Cash hoarders

A company may generate huge revenues and be extremely profitable, yet not have enough liquid currency to pay the bills. That’s why cash is described as the lifeblood of a business and why many smart investors favour using free cash flow, the amount of money left after all discretionary expenses have been taken care of, over questionable earnings per share (EPS) figures to value companies.

Nest eggs make it easier for companies to maintain and improve assets, fend off competitive threats, pursue acquisitions, pay off debts, weather the shock of litigation or an economic downturn and return money to shareholders. When the coffers are full, rights issues are less necessary, too, providing welcome relief to investors tired of being asked to stump up their own capital or see their existing holding diluted.

Red flags

Pundits obsess so much over cash that they routinely fail to mention that too much of it can also be a bad thing. Companies regularly boast about how much they have tucked away, flaunting it as a badge of honour. Accumulating lots of cash is worth bragging about. Not spending it, or, more to the point, letting it go to waste, less so.

Research shows that excessive stockpiling is almost as detrimental to future returns as being penniless. The poor historical performance of cash-starved companies is understandable – they probably lacked the resources to capitalise on opportunities. Hoarders can’t use the same excuse, so why is it that they misfire so badly?

• Opportunity costs

Hoarding rather than spending means missing out on opportunities. To put it more bluntly, it’s like taking profits and setting fire to them.

The average return on equity (ROE), a measure of how much money companies are capable of generating internally, is currently 9.8 per cent in the FTSE All-Share, according to S&P Capital IQ. Taking that into consideration, it seems absurd that a business would refrain from reinvesting its profit, especially as cash parked in most regular savings accounts currently yields less than 1 per cent, way below the level of inflation. Other liquid assets such as government bonds don’t fare much better, either.

Let’s look at an example. In a screen identifying companies with the most net cash as a proportion of market capitalisation in the FTSE All-Share, Wizz Air (WIZZ) ranked near the top.

Passenger ticket sales have boosted the budget airline’s operating cash flow significantly over the past few years. Management also appears to do a decent job using its assets to generate profit for shareholders – the Budapest-based group’s ROE has averaged 33.84 per cent over the past half-decade.

Chief executive József Váradi recently mentioned that he’s exploring opportunities, including potentially buying some of Thomas Cook’s (TCG) assets. Not rushing into decisions is important. That said, it must be painful for shareholders to see a large portion of their holding tied up in cash when Wizz Air is capable of generating much higher returns reinvesting its money.

• Lack of growth opportunities

Often, executives will say the capital it has accumulated is not being deployed because good opportunities have dried up. If that’s the case, investors might want to look elsewhere, particularly if their patience is not being rewarded with income.

Dividends are by no means perfect. Paying shareholders a cut of profits strips away funds that could otherwise be put to use on investments generating a high rate of return. If such opportunities exist, it would be foolish to ignore them as they should create more value for all parties over the long term.

When this isn’t the case, and for the foreseeable future potential investments are adjudged to come in below the company’s cost of capital, returning cash to shareholders represents a much more sensible option than just letting it waste away. Executives that ignore both of these alternatives, without a decent, credible explanation for doing so, perhaps don’t have their shareholders’ best interests at heart. 

• Mismanagement

Investors want companies to be managed by people capable of getting the most out of the resources available to them. When cash regularly sits idly on balance sheets, it suggests those in charge are lacking ideas and have no clue how to maximise value.

That isn’t an encouraging sign, particularly in today’s low interest rate environment when pretty much any investment would beat the returns on cash. Letting the money you trusted company executives to manage be eroded by inflation when so many better options exist suggests they aren’t doing their job properly.

• Lots of cash breeds carelessness

Cash-rich companies also run the risk of being careless. When vast sums are being accumulated investors tend to ask fewer questions, leading accountability to go out of the window.

When money and scrutiny isn’t an issue, laziness can prevail and bad decisions often get made. The onus on running a tight ship is forgotten, spending spirals out of control and questionable, poorly-thought-out growth strategies are pursued to make the company seem more profitable than it is.

Striking a balance

So how much cash do companies really need? That depends. Determining the line to draw between balance-sheet conservatism and maximising shareholder returns is a subjective judgement that hinges on a number of factors, including the financial goals and risk appetite of the investor and how each individual company operates.

• Exceptional occasions

A good starting point is to consider specific circumstances. Here’s a list of the companies with the most net cash as a proportion of market capitalisation, excluding financials, which are required to hold extra reserves for regulatory reasons.

