SATURDAY, MAY 15, 2010
Stronger Than Ever
By MICHAEL SANTOLI
Corporate America is sitting on piles of cash, ready to be spent on things like share repurchases and acquisitions. Yet another reason to rotate money into high-quality blue chips.
ACROSS THE INDUSTRIALIZED WORLD, governments are in hock.
American consumers are battling a debt hangover 20 years in the making. Yet big U.S. companies collectively are lean, financially sturdy and richer in cash than they have been for decades. Profit margins are approaching all-time highs a mere year after the Great Recession climaxed.
John Kuczala for Barron's .Corporate America is prepared to return cash to investors and to accelerate the spending, hiring, investing and acquiring that most companies curtailed amid the credit stress and deep uncertainty of the financial crisis and the 2007-2009 economic contraction. Mergers and acquisitions, capital spending, share buybacks and dividend increases have been running at historically low levels and are just beginning to rise.
While this anticipated corporate cash deployment won't in itself carry the economy or propel the stock market to towering new heights, it should contribute to growth and help enrich investors in companies with solid balance sheets.
Cash holdings by Standard & Poor's 500 companies, whether measured as a percentage of corporate assets or as a proportion of total stock-market value, are at or near record levels. The ratio of free cash flow to stock-market value, too, is close to an historic high.
Brian Belski, chief investment strategist at Oppenheimer, notes that companies have been operating "in the bunker" since the credit shock hit, paring payrolls, repaying or refinancing debt, cutting capital spending and nursing their profit margins.
SENSING AN EMERGING THEME, Credit Suisse's North American research group produced a nearly 200-page report this month breaking down the cash richness of U.S. companies. It begins: "Cash in a difficult time is like blubber on a seal: protecting the animal during the harshness of winter, but turning bothersome in spring and summer." And it argues: "We believe that U.S. companies are now ending their recent enforced hibernation. Survival mode is over and Corporate America is breathing easier, with cash as a percentage of market cap and aggregate free cash flow yield at all-time highs. Now it's time [for the companies] to cash out."
In typical times, capital expenditures by businesses neatly shadow "internal funds," a measure of spending power, adjusted for inventories, that's tracked by the Federal Reserve. In the tech-spending boom of the late 1990s, these lines diverged and capex surged beyond internal funds in a debt-enabled overinvestment binge, to the tune of a $300 billion annual rate.
From 2008 to 2009, the reverse happened. In fact, the collapse in capital spending was of even greater magnitude than the late 1990s excess, and far more sudden. Only since mid-2009 has capital spending begun to normalize, but companies have a long way to go to return to the long-term trend.
In M&A, the value of completed transactions as a percentage of U.S. gross domestic product and of S&P 500 market value were far below their 15-year average, implying plenty of pent-up demand for deals.
Buybacks last year also were minimal, while dividends paid slid 20%, so a mere return in the direction of long-term trends would start cash flowing in value-seeking and growth-generating directions.
Says Jason Trennert, chief strategist at the research firm Strategas Group: "The data are broadly indicative of companies putting cash to work. Whether M&A or dividends or buybacks, all are up, even if not substantially." But the trend appears to be gathering pace. Both ExxonMobil's (ticker: XOM) deal to buy XTO Energy (XTO) and Hewlett-Packard's (HPQ) bid for Palm (PALM) show that the idea of acquiring growth is reviving.
International Business Machines' (IBM) optimistic comments on corporate tech spending in its quarterly conference call last month indicated that CEOs are stepping out of the bunker. Time Warner (TWX) has assured investors that it soon will have a strategy to return a pile of capital to them. On their recent conference calls, Cisco Systems (CSCO) and Intel (INTC) executives were almost boastful about their plans to begin aggressively hiring, a stark departure from recent years when thrift and efficiency were the focus.
Mark Flannery, Credit Suisse's U.S. director of research, says that, in a sense, aided by the resiliency of Corporate America, companies have over-succeeded. "The big fact," he says, is that with cash balances and margins high, "there are a series of decisions coming" out of corporate suites on how to spend that money. His conclusion: Share repurchases will be the most predominant -- and, generally, most appropriate -- choice. But, Flannery adds, some companies will decide simply to do nothing.
Indeed, some investors and analysts doubt companies will rush to deploy their bounty of cash. The recent downturn was so traumatic, and the uncertainty about the durability and strength of a recovery is so deep, they argue, that managers will remain conservative for longer than in the recent past.
