By Joseph Neu
There’s been no escaping the statistic that US and European corporates have amassed $2 trillion in excess cash as part of their response to the financial crisis. This leaves many corporate treasurers feeling like their firms have a target on their backs. The justification to keep holding so much cash gets thinner each month that the crisis memories recede and access to capital continues to be described as “never better.” Thus, shareholder activism to return cash will also be back to normal soon.
In anticipation, recent discussions with treasurers in NeuGroup meetings point to increasing attention to changing buyback plans, dividend payouts and rethinking shareholder distribution policies—including the perennial how-much-cash-is-too-much-cash question.
Buybacks vs. Dividends
Regarding how to distribute cash to shareholders, the bias against dividends is clearly on the wane, even for growth sectors like tech. Some 40 percent of tech companies are now reported to pay dividends and a similar percentage of S&P companies with revenue growth above 20 percent do also. Some growth companies even seek to differentiate themselves by offering a dividend or increasing payout ratios, particularly if they see their peers doing the opposite.
Another factor in waning anti-dividend sentiment is an array of studies suggesting that the payout form or mix has little impact on earnings multiples over time. It’s the payout that matters. An article in the May issue of the McKinsey Quarterly, “Paying back your shareholders” by consultants Bin Jiang and Tim Koller, also makes this case. They argue that the right mix is mostly about management’s confidence in its cash flows and the desire to maintain flexibility.
For the growth companies driving the $2 trillion excess cash figure, the cash flows are clearly there, so it’s largely about flexibility in the end. Share buybacks give management much more flexibility than the recurring payouts of dividends. This probably explains why 50-60 percent of firms have chosen buybacks over the last three decades—it was just 10% in the 1980’s, the McKinsey consultants note. [The differing tax treatment argument, also favoring buybacks, falls apart when most firms analyze their shareholder base (the majority tend not to be taxpayers).]
The desire to maximize flexibility is also behind the impulse to hoard cash. It stands to reason then that if management starts to rethink flexibility in the context of dividend policies, it will also come to a new understanding about how much cash to retain.
Two views on crisis lessons
Embedded in the flexibility argument of maintaining large amounts of excess cash is the notion that it serves as an enterprise hedge should other avenues of funding close down. Large cash reserves enable firms to fund their existing business or pursue game-changing innovations even when faced with a firm-specific or systemic crisis. The value of this hedge, even if it remains unquantified, makes up for the “drag” in terms of lost return.
But, again, most cash-rich firms that subscribed to this sort of thinking found that both their access to funding and their existing cash flows held up well through a rather severe crisis. Thus, the value of the hedge and the flexibility said to come with it has been arguably overestimated.
Meanwhile, at banks, the sector hardest hit by the crisis, treasurers are confronted by regulators standing in the way of cash distribution. Regulators’ lesson from the crisis is not that access to funding held up, but that banks need both a capital cushion and a substantial layer of liquid capital to prevent government bail outs in the next crisis.
The thing is, the cushion that regulators appear to be asking for cannot be justified by any of the current models banks use to define capital reserves or liquidity levels on a risk-adjusted basis. And these cushions are far in excess of what banks can earn adequate returns on. So either their models are wrong or regulators should allow them to distribute cash to shareholders.
Indeed, as the McKinsey consultants argue, returning cash is inevitable in most cases, because there is no way firms can redeploy all the cash they earn at acceptable rates of return. Thus, absent regulatory intervention, more firms and their treasurers will need to accept this inevitability.