By paying the dividend, Felch says she has opened the door to another category of institutional investors. A dividend also suits Female Health because the company has significant insider ownership, which means management is strongly aligned with shareholders. “We’re one and the same,” Felch says.
Conventional wisdom in corporate finance, of course, argues against the example of Female Health. Developing dividend policies sends the wrong message to investors, say CFOs. Informatica posted 20%-plus revenue growth its last two quarters, and CFO Fry thinks issuing a dividend would be a mistake. “It would be signaling we don’t know how to continue to grow the business,” he says.
Unless economic activity falters again, many companies will continue to have the nice problem of throwing off lots of cash. Many will be increasing free cash flow, because they are only slowly ramping up hiring, while cutting discretionary costs like procurement spending and travel and entertainment. That will only increase the pressure on CFOs to put their liquidity to work.
Two wild cards in the economy complicate the question of when and where to deploy excess cash. The first is the prospect of deflation, or, less likely, inflation. The possibility of deflation increased in June, with producer and consumer prices falling. If deflation does take hold in the U.S. economy and corporate profits and asset values shrink, being in a net cash position may be beneficial. On the other hand, if inflationary pressure develops, the wisest path might be the opposite. When the value of money is deflated, companies would prefer fixed-rate debt to cash. Says Milano: “It will be better to be a debtor.”
The second wild card is the direction of tax rates on dividends and capital gains. If the Obama Administration raises the tax on capital gains, ends the rate reduction on qualified dividends, or both, that will dramatically change the dilemma CFOs have regarding returning cash to investors or reinvesting it.
Regardless of what CFOs are planning, the situation is building to a point where they have to move out of fear mode. At minimum, finance chiefs need to stress to investors and other stakeholders that idle cash is a strength, not a question mark or a weakness, say experts. That means showing they are prepared to use that strength — by having a clear set of M&A policies and boundaries, for example, and articulating the opportunities.
Large cash cushions may continue to provide comfort over the next couple of years, particularly if the economic recovery fizzles. But they may also indicate to investors that management has become too comfortable. Or, worse, too uncertain about how to achieve growth or otherwise satisfy shareholders.
Vincent Ryan is senior editor for capital markets at CFO.
How Much Is Too Much?
There are plenty of ways to measure whether or not a company is holding too much cash. One way is to compare cost of capital with short-term investment yields. If a company earns 2% on cash and has a 7% cost of capital, it is destroying shareholder value, says Eric Olsen, global leader of the shareholder-value practice at The Boston Consulting Group. A high percentage of cash on the balance sheet relative to market capitalization also raises a red flag.
But some experts say measures like cost of capital are too narrow. “CFOs talk about the trade-off between optimizing the cost of capital and maintaining financial flexibility,” says Gregory Milano, chief executive of Fortuna Advisors. “Most companies spend too much time optimizing cost of capital — because it’s easier to quantify.”
It makes just as much sense to examine cash from an operating-risk perspective. Katy Murray, CFO of talent management software firm Taleo, says she thinks about what she calls “the nuclear event”: “If collections were to stop, how much cash would I need to cover operations in the next quarter and a half?” That’s 6 weeks longer than the traditional rule of thumb, 12 weeks.
Other benchmarks, depending on the industry, include 2% of revenue, 6 months of fixed costs, or 12 months of research and development. If the company has debt, measures of debt-service coverage also need to be factored in. Comparing a company’s cash holdings with others in its industry is also a key gauge. “In IT, where there is rapid change, volatility, and consolidation, it’s difficult to define what too much cash is,” says David Goulden, CFO of EMC.
The good news for CFOs holding on to liquidity is that there is evidence challenging the conventional wisdom that large cash balances depress valuations. Research by Fortuna shows that the top-quartile companies holding the largest amounts of cash as a percentage of assets actually traded at a premium in almost every quarter, dating back to 2003.
Of course, companies that don’t have a lot of cash are often the ones with loads of debt and below-investment-grade credit ratings. But the results suggest that while investors may carp about cash-laden balance sheets, they behave otherwise. — V.R.