Category Archives: cash balances

Corporate financial policy deciphered (2)

In the upcoming years, European telecoms need to issue an average of €30 billion in bonds. But financial market instability suggests that even highly credit-worthy companies may have trouble gaining access to funds.

Liquidity risk management once again became a pillar of corporate financial policy following the Lehman collapse in 2008. It involves a continuous exercise of cash control and refinancing plans that goes far beyond the traditional purpose of bridging temporary imbalances between receipts and disbursements.

For the past two and half years we have been living with the ominous threat of a financial market freeze. These concerns were highlighted by the events of the past week, described in a June 24, 2011, Financial Times article by Michael Mackenzie and Nicole Bullock:

Investors are withdrawing cash from money market funds heavily exposed to short-term debt issued by European banks out of fear that a Greek default could spark contagion across the region’s financial sector.

At the same time there is increasing reluctance among US banks to lend to their European counterparts in the past two weeks…

Investors have not forgotten how some money market funds, viewed as cash-like holdings, had short-dated Lehman Brothers debt and lost money after the bank declared bankruptcy in September 2008.

Once banks stop lending to each other out of concern with counterparty risk, money markets shut down and short-term credit to corporations ceases.  When this happens, companies have to support themselves without backup, a situation which can be exacerbated if key customers and critical partners do not meet their obligations.

Companies therefore need their own liquidity sources to be robust enough to carry them through periods of disruption.  They need to ensure capital availability and a tight grip over operating cash flows in different scenarios, selecting for each scenario the appropriate actions that reduce the probability and/or impact of bad events, for a given degree of residual risk tolerance.

Most importantly, companies must correctly simulate their debt refinancing needs, adjust debt maturities to the risks of a market freeze, diversify alternative funding sources, and ensure that the available credit facilities are committed, unrestricted and long term.

Liquidity risk management is necessary for companies to implement their strategic goals and avoid costly business interruptions.  It is often said in finance that “cash is king”. It certainly is so when cash is the difference between success and failure, life and death.  When equity financing is not viable and good assets sell below their full value, companies should remember: long live the king.

Which Factors are Reshaping Corporate Cash Choices?

We’ve posted before about the increasing cash balances at many companies – here and here. The WSJ today has an article about Apple’s large cash hoard and the debate over whether the company should return some of it to shareholders or keep it for future investment. In one of our earlier posts, we emphasized the impact of the Great Recession on the expected returns from new investment. Of course, with the interest rate earned on cash balances at rock bottom, can the return on investment really be even lower? This question highlights the fact that the cash balance decision is about more than just a simple comparison of the immediate return on investment against the return on cash. Cash balances earn an implicit return as a precaution against future events – the so-called convenience yield. The Great Recession has not only recalibrated the forecasted return on investments, but has also recalibrated the convenience yield on cash, increasing the value of larger balances. Here are two ways.

First, the collapse of Lehman and all the troubles in the financial sector made access to external funding more difficult and uncertain. In the last two years, many banks have felt overextended in lines of credit previously granted to corporations, and with weak balance sheets banks have been unable to raise capital to expand their loan portfolios. So companies worry more that external capital is less available, which raises the value of accumulating their own reserves against future cash needs.

Second, anyone following the troubles of the Japanese economy in the last two decades knows that a weak financial system combined with deflation can be deadly to companies that rely on debt. With sales slumping and prices falling, levered companies find trouble servicing their debts given positive real interest rates. Cash reserves are useful not just to repay debt if deflation kicks in, but also as an alternative source of funds when debt needs to be rolled over by a reluctant financial system.

The options facing shareholders, too, have been reshaped by the Financial Crisis and the Great Recession, and this may be another explanation why some are untroubled by companies that are holding onto the cash. Until very recently things were so bleak and uncertain that investors didn’t have a better idea for their savings, and just replicated what corporations were doing. As recently as August 2010, there was talk that the US economy might fall into a double dip recession with the risk of deflation in the horizon, prompting an energetic response by the Fed (the QE2 program); in the Eurozone, a mounting government debt crisis kept many spirits alarmed. Under these conditions, investors put their money in short term assets and repaid their debts. Indeed, this is what the data on the flow of funds reveals.

None of these factors reshaping the corporate cash decisions is easily measured. We lack very useful normative models that can be recommended as reliable tools for guiding corporate decisions on cash; at least not any that are readily benchmarked against measurable factors. All we can really do is watch what individual corporations do and how their shareholders respond. It will be fun to watch the debates at Apple as the company reports its earnings today and begins to discuss its decisions about the future.

Using Cash to Repurchase Shares

Last week we highlighted a WSJ article on the growing cash balances at companies. We pointed out that in some cases the right thing for the company to do is return that cash to shareholders. The WSJ’s Real Time Economics blog reports today on Federal Reserve data showing increased share repurchases by companies.

Sadly, the blog worries that buying back shares “won’t lead to the kind of hiring the economy so desperately needs,” presumably because it means the companies are not investing in new capacity or other forms of expansion. But this confuses things. Just because a company is accumulating cash doesn’t mean it should be the one investing. A lot of good investments are to be made by new companies without cash, or by companies that suffered cash drains in the Great Recession. A signal element of a well functioning capital market is the ease with which cash is returned to shareholders to be reinvested where it is most needed.

