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West Coast Asset Management
Give Us Back Our Cash!
What if I told you that Cisco now has $39.1 billion in cash on its balance sheet versus only $12.1 billion in debt? What if you found out that Google and Apple had cash stockpiles of $30.1 billion and $24.3 billion, respectively, and were both debt free as of their most recent filings? You would not be alone if you felt shocked that they were holding so much cash that yields next to nothing. Unfortunately, those previous figures are completely accurate.1 According to Standard and Poor’s (S&P), US non-financial companies in the S&P 500 are holding $837 billion (up from $665 billion a year ago; a 25.8% increase) in cash.1 Many stock market commentators immediately take this cash hoarding to be a very bullish sign because they assume that the cash will eventually be deployed to fund R&D, share buybacks, dividend increases and most importantly, mergers and acquisitions. Additionally, Wall Street analysts are drooling over the consolidation this cash will facilitate in industries from pharmaceuticals to energy companies. But, let us make something very clear: the fact that some companies are carrying so much cash on their balance sheets is unfair to shareholders. Let’s review why companies may be rationally hoarding cash but also highlight why these reasons should be causes for concern for shareholders:
Cash & Short Term Investments ($US billions) $116.0 $39.1 $36.7 $34.7 $30.1 $25.7 $24.3 $20.2 $18.5 $18.3 Long Term Debt ($US billions) $489.7 $12.1 $4.9 $32.3 $0.0 $55.6 $0.0 $7.3 $11.5 $2.1
Company Name General Electric Cisco Microsoft Ford Motor Google Berkshire Hathaway Apple WellPoint Oracle Intel
1. Regulatory and fiscal uncertainty:
FinReg. ObamaCare. Cap & Trade. Johnson & Johnson $18.0 $8.5 Offshore drilling moratoriums. Pfizer $17.3 $38.3 Bush tax cut expiration. Put Hewlett-Packard $14.2 $13.7 yourself in the shoes of a CEO in Amgen $14.5 $9.3 America and you will soon realize ExxonMobil $13.8 $7.1 that the lack of clarity surrounding IBM $12.2 $21.0 the previously mentioned items has added an incredible amount of uncertainty to economic fundamentals of just about every industry. Without much contemplation you start to come up with a list of questions for which the ultimate answers could have a significant impact on US companies. Are the Bush tax cuts going to expire and push up corporate income tax rates? Is ObamaCare going to increase the cost of providing health insurance to employees? Could the passage of cap and trade legislation cause a spike in the cost of energy? What would a prolonged offshore drilling moratorium do to the economy of the states located near the Gulf of Mexico? Could the FinReg bill limit the amount of credit banks will be able to provide to businesses? The problem, of course, is that there is no way to know the answers to these questions. But, no matter the type of company, the industry, or number of employees, these issues need to be resolved before CEOs and managers feel comfortable making investments in their companies. Accordingly, many firms will continue to hold cash until they know how to plan for the future. Unfortunately, this means that investors can expect minimal discretionary capital expenditures, dividend increases or share buybacks until companies are more comfortable. Specifically, companies will be reluctant to allocate capital until they are less afraid that our leaders in Washington will not cause future harm to businesses through their seemingly capricious policies. But worst of all, this widespread uncertainty just about guarantees that companies will be cautious when it comes to hiring new employees, a circumstance that will likely contribute to a long period of uncomfortably high unemployment.
The Inoculated Investor
West Coast Asset Management
2. A return to panic The takeaway by CEOs of the aftermath of the worst parts of the financial crisis
was that the global economy can fall off a cliff at a moment’s notice. Specifically, after Lehman Brothers failed the financial markets seized up and caused worldwide commerce to basically shut down. Furthermore, interest spreads blew out, counterparties stopped trusting one another, and companies ceased making capital expenditures and purchasing new inventory. With the imprint of that traumatic period still in the minds of American business leaders, it makes sense that they want to hold cash as a hedge against unforeseen events. Some companies such as Berkshire Hathaway want to have dry powder in case the valuations of potential acquisitions drop dramatically. However, the majority of companies likely see cash as the only asset that can guarantee flexibility and solvency in stressed economic times. Regrettably, this situation brings to mind John Maynard Keynes’s Paradox of Thrift which said that while it is prudent for an individual to cease spending and save during uncertain times, when everyone does so then aggregate demand falls and economic growth suffers. In other words, the fact that so many companies are building cash reserves instead of spending and investing serves to hamper the nascent (and tenuous) economic recovery.
