Companies are sitting on mountains of cash, much more than they need. Holdings at NYSE- and Nasdaq-listed companies topped a record $2.7 trillion in 2005, and they are growing at 24 percent annually. By industry, the largest cash increases in the past decade were in media (1,700 percent), utilities (1,360 percent), and telecommunications (1,300 percent).
Until recently, excess liquidity seemed like a smart strategy. It was insurance against risk and provided capital for growth. But now, with balance sheets largely mended, cash flow volatility easing, the outlook for corporate earnings generally improving, and interest rates on the rise, the benefits of keeping large amounts of cash on hand are less easy to discern. This leaves many companies facing a troubling dilemma: Just when the actual need for excess cash has decreased, they have too much liquidity. They’re hoarding capital instead of putting it to good use, wasting critical opportunities to benefit from it. And they’re making themselves vulnerable to corporate raiders — private equity firms and hedge funds that would like nothing better than to move in on an organization with large sums of money in the bank.
In this environment, a so-called decapitalization strategy that reduces the cash on hand to a sufficient amount for day-to-day business and growth — an approach that in turn can simultaneously enhance creditworthiness and return on equity — offers the most compelling economics. The purpose is not purely to minimize cash, but also to realistically determine how much liquidity is required for both routine and strategic operations and to wisely earmark the rest of the money for shareholders and debt reduction programs.
Indeed, there are periods when more rather than less cash is necessary. For instance, cash can be a competitive advantage, especially in an industry prone to aggressive pricing, like retail or airlines. Wal-Mart and Microsoft have famously used their financial strength and excess liquidity to cover deep discounting that competitors are often unable to match. Manufacturers typically have a different reason for accumulating cash: It provides bargaining strength for dealing with suppliers and labor unions. And startups such as biotechnology companies may have to depend on liquidity to acquire a new technology or launch an unanticipated research and development effort.
So whether decapitalization is intended to minimize cash on hand or to allot it wisely, an evaluation of organizational needs and industry imperatives must first be conducted to identify short-term and long-term priorities. From there, a balanced capital structure that allocates cash among these spending and debt categories can be fashioned:
Operating Liquidity. A minimal amount of cash should be designated for work in process, sufficient to ensure continued operations without undue risk of financial distress. Operating liquidity needs to rise during periods of industry volatility, lower expected cash flows, and higher fixed costs, including dividends and debt servicing.
Growth Capital. Also called dry powder, this money is set aside for research, expansion, design, development, and acquisition opportunities. In other words, it’s the cash disbursement with the greatest potential upside. However, reserving excess cash for long periods of time to cover prospective (but unidentified) growth opportunities can drag down a company’s performance and profitability, a condition that may worsen as interest rates rise and it becomes more expensive to rely on debt to fund growth. The need for dry powder increases as growth prospects rise or the challenges associated with raising capital worsen.
Share Repurchases. Buying back company shares is an efficient way to reroute excess capital not needed for liquidity and growth. Share repurchases are a positive sign to capital markets and to investors, signaling fiscal discipline and confidence in future earnings. Moreover, empirically, share prices tend to increase in value after a repurchase because there is less outstanding equity. However, the share float at some companies is too small for a significant share repurchase program.
Pension Funding. This use of cash is attractive because it improves a company’s credit profile, and in some countries, including the U.S., it is also tax deductible. Moreover, accounting changes are under way to categorize net underfunded pension positions as debt rather than as a mere footnote on the balance sheet; this accounting change will make pension funding even more desirable. To limit the risks of overfunding, pensions should be endowed to only about 80 to 90 percent of their total.
Dividends. Especially in today’s more dividend-friendly tax environment, this is typically the first decapitalization option for a company with too much cash. However, most companies’ dividend level is dwarfed by the amount of excess capital, making this an inefficient route to redeploy cash. And because they are a fixed cost, large dividends impair operating liquidity and credit quality, making them especially inappropriate for cyclical or volatile sectors such as mining, pulp and paper, and automotive.
Notwithstanding media attention and investor interest, market gains from most dividend increases are small, at less than 1 percent. However, new or higher dividends can improve share performance for those companies with low volatility, low valuations, high margins, and dividends that are well below those of others in their industry. In a balanced capital structure, dividends should not exceed recurring and stable quarterly cash flow. Volatile or uncertain excess cash flow may be better distributed through share buybacks.
Debt. As a tactic that is similar to holding cash for growth, debt reduction is a source of financial strength by freeing debt capacity. However, debt reduction is not always possible: Many companies have illiquid or noncallable debt, and the cost to unwind it can be significant. Also, during the recent period of low-rate loans, many organizations refinanced their most costly debt with new debt under attractive terms.
Optimally capitalized companies should balance share repurchases with debt reduction to maintain the ideal mix of debt and equity. If debt reduction outpaces share repurchases, a company’s credit profile may improve; but because equity is more expensive than debt, its average cost of capital will be higher.
Triggered by analysts, investors, and heightened public concern about corporate governance and proper management of capital, interest is growing among companies in the possibilities of balanced capital structures and corporate decapitalization. Indeed, since July 2004, when Microsoft announced a massive $75 billion decapitalization that included a special dividend, a doubling of the regular dividend, and a $30 billion share repurchase, corporate boards around the world have begun to reevaluate their own cash positions.
There are many rules of thumb for cash allocation — setting aside a percentage of revenue or of fixed costs, for instance — but one-size-fits-all solutions are a mistake. Decapitalization is an extremely complex endeavor, requiring deep analyses to produce an effective allocation plan. However a company approaches the issue, though, one fact is undeniable: Too much cash is a wasted asset.
Justin Pettit ([email protected]) is a vice president with Booz Allen Hamilton based in New York who specializes in shareholder value and corporate finance. He is the author of Strategic Corporate Finance: Applications in Valuation & Capital Structure (Wiley, 2007).