The Activist-Beleaguered CEO's Survival Guide
Excess cash on corporate balance sheets has been a hot topic the better part of the last decade, but ConverEx's Nick Colas believes it's about to become even more important to capital markets. U.S. companies have, after all, regained all the profitability they collectively enjoyed prior to the Financial Crisis. Moreover, they've accomplished that by rationalizing their business models to succeed in a period of distinctly subpar growth. Combine that with markets that will likely offer only average returns, and activist investing seems like a worthwhile approach to alpha generation. Sometimes, however, it pays to look at the world through the eyes of the fox rather than the hounds. As the Einhorn-Cook battle commences, we graciously offer up a few kernels of advice for other companies who get the "Where’s my money at?" call from an activist.
Via ConvergEx's Nick Colas, You Never Give Me Your Money… Only Your Funny Paper
I have a bad habit of rooting for the underdog. If I happen to turn on a random game that’s already started, I find myself totally invested in the losing team’s cause. If I see a betting line, I think more about the presumptive loser’s chance of closing the gap, rather than the winning team’s ability to blow out the game. And yes, this is largely why I don’t gamble.
Moving to issues inside the capital markets, my bias is coming to the fore as I hear more and more about activist investors who want public companies to start using their cash balances in more shareholder-friendly ways. I do get why these are usually sensible requests. Cash is a lousy asset – it earns almost nothing and it can easily cause managements to grow lazy since strategic failure isn’t often fatal when there’s 10 years’ worth of cash in the bank. Shareholders ultimately own the company and its capital. Yes, there’s that pesky agency problem – management wants the company to be stable enough to endure, but any diversified shareholder couldn’t care less if one company in their portfolio went bust. But at the end of the day, the shareholder’s desire to earn a competitive rate of return on all their assets should – and usually does – trump everything else.
But what should we say to the fox, rather than the hound? There are plenty of theoretically valid arguments for higher dividends, special payouts, and stock repurchases for companies with unusually high levels of cash on their balance sheets. But if you were a Chief Financial Officer, or Chief Executive, or board member, and wanted to push back on these requests – what would you say? How would you rally investors to your side of the cause, rather than voting with your cash-hungry critics in a proxy fight?
Here are five potential messages for the activist-beleaguered company and its management:
#1 – The country’s central bank doesn’t think we are really out of the crisis – why do you? Using cash for buybacks and incremental dividends makes sense if the macroeconomic environment is stable and improving. In a downturn – even a shallow one – cash becomes a critical asset. Working capital leverage turns negative. Competitors cut price to clear inventory, and even stronger competitors have to follow. On the plus side, this is the part of the economic cycle where you can do M&A on the cheap. Cash is extremely useful for all that.
For the corporate manager going toe-to-toe with an activist on this point, he or she has a strong ally in the U.S. Federal Reserve. Just read the latest FOMC minutes and you’ll see that their confidence about the continued growth of the domestic economy is muted, at best. The U.S. central bank still feels that the U.S. economy needs unusually large – unprecedented, really – levels of monetary stimulus. And this is the environment where you think it would be wise to reallocate our cash?
#2 – That “Extra” cash is to maintain stability among our other stakeholders – primarily our intellectual capital. The line between intellectual capital (largely in the form of employees) and investment capital (provided by shareholders) is remarkably thin, especially in a technology company. Yes, shareholders own the company. But the employees ARE the company. It’s more of a Mexican standoff than the pyramid structure taught in business schools.
Everything else equal, most people probably – especially a lot of great ones - prefer to work for a company with a large cash balance than a small one. The former is well-placed to pay a good salary, provide benefits, and grow the business. They can also afford to issue stock and use excess cash to execute buybacks to eliminate dilution. All good stuff. The less cash rich company? Not as much.
#3 – We are not alone in our efforts to hold cash – our competitors do it as well. In one key respect, cash is only a competitive advantage if you have more than your nearest competition. Consider what happens during an economic downturn – one of the key planning scenarios which cash-rich companies use to defend their outsized liquidity. If every competitor can cut price to try to hold market share because they all have the same relative cash position, they will all burn through their cash. Only the company with MORE cash than its peers will be able to leverage that advantage, and only after everyone else has burned through the contents of their piggy banks.
This is a point that is often overlooked in the discussion of appropriate cash balance, but it actually matters quite a bit. There are case studies galore – just consider why Ford was the only domestic auto OEM to not need bankruptcy protection during the financial crisis – which bring this point home. At its core, it is a simple but powerful observation: “Yes, we have a lot of cash. But so does everyone else. So we need more. Go away.”
#4 – History shows that cash-activists usually get it wrong in terms of when to ask for the money. At the bottom of an economic cycle there is precious little arguing between shareholders and companies about the appropriate level of corporate cash – no one has any. Then, as things improve from a macro perspective, the conversations start. By the time they get to peak earnings, they are at full bore. That’s pretty much where we are now, but it is the worst time to pull capital out of companies. If they do a stock buyback, it’s likely to be at the peak. If the company chooses to pay an ongoing dividend, they’ll likely set it too high. As for a special dividend, anyone receiving it will likely reinvest it in other equities. Also at a cyclical peak.
#5 – If you like it so much, bid for the whole company. At the end of the day, there is really only one way to create lasting change in the financial strategy of a public company – buy it. All of it. This is not as easy as it was in prior cycles. Mammoth bank or public debt market – funded leveraged buyouts aren’t yet back in vogue. And given the fragility of the financial system, they may not make an appearance during this particular cycle. And without that threat, the role of the activist is much more that of an unpaid investment banker – offering up ideas in the hopes of getting paid – than anything else.