We begin with a chart showing the cash build for the firms composing S&P Industrials Index. As seen, cash for the Industrials has been in a steady rise over the past 8 quarters.
There is some good news on top of this. Credit quality and balance sheets are getting stronger. This added financial flexibility along with the stronger free cash flows are always good for stock prices, cost of capital, and merger activity. The improvement in credit quality is an important determinant in CT Capital’s risk model and will be an important impetus if stock prices are to move higher. Although the chart below shows balance sheet debt ratios improving, when lease obligations are included (as CT Capital does in its models), the total debt/equity ratio for the Industrials has actually risen modestly over the past three years. Coverage ratios have improved due to the rise free cash flows.
The following is noted:
- The S&P 500 companies have, over the past 20 quarters, produced, on average, $551 million in cash flow from operations, but just $354MM when adjusting for normalized changes in the balance sheet (which CT Capital calls “power” operating cash flow). This sub-par: “power” operating cash flow should keep a lid on valuations.
- Year-over-year growth in cash flow from operations (OCF) for the S&P Industrials has shown surprising strength, owing to some improvement in top line (although that growth is sluggish for many companies), and the large improvement in expense control, including labor, supply chain, manufacturing and working capital. This growth rate on OCF should now settle down to the 2%-4% range over the coming few years, insufficient to warrant further multiple expansion.
- The Industrials have been on average each quarter, spending $530MM repurchasing shares and paying dividends (with a $82MM median spend rate).
- During the March 2010 quarter, S&P 500 companies repurchased net shares (after issuance for items such as options, etc) of $52.8 billion, on par with the $53.1 billion the previous year. However, this is less than half the net buybacks of 2 years earlier, whether measured in aggregate or average.
For investors waiting on big dividend paychecks and large share buyback announcements, the evidence is ambiguous: companies would, in general, be foolish to change current policies based on the growth rate in prospective normalized (after all the cash has been squeezed) cash flows. For the year-end 2009 quarter, S&P 500 cash dividends were roughly flat verses the year ago quarter, while for the calendar year 2009, total dividends for the S&P 500 fell. There has been a low single digit rise so far in 2010.
So, where has the cash been going? Three areas:
- Much has remained on the balance sheet.
- To reduce debt. Since year-end 2008, total debt for the S&P has been reduced by about $400 billion.
- Share buybacks, as noted above.
As the chart below shows, it hasn’t been going towards increased capital spending. While many view that as a negative consequence, an enterprise must match its spending on discretionary items with its ability to produce free cash flow and its unit rate of growth. As such, corporate executives have been diligent with this largest capital item.
A more interesting perspective is seen in the following chart. Here cash flow from operations is adjusted for normalized balance sheet changes (Power operating cash flows), and then subtracting capital spending during that quarter, going back 5 years to March 2005. Recall that capital spending has been held back to, in many cases, maintenance levels, so that if anything, these modified free cash flows are exaggerated. Even so, we are only 5 quarters into strength. Thus, although free cash flows have been strong, they have been amplified from the balance sheet changes and minimal other and capital spending. To me, this signals that, in general, a change in management strategy regarding dividends, share repurchases and acquisitions, would be premature.
Firms now need to see enhancements to top-line growth to continue the great cash build. If this does not occur, it would be foolhardy to think Boards of Directors would, in general, significantly allow for a step-up in acquisition activity, although they clearly currently have the balance sheet flexibility to do so. At the same time, financially strong entities could enhance their return on invested capital (providing a wider margin over their cost of capital) thru one or more strategic free cash flow-based acquisitions—particularly, given the current very low cost of debt they might need to raise to fund the purchase. A well-priced and timed acquisition can significantly add to shareholder value, while of course, an ill-priced, ill-executed and poor candidate, would severely destroy value.
As for dividends, increases are all but certain given the large cash pool and slow growth. But is that what investors are really looking for? Given the choice, investors would much prefer capital gains, the result of value-adding improvements to the capital base. Increases in tax rates (Federal and State) would drive investors further towards capital gains opportunities.
I would never under-estimate Boards of Directors to give their blessing to business combination at the wrong time. Their history is clear and littered with failure, such that if the recent slight run in stocks provides provocation, I would not be totally surprised.
But based on the evidence, generally, it would be the wrong decision. The right decision is to let the cash line the corporate wallets until a suitable acquisition target is identified. Dividends will lose their luster with rises in tax rates and, later on, increases in inflation. Capital gains is the answer.
Also recall (how could one forget?) it was just a year and a half ago the economy was in need of a Federal bailout. New Era of Buybacks, dividends and mergers? As the 1970s singer Meatloaf once said: “Two out of three ain’t bad.” But even rising dividends should be viewed with suspicion.
- Return of the “Hostile” Takeover?
- Why It Would Be Unwise For Firms to Boost Dividends
- The Folly of Share Buybacks
- The Folly of Stock Buybacks-Part II
- CFOs Making the Same Mistake Again-Stock Buybacks
Disclosure: No positions
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