3. Fear of debt: The other takeaway from the turmoil in
the financial markets in late 2008 and early 2009 was, as Warren Buffett has so eloquently stated, companies never want to be dependent on the kindness of strangers. These strangers who The Oracle of Omaha was referencing are providers of capital for companies and specifically potential purchasers of debt. When the debt markets completely froze after Lehman went down, many levered companies were completely locked out of raising debt. Even very credit worthy companies were forced to pay rates that did not reflect the strength of their business models and cash flows. Additionally, any company which analysts and investors felt was at risk of not being able to meet a debt maturity saw its stock price decimated by scared sellers fleeing the stock. Accordingly, whether their fears turn out to be prescient or not, it is completely logical for business managers to hold cash in order to make sure they do not have to tap the credit markets at inopportune times or risk a large stock decline due to concerns over debt repayment.
4. The repatriation problem: According to US accounting rules, if companies deem that cash
generated outside the US will remain there permanently, they do not have to pay taxes on that amount. However, if companies decide to bring that cash back into the US, they often have to pay the full 35% corporate tax rate on the amount transferred. That is an incredibly steep penalty to pay for companies that want to make domestic investments that create jobs, buy domestic companies and pay dividends. Just last month, Cisco CEO John Chambers publicly advocated loosening the rules on repatriation so that his company could bring back some of the $30 billion in cash it currently holds overseas.2 Unfortunately, such forbearance does not currently appear to be on policy makers’ agenda. As such, even if companies wanted to spend some of their overseas cash in the US or return some of it to shareholders, the tax is so prohibitive that it is unlikely to return home anytime soon. Now that we have established that companies’ desire to keep a lot of cash on hand is logical and maybe even prudent in some cases, the question arises of what should shareholders do? The reason some kind of action may be warranted is that companies are earning negative inflation adjusted returns on their cash. In fact, they are likely not receiving any better yields than individual investors can on their own. At the end of the day that cash belongs to shareholders but we entrust it to management with the hope that it will be allocated in a way that maximizes return. Clearly that is not happening today and, as a result, earnings, employment opportunities, and economic activity are being negatively impacted. The truth is that, as
The Inoculated Investor
West Coast Asset Management
investors, it is our decision whether or not to hold cash in our investment portfolios. We do not buy shares of Cisco so that John Chambers can manage our cash for us and should not pay for Google to establish a bond desk just to pick up some incremental yield. We want these companies to make investments in their businesses that generate returns which are not available to us otherwise. Accordingly, while we understand why companies have decided to hold so much cash, we think the pendulum has swung too far for some companies. Management teams have become too conservative and cautious and it is hurting returns and hurting the US economy. Having said that, despite the huge cash balance, companies like GE should not be focused on rewarding shareholders. Instead, one simple and effective solution is for companies with steady cash flows and minimal leverage to return the cash to shareholders in the form of share buybacks and dividends. It is obviously undesirable for firms to use cash that has to be repatriated, but unless companies have M&A opportunities that are already in the pipeline, they should put US-generated cash back in the hands of shareholders so that we can make our own decisions on how to manage it. In addition, for those companies with a significant amount of leverage and whose large cash balances stem from recent debt issuance, our desire is for them to pay down more expensive debt in order to delever. In summary, we want companies to do something with the cash that is in the long term interest of shareholders as opposed to letting it languish on their balance sheets. References: 1. Sources: http://www.usatoday.com/money/companies/2010-07-28-cashcows28_ST_N.htm and Capital IQ 2. http://www.foxbusiness.com/story/markets/industries/telecom/cisco-ceo-urges-loosen-tax-termscash-repatriation/ 3. First picture courtesy of: not-normal-media.co.uk 4. Second picture courtesy of http://www.sbcounty.gov/