Aggregate investment is still low right now, and the economy may be waiting a long time for sizable new hiring. But that is fundamentally driven by global economic forecasts. It won’t be helped by a mechanical focus on driving new investments specifically from the companies where the cash is piling up. That’s just a recipe for sclerosis. Given any forecast, we are liable to get greater new investments because cash is freely flowing back to investors where it can be channeled to the highest value new investments.

Companies Cling to Cash

That’s the top headline in today’s WSJ, reporting on the continued growth in cash as a percentage of all corporate assets. The figure now stands at 7.4%.

One obvious reason that cash is increasing is that The Great Recession makes some investment projects look less profitable. But that begs two key questions.

First, the level of cash has been growing fairly consistently since the early 1980s, as the WSJ’s front page graph highlights. So while The Great Recession may be relevant to the recent spike, this spike appears to be just a swing along a longer term trend. There’s a nice paper in the Journal of Finance by Bates, Kahle and Stulz documenting the longer trend and identifying the causes. Their conclusion: company cash flows are riskier, and more of the businesses are R&D intensive with fewer assets in inventories and receivables, so that a company’s normal need to be cautious will lead it to hold a higher amount of cash.

Second, if a company is not going to invest the money, then shouldn’t it return it to shareholders? Perhaps not, if the company expects The Great Recession to be short-lived and investment opportunities to return.

Mario Goes to the FX Market

Nintendo’ management has decided to keep in US$ a significant fraction of its revenues from exports. Nintendo has a large $7.4 billion pile of cash held in foreign currencies (70% of Nintendo’s total cash reserves). See this Wall Street Journal article.

With the sharp rise in the Yen since May 2010, after a crisis in the Eurozone erupted, and recently with the FED stimulating the economy with an aggressive monetary policy, Nintendo has accumulated large currency losses, when most of the other large currencies (Euro, Sterling and $) depreciated against the Yen.

Does it matter?

At first, one would say no. These are merely translation losses, and the competitive position of Nintendo (its ability to sell its products) is not affected by accounting losses. Moreover, Nintendo has expenses in foreign currency, so matching its revenues with operating costs in foreign currency makes sense.

This is not entirely correct, however.

Nintendo has over the past years aggressively shorted the yen to invested in other currencies, and taken advantage of higher yields abroad when compared with almost zero interest rates in Japan. This foreign currency strategy goes by the name of carry-trade, and has been massively employed by both Japanese companies and households since the late 1990s. It yielded very large gains until the eruption of the current financial crisis. Since then, investors and companies in Japan have used this strategy on and off depending on market conditions.

The Japanese Yen, like the Swiss Franc, is a currency of refuge to investors when markets get nervous. In recent years, the correlation between different measures of market volatility (for example, the Vix and iTraxx) and the Yen has been pretty high. When investors become more risk averse and fearful they go long the Yen, and when markets calm down and volatility declines, the Yen tends to lose its value. The point is that a lot of companies and individuals use the Yen to express their fears about deteriorating economic and financial conditions. And there’s plenty of that nowadays.

What this means is that, in addition to matching the currency in which its cash is held with the currency of its cash flows, Nintendo’s management has deliberately made a bet on currencies with the shareholders’ money. And recently, the bet has lost money, as in the past it has made money.

This begs the following question: Should Nintendo’s management use shareholders’ money to bet on currencies, or should it let investors decide by themselves on currency betting?

It is obvious that the majority of Japanese shareholders in Nintendo are upset with Nintendo’s currency losses, as they were presumably quite happy when Nintendo was making profits in the past from its portfolio of foreign currencies. But the management should not be surprised with shareholders’ reaction. Shareholders give the management discretion as to how retained earnings are invested, but voice their disapproval when management decisions go wrong. Betting on currencies is no different from any other investment decision. Except for the fact that Nintendo’s management has no business on betting on currencies. It’s hard to make a case that they have particular skills in doing that.

The other part of the problem relates to executive compensation. More precisely, how currency betting is treated in compensating management. Often times, currency losses and gains are not treated symmetrically in managerial compensation. Because of this, the management might be inclined to take currency bets, if it can persuade shareholders that currency gains are the result of its talent, and therefore should be followed by unexpected higher bonuses, while at the same time currency losses are not penalized with lower bonuses. How the compensation is designed creates the incentives to act so as to maximize the chances of getting the targeted compensation. Moreover, executive compensation is not entirely outside of the management’s control, and can be subtly manipulated by managers. In general, managers are smart operators, and are able to focus the attention of shareholders on operating profits when (financial losses such as currency losses) occur, claiming that these are unpredictable, and therefore not their fault. Shifting shareholders’ attention on different results ex-post is a very common managerial tactic.

Shareholders Debate Corporate Cash

As the level of cash stockpiled by companies grows, so do the disputes between shareholders and management. The Financial Times reviews the positions being staked out by activist shareholders who want management to pay out more of that money. It’s no surprise that there are disagreements about whether the amount of cash held is too much. One attorney for activist shareholders is quoted saying that “There is concern that such high levels of cash may end up being used for less than optimal purposes.” What I found interesting in the article was the discussion of the macro determinants. The recent financial crisis undermined the ability of activists to fund acquisitions using debt, leaving management safer to build up their piles of cash. As the crisis subsides and debt financing becomes easier, the market for corporate control may be heating up. In this story, what determines how much cash companies accumulate isn’t the internal needs of the companies—not the ebb and flow of the need for cash, nor the ebb and flow of investment opportunities—but the external dynamics of the market for corporate control.

This is in-line with the model of the takeover market being developed in a series of papers by Bart Lambrecht and Stewart Myers — see here and here.