Corporate Cash….All that Glitters
All that Glitters……..
A recent report out of McKinsey in Co.(McKinsey Quarterly, May 2011) stated European and U.S. companies hold excess cash on the order of $2 trillion. The general point of the article is how companies’ should begin paying back its shareholders given the large excess funds they both hold and will continue to produce.
I find McKinsey’s arguments to be both an exaggeration and misleading for the following reasons:
1- The cash does not account for funds held in geographies which, if pulled would result in a large tax, in perhaps two countries. In fact, certain countries would not permit such payments at all.
2- It does not account for needed working capital
3-It does not account for debt due
4- It does not take into account funds needed for expansion, or business combinations, R&D, or additional hiring.
5- The desire to hold excess cash may be needed for other obligations, such as pensions, employee buyouts due to restructuring, commitments, or guarantees, both legal and moral.
6- The authors do not explain why firms must distribute cash back at all, even if several years have passed awaiting opportunities. Capital gains has always proved the better after-tax reward.
7-The authors defined excess cash as the amount of cash outstanding over and above operating cash, which is defined at 2 percent of revenue. This is clearly a poor definition of excess cash.
What the article does correctly point out, however, is the net effect on the firm value of share repurchases is zero. This is a subject I have long ago pointed out. Share buybacks improve accounting metrics, but do nothing to improve ROIC.
My point is the amount of excess cash is not nearly that amount claimed. I strongly believe a secondary reason for the US economy and stock market free-fall just a few short years ago were the massive buy-backs, which, by eating up capital, only served to deepen the credit crisis while driving some pretty large institutions out of business. I believe shareholders would have earned greater than 3% over the past five years had companies acted more prudently, and invested in assets and projects earning a safe spread between ROIC and cost of capital than depleting cash and equity.
Buybacks have not proved to be a “reward” to shareholders, as managers and too many investors and stock analysts, claim the programs to be.
For more information on this subject, contact Kenneth Hackel or consult “Security Valuation and Risk Analysis.”
