The cash paradox: How record cash reserves are influencing corporate behavior Deloitte Review Issue 15
Financial conservatism served companies well in the downturn but in an economic recovery may be dragging companies into a vicious circle of cash accumulation at the expense of investment in growth. New research suggests markets are more rewarding of companies spending astutely in the pursuit of growth.
All told, the leading 1,000 public non-financial companies globally held $3.53 trillion in cash reserves at the end of 2013.1,2Market commentators frequently cite these record cash figures as a key indicator that will boost capital expenditure (capex) and M&A activities, which will rekindle growth. But the truth of the matter is far more nuanced.
A closer look at the cash reserves suggests an uneven distribution. Deloitte LLP analysis found that just 32 percent of the companies have accumulated 81 percent of the total cash reserves.3 These “large cash holding” companies tend to be more conservative in their spending habits compared to their “small cash holding” counterparts, who have been spending more aggressively in the pursuit of growth, and they appear to be reaping the benefits.4 Our analysis shows a clear divergence in revenue growth as well as the share-price performance for these two sets of companies and on both measures, the small cash holding companies are outperforming their large cash holding counterparts.5
During the financial crisis, companies were well served by financial prudence, but these traits could hamper their quest for growth. Companies should now rethink their cash strategies with an eye toward creating growth opportunities.
The corporate sector’s changing landscape
Corporate sector leverage, aided by a vibrant financial sector, fuelled the pre-crisis boom. The subsequent shift of debt from the corporate and financial sector to the government following the high-profile government-led bailouts is one of the defining consequences of the financial crisis (see figure 1). Since 2009, the corporate sector, particularly in the United States and Europe, managed to successfully deleverage through a combination of rigorous cost optimization programs and divestments of non-core assets.
As a result, the corporate sector built up record levels of cash reserves. US companies are the largest constituent of the S&P Global 1200, and with $1.6 trillion in cash reserves, they account for 45 percent of the total reserves for the index. Then come Japanese companies who account for 14 percent of the cash reserves globally, followed by companies based in France, Germany, and the United Kingdom (see figure 2).6
The record levels of cash within the technology, media, and telecommunications (TMT) sector are well publicized in the media. The cash reserves of TMT companies increased by 124 percent from $482 billion in 2008 to $1.1 trillion in 2013.7With nearly $147 billion in its coffers, Apple alone was sitting on nearly 14 percent of the TMT industry’s total cash reserves.8 Apple, Microsoft, Google, and Samsung collectively have nearly $336 billion, nearly equivalent to the GDP of South Africa.9
In the United States, the TMT sector dominates with $701 billion or 44 percent of the cash reserves.10 A large proportion of the cash is held overseas because the cash is the result of profits derived from global operations. In some cases, US companies prefer to keep cash overseas instead of bringing it back and facing large corporate tax bills if they pay out in dividends and share buybacks.11,12 This trend is sparking a major debate in Washington about how to entice companies to repatriate their cash back to the United States.
In fact, much of this cash is held in secure but low-yielding US Treasury securities, earning these companies a steady stream of interest payments. It is estimated that Apple, Microsoft, Google, and Cisco alone have around $163 billion invested in US treasuries and government debt, collectively making them the 14th largest investor in US treasuries, higher than many sovereigns, including Norway and Singapore.13
Cash accumulation is certainly not restricted to the technology sector, and indeed there is a distinct sector bias in different countries. For instance, in Japan, the manufacturing sector dominates with $188 billion in cash reserves, which is 39 percent of the total for non-financial Japanese companies in S&P’s Global 1200, while in the United Kingdom, energy and utilities companies lead with $68 billion in cash reserves or 38 percent of the total for non-financial UK companies in the S&P Global 1200 (see figure 3).14
The cash paradox
When we analyzed the trends in cash accumulation and the historical spending patterns for these companies, a far more complex picture emerged. A closer look at the cash reserves suggests an uneven distribution with just 32 percent of the S&P 1200 non-financial companies holding 81 percent of the cash reserves. The remaining 68 percent of the companies hold just 19 percent of the cash reserves (see figure 4).15 It is important to point out that large or small cash holding companies do not imply these are also large or small by market capitalization. Some companies with a small market capitalization are sitting on large piles of cash.
Evidence of the Pareto principle, also known as the 80/20 rule, the phenomenon whereby the greatest impact (typically, 80 percent) is attributable to the vital few (generally, 20 percent), is found most famously in the concentration of global wealth but also in other areas, such as professional sports (see case study 1). But this was not always the case with the corporate sector. At the height of the pre-crisis boom in 2007, the large cash holding companies held $1.59 trillion in cash reserves compared to the $462 billion in cash reserves held by small cash holding companies, a ratio of 3:1.16When the financial crisis hit in late 2008, caution set in, and companies started to curtail spending and accumulate cash instead.
