Tuesday, January 15, 2008

* When Is A Lot of Cash A Bad Thing?

A November 2007 article in CFO titled "The Cash Trap" had a lot of information that a dividend investor would find interesting. The article takes a case study approach and looks at Terex, a S&P 500 company. Terex's total shareholder return (TSR) ranks sixth in the S&P 500 (excluding financial institutions) over the past five years, based on an analysis done by The Boston Consulting Group (BCG).

Historically, Terex piled up cash on its balance sheet waiting for the next acquisition. This practice was once viewed favorably by Wall Street as having a strong balance sheet, but this is now increasingly viewed as as a lazy balance sheet. There are a lot of companies like Terex with significant cash reserves on the balance sheet.

In an effort to find something to do with all that cash, many companies have turned to stock buybacks. Through the end of 2006, companies in the S&P 500 had bought back more than $100 billion in shares in each of the past five quarters, nearly double what they were paying out in dividends. BCG argues that buying back stock doesn't deliver much in the way of long-term value, meaning that corporate executives must still find ways to differentiate their companies from their competitors and demonstrate that they can deliver profitable, above-average growth.

In their efforts to balance short-term investor expectations with long-term strategic goals, BCG warns companies to avoid these cash traps that can negatively impact near-term shareholder returns:
1. The Lazy-Balance-Sheet Trap
Companies that ignore investor pressure for near-term returns run the risk of reducing their valuation multiple and jeopardizing their independence. While public companies probably can't get away with leveraging their balance sheets as highly as a private-equity owner would, many will find they can squeeze out cash for stock buybacks or dividends without jeopardizing their long-term goals.

2. The Reinvestment Trap
Beyond deciding how much to reinvest in their business and how much to return to shareholders, companies also need to be smart about how they reinvest for long-term growth. Companies fall into a reinvestment trap, BCG says, when management misallocates resources across the business portfolio — either by feeding all businesses at the same rate despite their differing growth prospects or contributions to shareholder return, or by allocating too much capital to problem businesses.

3. The M&A Trap
Acquisitions are highly appealing, especially when they are immediately accretive to earnings. But an accretive deal won't necessarily boost shareholder returns if, as is possible, it also reduces the acquirer's multiple. BCG cites the example of a consumer-brands company whose CEO engineered the purchase of numerous low-tier, low-margin brands. The acquisitions boosted earnings in the first year but diluted the company's average organic growth rate and margins, causing investors to drive down the multiple on the company's stock and ultimately yielding no improvement in shareholder return.

4. The Stock-Buyback Trap
BCG doesn't discount the role that stock buybacks can play in boosting near-term returns for some companies. But the firm's research indicates that buybacks do not change investors' estimates for long-term earnings-per-share growth, or induce them to accord a company a higher valuation multiple. By contrast, it says, dividends have a far more positive long-term impact. In a study of 107 companies that boosted their dividend, and another 100 that announced an increase in share repurchases, the dividend payers saw their multiples go up over the next two quarters by an average of 28 percent, and the top-quartile performers by an average of 46 percent. In comparison, the buyback companies saw their valuation multiples erode on average, and top-quartile improvements averaged only 16 percent.
The bottom line is that shareholders no longer will tolerate companies building large cash reserves as they have in the past. I think the article's subtitle says it all "Cash may be a comfort in an uncertain economy, but it can also be a drag on shareholder value."

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