Douglas Cliggott, the chief investment strategist at Credit Suisse, says, "Corporate cash can be ballast. The money is there, but you need the animal spirits [to return]. Capex as a percentage of cash flow won't get back to the recent trend." This, he believes, is because we are now in a world of shorter, sharper economic cycles, far more like the immediate postwar period of high structural debt levels than the gentle easy-credit cycles of the past couple of decades.
PERHAPS THIS IS HOW IT WILL play out. Yet corporate spending and investment has been running so far below the norm that even a revival that falls short of the usual levels would mean a notable quickening of deal-making, hiring and investor-friendly recapitalization. What's more, not even the financial crisis could curb the standard CEO's appetite for growth.
Belski says "continued corporate and economic outperformance" will motivate managers to part with more cash: "Performance drives greed. Companies should be buying other companies now."
Ajay Kapur, formerly with Mirae Asset in Hong Kong, calls multinationals "underleveraged, efficient and cash-rich." He says that "continued corporate deleveraging and cash accumulation is now anti-shareholder and anti-economic growth." When companies are underleveraged, their return on equity suffers. And ROE represents the gain on shareholders' capital and, ultimately, drives the market's valuation of stocks.
This isn't a call for a return to the over-aggressive balance-sheet engineering that reigned at the end of the credit boom, when companies commonly did "leveraged recapitalizations," maxing out borrowing to repurchase shares. Nor does it suggest that it makes sense to build an empire through overpriced acquisitions or blind repurchasing of shares at any price.
But at this point of the cycle, corporate risk-taking and growth-oriented capital allocation will be positive forces for quite some time before they become overdone and self-defeating.
Jerome Heppelmann manages the Old Mutual Focusedy Fund (OAFCX), which targets high-quality blue-chip stocks. His portfolio contains a number of companies freighted with cash. While he doesn't think it's particularly crucial for them to mobilize it, the cash bolsters value in the likes of Apple (AAPL). Backing out its massive cash balances helps him arrive at a true, fairly modest, valuation for its shares.
Some of the companies he favors have been active in M&A lately, whether to build scale ( Merck [MRK] buying Schering-Plough), or to pick up compatible businesses (Exxon and XTO or Dell [DELL] and Perot Systems) or to broaden their international reach ( MetLife [MET] buying a division of American International Group [AIG]).
Says Trennert of Strategas: "When I talk to clients, there is an awful lot of discussion about what effect presumably inevitable tax increases will have on corporate behavior. Investors will probably agitate for the use of corporate cash." He believes there's a good chance for a trend toward issuing special dividends before the tax man's bite gets nastier.
Among stock sectors, technology stands out for its mega-cap companies with outsized net cash balances. But capital-goods, business-service and health-care companies aren't too shabby either, with appreciably higher cash positions than their 2002-to-2008 average, according to Credit Suisse. The firm ranked the companies with the greatest financial flexibility to boost capital spending, dividends, buybacks, M&A or all of the above. Among those also deemed attractive were Stanley Black & Decker (SWK), Tenet Healthcare (THC), General Maritime (GMR) and Novellus (NVLS).
All this could be pointing to a shift in investors' preferences. As often happens in a post-recession, liquidity-propelled environment, the stock market since the March 2009 low has been led by the riskiest, most leveraged and cyclically sensitive companies, notably smaller ones. All along, many value-conscious commentators have been futilely advocating high-quality, dividend-paying, reasonably valued companies.
But getting investors to listen requires a catalyst to raise market volatility and increase risk aversion. Will the scare over European debt and the alarming one-day plunge in the U.S. market in early May be that catalyst?
Mark Luschini, chief investment strategist at Janney Montgomery Scott, believes so. He calls quality companies "an under-owned sub-asset class." He marvels, for instance, that a dominant Hewlett-Packard, with leverage to a global tech-spending cycle and a good chance to goose margins, trades at a steep discount to the market, near 11 times current-year earnings forecasts.
Is a rotation to such companies under way? The Vanguard Dividend Appreciation exchange-traded fund (VIG), which is based on the Dividend Achievers Select index, seems to be saying so. In the past month, it has outpaced the S&P. Before then, it had trailed that benchmark index for a year.
In the stock market, cash might not be king again. But buying companies laden with it could produce princely gains over the next year.
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