure. One shouldn’t indict top executives purely because they have more cash than they know how to invest, especially in the wake of financial upheaval and tight credit markets. However, uncertainty can’t excuse cash levels that amount to insurance for management at the expense of shareholders. Cash is at best a nonperforming asset that earns almost nothing these days.
What else to do with it? “Finding good investments is a better outcome than giving it back to shareholders,” says Gregory Milano, CEO of New York–based consulting firm Fortuna Advisors. But ill-fated acquisitions and other unwise outlays burn massive holes in corporate pockets. If those are a company’s only prospects, it’s time to return the capital to shareholders.
In fact, our findings make boilerplate explanations for not doing so sound dubious if not hollow. Johnson & Johnson might have sound strategic reasons for sitting astride $31 billion, never mind the pristine borrowing capacity a triple-A rating confers, but it’s mum on why almost one third of its reported assets are in cash. Apart from other consequences, this means that performing assets have to work twice as hard to make up for one third of the balance sheet’s earning money market rates of return.
Dominic Caruso, CFO, fails to justify the policy on cash in any substantive way. “The financial flexibility we maintain allows us to continue to be opportunistic with these investment opportunities, and invest in them only when we believe we will create shareholder value,” Caruso says.
Salient facts argue otherwise. Cash tripled at J&J through the recent recession and its aftermath. By the fourth quarter of 2011, J&J had more cash than all but five non-financial companies, including General Electric Co., which has a huge financial services subsidiary. To be sure, J&J does look more efficient than some companies. But it has some work ahead to prove fidelity to shareholders. Of 25 companies in the Pharmaceuticals Products industry, J&J was 15th-leanest in cash to revenue, 17th in cash to market cap, 11th in cash to capital expenditures, 18th in cash to free cash flow, and 14th in cash to income from continuing operations. The New Brunswick, New Jersey–based drug company lagged cash median benchmarks by varying margins in all but cash to capex.
It’s difficult to find correlations between cash levels and stock market performance, warns Charles Mulford, director of the Financial Analysis Lab. No current data measure a precise link between low cash and shareholder returns, says Mulford, and such data might be hard to isolate. But it clearly stands to reason, he contends, that a correlation exists. Cash is an inefficient, low-yielding asset. When companies or individuals invest in more-productive assets, shareholder returns should increase.
“That’s not saying a company cannot perform well with large balances,” notes Mulford, citing Apple as the case in point. “But it might perform just as well and give cash back to shareholders.” Sure enough, CEO Steven Jobs’s successor, Timothy Cook, recently acknowledged that Apple had too much cash on hand — at current rates of cash generation, it would top $200 billion in 2013. Sure enough, the company announced on Monday that it will start paying a quarterly dividend of $2.65 a share starting with the quarter that begins July 1. Apple also said it would repurchase $10 billion of its shares over a three-year period.
Better use of dormant cash should result in more income and cash flow growth. “When we think of creating value for shareholders, just having cash sitting on the balance sheet and earning the rate it earns today doesn’t feel like the best place for that capital,” says Michael Meyer, vice president of treasury and tax for Pentair, a Golden Valley, Minnesota–based manufacturer of industrial products. In late 2011, Pentair boasted the lowest ratio of cash to revenue in the Machinery sector.
“Very core to Pentair is a lean enterprise,” says Meyer. While easily outperforming lean cash benchmarks, Pentair achieved robust results. Revenue rose 14 percent in 2011, to $3.5 billion, and earnings by 21 percent, to a record $2.41 per share. In December, for the 36th consecutive year, Pentair increased its cash dividend.
Monro Muffler Brake of Rochester, New York, topped the Personal Services group comprising 14 companies that provide services from tutoring high school students to preparing taxes and installing mufflers. (Even if moved to the automotive category, Monro would retain its leanest cash profile.) In late 2011, Monro swept its Standard Industrial Classification category with the lowest cash ratios in all five categories.
Its trim cash philosophy rests on two facts, says CEO Robert Gross. Performing assets earn an 11 percent return at Monro. Cash returns zero. A lean profile did not constrain Monro through the recession. Without requiring a lot of cash stashed in its treasury, Monro has closed 17 deals in the past decade. It borrows currently at 1.25 percent and has a $160 million credit line on tap. In January the company reported a 21 percent year-over-year jump in third-quarter operating earnings, to $22.6 million, and record net earnings, up 22.5 percent to $13.6 million.
Danaher Corp. — which with a $36 billion market cap designs, manufactures and markets products and services globally in measurement, environmental and industrial technologies segments — set the lowest cash bars for 14 companies in the Measuring & Control Equipment sector, including companies that generate less cash. In 2011, which CEO H. Lawrence Culp Jr. called “a tremendous year,” Danaher posted a new high of $2.4 billion in free cash flow.
Washington-based Danaher has maintained a low cash balance without resorting to a stock buyback since it repurchased shares worth $74 million in late 2008, according to S&P data. However, in the first nine months of 2011, it found other uses, including $6 billion in cash for acquisitions and investments, offset by slightly more than $1 billion in proceeds from issuing stock and $1.9 billion in total operating cash flows.
Colgate-Palmolive Co. of New York demonstrated that enormous companies too can keep cash profiles lean. Its cash to free cash flow and cash to income from continuing operations beat results for ten Consumer Goods companies with robust free cash flow. In all categories except cash to capex, Colgate also beats median measures.
In the Electrical Equipment sector, Ametek snared bragging rights to the leanest cash in three categories: cash to market cap, cash to free cash flow and cash to income from continuing operations. The Berwyn, Pennsylvania–based manufacturer in January reported fourth-quarter and full-year results that set highs for sales, operating income, operating margins and diluted earnings per share. In the same sector Regal Beloit Corp. posted the leanest cash to revenue and cash to capital expenditures. That was an auspicious start to a fourth quarter in which the Beloit, Wisconsin, company generated record sales and net income.
Still, whopping amounts of cash reside on corporate balance sheets — $329 billion at ten companies with the most cash after GE, including J&J. Some observers say this is the new normal. Says Ernesto Perez, a tax partner at Alvarez & Marsal, a turnaround firm based in New York: “We are witnessing a permanent reset of cash volumes at companies. Companies don’t want to be in a position where they are running out of cash.” But sooner rather than later they must reckon with the downside of balance sheets swollen with cash and return it to shareholders if no other uses exist, or risk losing ground to nimbler rivals. • •