Surprisingly, the large cash holding companies became far more conservative than the small cash holding companies. Between 2008 and 2013, they nearly doubled their cash reserves from $1.61 trillion to $2.88 trillion, and at the same time, the small cash holding companies kept accumulating at an even pace and increased their reserves from $433 billion to $656 billion. By 2013, the ratio of cash reserves became 4:1 in favor of large cash holding companies (see figure 4).17 While financial prudence was widely welcomed by the markets in those tough years, such aggressive cash hoarding by these large cash holding companies remains unprecedented.
Case study 1: The English Premier League
The 80:20 rule, or the Pareto principle, is well documented across many spheres, and we have observed a similar phenomenon in the corporate sector in the business of football (or soccer, for our US readers). The English Premier League is the richest football league in the world. With combined estimated revenues of £2.40 billion for the 2012–2013 season, it far surpasses the comparative revenue of the top tier teams in Germany (£1.64 billion), Spain (£1.51 billion), Italy (£1.37 billion), and France (£1.06 billion).18
The four richest clubs—Manchester United, Manchester City, Chelsea, and Arsenal—dominate the English football landscape. These four clubs represent 20 percent of the league’s constituents, but they collectively account for 45 percent of the 20 clubs’ total revenue,19 placing them among the top 10 largest revenue-generating clubs in the world.20 They are also, by far, the biggest spenders on new players (the football equivalent to M&A), accounting for £310 million (41 percent) of the £760 million spent on players in the 2012–2013 season.21 Investment does not stop at acquiring the football world’s leading talent, and each of these clubs has painstakingly developed their infrastructure over the years, including the expansion of their stadiums to maximize match day revenue; higher-margin corporate facilities; the introduction of global academies, feeder clubs, and worldwide scouting networks to identify, sign, and hone the leading young global talent; and the introduction of marketing and sales offices in the United States, Asia, and Africa—all comparable with the corporate world’s capital expenditure on growth and maintenance. It is, perhaps, unsurprising that one of these four clubs has won the league title in all but one season since the creation of the English Premier League22 and 77 percent of the FA Cup competitions—for which 737 teams across England and Wales enter—since 1992.23,24
Under normal economic principles, when there is an acute concentration of resources, it appears that the tendency is to use those resources to gain a considerable advantage over the competition, at least in football. This is contrary to the behavior exhibited by large cash holding companies.
How companies spend their cash
We considered the spending patterns of these two sets of companies by analyzing their capital expenditure as a proportion of cash from operations and their M&A spending as a proportion of cash reserves to understand how these companies allocate their cash.
Capital expenditure (capex)
Capital expenditure is critical when trying to sustain growth. In the immediate aftermath of the financial crisis, capital expenditure fell sharply across the globe, and companies focused on cost-reduction measures.25 In the last couple of years, both the large and the small cash holding companies increased their capital expenditure, suggesting they have confidence in their ability to generate cash.26
The large cash holding companies increased their spending by 16 percent from $979 billion in 2008 to $1.14 trillion in 2013. However, they channeled just 37 percent of the cash they generated from operations toward capex in 2013—well below their long-term average of 50 percent.27
On the other hand, the small cash holding companies increased their capital expenditure by 37 percent from $461 billion in 2007 to $633 billion in 2013 (see figure 5). In 2013, they channelled 63 percent of their cash from operations into capex.28
We looked into capital expenditure as a percentage of depreciation and amortization to determine the trends in so-called “maintenance” and “growth” capex (see figure 6). Since 2009, large cash holding companies, on average, assigned 84 percent of their capex on maintenance activities and 16 percent on growth activities. On the other hand, during the same timeframe, the small cash holding companies, on average, spent 72 percent of capex on maintenance activities and 28 percent on growth activities.29
M&A deals tend to be a significant area for utilizing cash reserves. Since the onset of the financial crisis, there has been a significant decline in global M&A volumes as companies waited for market sentiment to improve before taking on greater risk in the pursuit of growth.30
Since 2009, the large cash holding companies spent $1.02 trillion on M&A deals, but as a proportion of their cash reserves, annual M&A spending has been on the decline. In 2013, M&A spending as a proportion of cash reserve was just 13 percent, compared to a high of 60 percent in 2007, which was a record year for global M&A deal volumes.31
In comparison, the small cash holding companies have spent $603 billion on M&A deals since 2009, and in 2013, their M&A spending amounted to 78 percent of their total cash reserves—far higher than their cash-rich counterparts (see figure 7). In fact, during the boom year of 2007, small cash holding companies spent 217 percent of their cash reserves.32
This suggests that large cash holding companies, even when they are making M&A deals, continue to remain financially conservative. On the other hand, the smaller cash holding companies are far more bullish in their pursuit of growth and have been consistently more aggressive in their M&A activities.33
In the five years preceding the financial crisis, both large and small cash holding companies actively raised debt from the markets, and their debt accumulation grew at a similar pace. The total debt for small cash holding companies rose 52 percent from $1.5 trillion to $2.3 trillion between 2003 and 2008. In a similar manner, the debt for large cash holding companies grew by 47 percent as they increased their total debt from $3.2 trillion to $4.8 trillion.34
One of the major themes of the post-crisis environment was that the global corporate sector made use of the low interest rate environment to refinance its existing debt to longer-term maturities and raise new debt on favorable terms.35 However, here again, markedly different attitudes toward debt financing from these two sets of companies become apparent.
