Excess Cash, Leftover Wine, and Acquisitions

Quiz:

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,

Ralph

Repurchases: Part 2 The Positive Side

On our last post, Repurchases: Part 1 Shareholders Beware Joe pointed out some concerns about repurchases.  These are good cautions, but I'm an empiricist and I need to point out that the empirical evidence on repurchases is much more positive.  In the paragraphs below,  I'll first outline some theories about share repurchase and then discuss some empirical evidence.  

We generally assume one of six things is going on with a share repurchase.  First, a firm could feel that its stock is undervalued and the repurchase signals positive news to the market about this inside view.  In this case, we'd expect to see the stock price rise on the announcement of a repurchase.  Second, the firm could use repurchases as an efficient tax-advantaged way to return excess cash to shareholders.  It is efficient and tax advantaged since capital gains are taxed at a lower rate than dividends.  Third, the repurchase signals that management is not going to squander excess cash on things like unproductive acquisitions.  Both of these are positive effects and the stock price should rise upon announcement of a repurchase.  Fourth, an in contrast to the previous item the repurchase could signal a lack of growth opportunities for the firm.  In this case, we'd expect the stock price to decline at the announcement of a repurchase.  Fifth, since repurchases reduce the equity position in a firm, they change the capital structure producing less cushion for debt holders.  If true, debt holders would lose upon announcement of a repurchase; equity holders would gain.  Sixth, firms sometimes repurchase shares to fund executive options. One can imagine other motives, some of which Joe outlined in his post.  I'll return to that in a moment.  

The empirical evidence on repurchases is strongly consistent with a positive impact to shareholders and generally supportive of the first three hypotheses mentioned above: signaling, tax efficiency, and the return  (rather than squandering)  of excess cash.  The fourth and fifth hypotheses ( a lack of growth opportunities and wealth transfers from bondholders)  find less support.  On the sixth hypothesis, Kahle (2002) also provides compelling evidence on the use of repurchases to fund executive options.  This is not, by itself detrimental, but has clouded some empirical tests of the other hypotheses.  (For an elaboration on this see Share Repurchases see our article in the Journal of Corporate Finance, Share Repurchases Executive Options and Wealth Changes to Stockholders and Bondholders.) 

So the empirical evidence is overwhelmingly positive and I find myself more optimistic about repurchases than Joe.  This does not mean that shareholders shouldn't be concerned with the cautions that Joe notes.   The empirical results we discuss in this post are statistically significant tendencies.  Individual firms could still be using repurchases for less than desirable reasons.  Indeed, some of the items Joe notes (use of repurchases to mechanically raise earnings per share, for example), have no empirical justification.  Concerns about firms overpaying shareholders who tender make sense.    Other items like repurchases to alter option values suggest fruitful additional ideas for additional analysis.    These things may exist in a subset of the data.  The wise investor or board member can take comfort from the positive evidence about repurchases, but should sprinkle this with healthy skepticism for possible abuse.  

Ralph