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Some recent articles have thrown cold water on the possibility of a big surge in cash payouts now that companies are beginning to pare their massive cash hoards. Economic conditions are still too weak, and foreign earnings on US balance sheets would be taxed if brought home for this purpose. Managements aren’t always the best stewards of capital and often don’t time their cash-giving well.
That’s all true. Not all cash givebacks add value. But after extensive research into this topic, as covered in a recent paper by my colleague Brian Lomax, we still see an exceptional opportunity in excess cash today. Even if we’re only half right about the upside potential, we expect the payoff for shareholders to be significant.
But you need to look behind the numbers to get the real story. The following factors can influence whether a cash giveback will help or hurt shareholder value:
• Lifecycle Stage. The market is less receptive when a high-growth company (such as Google) returns cash, since it sees that as an admission that management has run out of new ways to generate growth. However, investors generally like it when stable growth or mature companies return cash, as that signals confidence in the soundness of their cash flows.
• Intrinsic Value and Timing. As with any investment, fundamentals and timing matter. Repurchasing shares after a long period of outperformance will likely be a bad deal for shareholders, if the stock price is above the fundamental value of the company’s assets. Conversely, buying back shares that are trading below intrinsic value allows investors to enjoy any future upside in the value of the remaining shares.
• Financial Leverage. Using debt to finance a cash giveback can amplify the buyback’s benefit to shareholders, if the debt level reached is reasonable. Today, companies can take advantage of the ultralow interest rates to reduce their cost of capital, while also benefiting from the tax deductibility of interest expense. The upside to shareholder value is even greater if the company repurchases undervalued shares. However, if debt is excessive, the benefits of the tax shield will be dwarfed by the greater interest expense burden and increased risk of insolvency.
• Employee Compensation. Some buybacks simply offset the dilutive effects of employee stock grants, which don’t reduce the number of shares outstanding.
As the above suggests, fully capitalizing on the opportunity in corporate cash requires thorough case-by-case investigation of cash flows, liquidity needs, reinvestment opportunities and financial leverage. In other words, it’s a differentiated opportunity that requires research-based active management.
Joseph G. Paul is the Chief Investment Officer of North American Value Equities
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio management teams.