Small cash holding companies used the low interest rate environment to increase their debt by 31 percent from $2.3 trillion in 2008 to $3.0 trillion in 2013 (see figure 8). They also increased the proportion of their long-term debt to an average of 85 percent since 2009, which is up from a pre-crisis average of 79 percent. The increase in proportion of long-term debt means they are less susceptible to short-term economic shocks and can plan for a long-term growth strategy.36
In comparison, the large cash holding companies increased their debt from $4.8 trillion to $5.8 trillion between 2008 and 2013—an increase of 21 percent (see figure 9). The large cash holding companies have also increased their long-term debt to an average of 75 percent—up from a pre-crisis average of 68 percent.37
Divergence in performance
The divergent attitudes toward cash accumulation and spending gain a clearer context when the relative performances of both sets of companies are considered. Both sets of companies grew their revenues at a consistent pace since 2000, but there was a clear divergence after the financial crisis when the small cash holding companies grew revenues at a faster pace than their larger counterparts (see figure 10). In part, this can be attributed to more bullish M&A activities.38
Critically, a divergence in share price between the cash hoarders and the spenders has emerged (see figure 11). Since 2000, the share price performance of the small cash holding companies has outperformed their large cash holding counterparts, growing by an astonishing 632 percent compared to 327 percent for their larger cash holding counterparts. Remarkably, the gap widened even more after the financial crisis. This suggests that in the long run, the markets are rewarding companies that take a more bullish attitude toward growth.39
One explanation for the divergent attitudes could be tracked back to the corporate leaders at the helm. Tellingly, the average tenure of CEOs at large cash holding companies is 45 months, whereas the tenure of those at small cash holding companies is 77 months.40
The CEOs of small cash holding companies have seen prosperous years, and they have steered their companies through the crisis. This corporate memory seems to have served them well, and it potentially gives them the confidence to make more aggressive long-term investment decisions.
The growth conundrum
Not just a case of bulls versus bears
On October 16, 2008, Warren Buffett wrote in an opinion piece in The New York Times, “a simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.”41 He was vocally critical of holding cash and argued that in crisis conditions, cash is a terrible long-term asset that pays virtually nothing and is certain to depreciate in value. Instead, he advocated equities as a much safer bet, and five years later, the major indices are breaking new records.42 In many ways, our analysis of the cash paradox vindicates Warren Buffet’s words of caution.
But it is not just a case of bulls versus bears. Since 2009, S&P Global 1200 non-financial companies paid $3.0 trillion in dividends, $1.8 trillion in share buybacks, and the massive cost-optimization drives resulted in a 39 percent growth in EBITDA (earnings before interest, taxes, depreciation, and amortization).43 The markets were rewarding such measures, and earlier this year, the S&P Global 1200 index hit new highs.
Even as the S&P Global 1200 share price index touched record highs, year-over-year revenue growth has fallen for two consecutive years since 2011 (see figure 12).44Investors will likely put the spotlight back on revenue growth, and companies will need to communicate a compelling revenue growth strategy to the markets.
Making better choices
In the coming years, companies should find a way to thrive in a new economic reality that is characterized by below-average growth conditions and shorter but more volatile economic cycles. In such conditions, pursuing growth opportunities is less about earnings-per-share enhancement and more about long-term prospects. Therefore corporate leaders should make fundamental choices on the growth strategy that they should pursue. This calls for a combined assessment of their company’s relative strategic capability, which is indicative of its ability to capture growth, and its financial strength, which will reveal its ability to fund future growth opportunities. Such an assessment may allow companies to make choices that take advantage of their distinct situation and capabilities (see figure 13).
In the first four months of 2014, $1.2 trillion worth of deals were announced, the highest level since 2007 and 42 percent up on the same period in 2013.45 Sectors that have historically had large cash reserves such as TMT and those in a state of flux such as the health care sector have been at the forefront of the deal making. It seems the confluence of investor pressure, the improved macroeconomic environment, and the pursuit of growth opportunities has loosened the purse strings. The success of those deals will likely depend on clarity of purpose and execution capabilities.
It is increasingly clear that the corporate sector will emerge as the likely engine that will drive future growth and economic prosperity. Financial conservatism served companies well during the downturn but in times of economic recovery this could well prove to be a double-edged sword, dragging companies into a vicious circle of cash accumulation at the expense of investing in growth.
In this paper we sought to highlight how cash accumulation has unleashed a new competitive dynamic, where the contrast between the hoarders and spenders is increasingly stark. Indeed our study shows that markets are more rewarding of companies that are spending astutely in the pursuit of growth. This paper thus serves as a clarion call for all companies who are sitting on their laurels and risk squandering their hard-won cash advantage. Winners will likely be companies that take a long-term outlook and are decisive in their pursuit of growth; in other words, it could turn out to be the triumph of the optimist.