Rates may be rising this year but the capital allocation conundrum continues. That is, whether to return capital to shareholders, pursue M&A, or retire debt. But for the most part, all indications point shareholders as the winner.
“Although the rising rate environment will have some impact, people are not anticipating rates to rise quickly, like in the Volcker days,” said Melody Hart, a senior consultant at Strategic Treasurer, thus companies are unlikely to dramatically shift their current strategies.
Ms. Hart said that looking at capital allocation as a pie to be divided between returning capital to shareholders via stock repurchases and dividends, pursuing M&A, capital expenditures and retiring debt, the overall pie will shrink a bit due to rising rates. However, if the increases are gradual, they should not have significant impact on companies’ capital allocation strategies, except perhaps for highly leveraged companies, especially if their performance is poor.
A recent study by Standard & Poor’s largely backed up Ms. Hart’s view. The rating agency forecasts return of capital to shareholders in 2017 dropping somewhat from 2016 for investment-grade issuers but still remaining higher than previous years going back to 2011. For speculative-grade companies, it forecasts the return of capital in 2016 and this year at least doubling from 2015 and earlier years going back to 2006.
S&P’s report examines major industry sectors, to forecast likely dynamics in terms of companies’ use of capital. And here’s how they should play out:
US Media and Entertainment – likely acquisitions may prompt scaling back or suspending share repurchase programs.
US Defense Contractors and Railroads – defense has provided steadily growing share repurchase and dividends. That may moderate somewhat in 2017 but largely stay in line. Railroads have also outspent free cash flow on shareholders, but S&P expects both dividends and repurchases to drop in 2016 and 2017.
US Consumer Products – companies have scaled back repurchases to preserve cash flow to support acquisitions of complementary companies. Dividends have increased, but dividend growth will likely slow considering industry consolidation.
US Healthcare and Pharma – several companies in this sector provide modest dividends and aggressive share repurchase programs, and in 2015 both became more aggressive. Trump tax reform could increase repurchases.
US Retail – Discretionary repurchases are the main vehicle for returning capital for investment grade companies, with M&A less of a focus. Speculative grade companies have been willing to reward shareholders at the expense of higher leverage.
Technology – In tech sectors, except software, share repurchase and dividends have declined since 2015, and dividends remain a modest use of cash flow. Software companies increased share repurchases in 2016 but S&P anticipates they will moderate repurchase this year, to reduce leverage.