Thursday, June 19, 2014

Excess Cash, Leftover Wine, and Acquisitions


When a company has excess cash, what is the optimal thing to do?

a) return the cash to shareholders via dividends or repurchases

b) make acquisitions

c) return cash to shareholders only when they have a better use of the funds than the company

d) retire debt

e) save the cash, rainy days are ahead

(f) increased CAPEX.

With some explanation, the only correct answer is (a).

First, let's look at (e) and (c) and (f) which could be the best answers if we hadn't specified  the phrase 'exess cash'.  By definition, 'excess cash' occurs after consideration of the safety and usage reasons for holding cash.  The term 'excess' also implies that management has already taken all positive NPV projects which would seem to rule out any reason for management to keep cash for safety reasons (e) or as in (b) make acquisitions.  If there were good acquisitions to make, the cash would not be 'excess'. The same is true of increased CAPEX. 

Retiring debt (d) might make sense if a firm was over-leveraged and/or interest rates were high, but in general only makes sense if the cost of debt is less than the return shareholders can earn on their funds at risks typical to those of this firm. Typically, this is the cost of equity for the firm which exceeds the cost of debt and especially the after tax cost of debt.  Rule out (d).  

Now lets give greater credence to (b).  Sometimes it is argued that when a firm's stock price is inflated, it makes sense to use that over-priced currency to acquire hard assets.  When the firm's stock price adjusts to reality, the firm will still have acquired the hard assets at inexpensive prices.  This argument may explain why the number and dollar volume of mergers is strongly correlated with the stock market.   When stock prices are high, more deals get done.  The problem with this argument is that the target's stock price is also  likely to be high so the acquiring firm could be purchasing overpriced assets.  

Thus, when a firm truly has 'excess cash' the only correct answer is (a). Nevertheless, when faced with a decision to relinquish cash or build the empire, many managements choose the later. 

And it is well known that deals increase with stock prices.  

Currently stock prices are at or near record highs.  

So are the number of deals being completed.  This graph from Jesse Solomon in  CNN Money reveals that the number of deals completed in the first half of this year outpaces the total number of recent years and is on pace to surpass the all time highs of 2007.  

Why?  Certainly some deals make sense - and the conditions in many industries are demanding consolidation, but for many firms, one can suspect that excess cash, like excess wine is just not that apparent when it is in your hand.  

All the best,


1 comment:

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