Cash as a Liability
Building Cash vs ‘Maximizing’ The Bottom Line
The no-return-on-cash dilemma is very real – CEOs have a fiduciary responsibility to generate sufficient returns for shareholders. Acquisitions are eye-catching, and their proposed benefits and synergies easily explained. Moreover, cheap debt is dangled in front of CEOs by investment bankers every day. This is like pouring gasoline on an already blazing fire.
Borrowing at 3% and less doesn’t feel like real leverage normally does. CEOs can make an instant positive impact on revenues without losing any profit through the commensurate increase in interest expense. In some ways, why wouldn’t a CEO take advantage of artificially cheap money to magnify revenue growth vis-à-vis acquisitions? After all, they are partly compensated through increases in earnings per share and the share price.
To use a previous example, Danone is acquiring WhiteWave Foods for 40x earnings. The going-in return for this acquisition will be 2.5% (1/40). Microsoft will initially earn 1.8% from its LinkedIn acquisition, which is occurring at a 56.8x multiple of earnings. These returns, low as they may be, are actually justifiable considering current borrowing rates and cash yields. A 1% or 2% return is better than zero.
There is one great problem to all of this. In the case of cheap debt, this is in fact real leverage. These companies have taken on additional balance sheet liabilities, though the interest burden is not really noticeable now on the income statement. If any of these companies ever face earnings difficulties, or some degree of future credit risk, shareholders could be in real trouble. Or, to the extent this is variable rate debt (or maturing debt), what if interest rates rise? This filters through to the income statement, expressed through a lower P/E, and shareholders suffer.
If these companies are not generally the credit risk-type situations, perhaps like Microsoft, there is always an impairment risk. In other words, if these acquisitions made at enormous valuations do not prosper, there almost assuredly will be impairment charges to follow. Who bears the consequence of this? Shareholders, of course.
This naturally is not a mainstream argument. There are those who will contend that the acquisitions occurring now are all sensible, a product of low interest rates. They will argue that each company is guided by a skillful CEO who will be able to achieve massive synergies and revenue expansion, such that the high multiple will ultimately be justifiable. Or, future credit risk is a non-issue, as interest rates are not going to rise anytime soon. Or, CEOs are hired to grow the business, not hoard cash (earning 0% from an asset is not effective management). And so on, and so on.
This low return environment, at the very least, will have some consequences for shareholders. Reasonable minds might disagree as to the severity, but we are most certainly in untested territory. The cash-as-a-liability mentality is very likely creating balance sheet bubbles. Those who still believe cash is a valuable asset and protector against financial difficulty and a well of investment possibilities when the tide turns could be rewarded in the years to come.
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