Cash hoarders

Source: Capital IQ

It’s clear from this data that the biggest hoarders of cash often have a reasonable excuse for doing so. Indivior (INDV), the leader by quite some margin, certainly fits into this category.

Earlier this year, the US Department of Justice charged the group with fraudulently boosting prescriptions of its flagship drug. Regulators claim Indivior generated billions of dollars in revenues for Suboxone, its patented product designed to help wean addicts off heroin, by incorrectly marketing it as a safer option than other opioid addiction treatments. The group has also been accused of encouraging junkies to visit doctors more willing to prescribe opioids.

The drugmaker needs a big war chest to defend itself against these allegations, salvage its tarnished reputation and develop new alternative treatments. Factor in those costly expenses, on top of the mammoth $3bn fine that the US Department of Justice is demanding, and suddenly Indivior looks rather poor.

Whitbread (WTB) also finds itself in unusual territory. The hotel and restaurant chain is flush with cash because it sold Costa Coffee last August for £3.9bn.

A chunk of that money is now being spent on share buybacks – a controversial topic in itself given that the Costa deal was orchestrated by activist investor Elliott Management, the New York hedge fund known for doing whatever it takes to quickly fill its own pockets. Meanwhile, other reserves are being deployed in Germany, where there is said to be a lack of budget hotels and great demand for them.

Cash may pile up again soon, if Elliott’s plot to sell off some of the group’s property portfolio comes to fruition. That said, should the activist investor succeed in its asset-stripping mission, any generated funds will probably be put to work relatively swiftly, hopefully re-energising what brands Whitbread has left.

SOCO International’s (SIA) presence high up the list is a little more complicated. The oil explorer is known for piling up cash, prompting some investors to question its strategic direction.

In its defence, it’s not unusual for companies in the business of drilling for energy resources to prioritise cash over investment at times. When the value of oil languishes, as it has done on and off for the past few years now, SOCO, mirroring big oil stocks Royal Dutch Shell (RDSA) and BP (BP.), is often happy to sit back and prioritise sharing its wealth, or at least some of it, with shareholders instead.

Investors are usually forgiving, mindful that resources companies can be excellent cash generators and that ROE in the sector is volatile – investment costs are high, supply and demand for oil goes up and down like a yo-yo and the risk of drilling into a dry hole are huge.

Sometimes, the best strategy is to wait for the right opportunity to present itself. SOCO has been looking for a while now and finally appears to have found one, in the form of low-cost Egyptian oiler Merlon Petroleum. The acquisition offers access to lower-risk petroleum reservoirs than the ones found in SOCO’s core Vietnamese market and, if all goes to plan, should double the group’s production. Splashing out $215m (£176m) on Merlon also means SOCO can no longer be accused of hoarding cash – at least for the time being.

• Sector focus

Exceptional circumstances mean it is generally advisable to examine each company on a case-by-case basis. However, it’s also true that investors can develop a basic idea of how much cash each individual company might require by understanding the dynamics behind the sector it operates in better.

Needs vary. For example, some industries, such as engineers and commodity extractors, are much more capital intensive than others, spending a fortune on things such as land, factories and fancy manufacturing equipment to grind out revenues. These companies usually take longer to get paid, too, and may, especially in the case of aerospace and defence contractors BAE Systems (BA.) and Rolls-Royce (RR.), have lumpy revenue streams, both triggers of volatile cash flows.

Pub and utility companies tend to spend quite a bit of money and carry lots of debt as well. The difference being that the latter often produce stable, regular streams of cash flow, while the former generally don’t – regularly allocating funds to keep their establishments in decent condition depresses free cash flow.

Pub stocks are also more vulnerable to shifts in the economic cycle. Them and other cyclicals, such as miners, housebuilders, capital goods, technology, recruiters and fellow travel and leisure companies, may behave conservatively when they fear a downturn is coming, particularly if they have high operating expenses.

That’s less of a problem for the middlemen of the world. Some companies outsource a lot of the expensive legwork, barely needing to spend a penny to make cash once their business is up and running – a good example being drink mixers supplier Fevertree Drinks (FEVR). As companies of this nature pile up cash, shareholders should be asking why they are not looking to make further inroads or, failing that, increasing their dividends more.

• Beware of intangibles

Special care is required when examining up-and-coming companies with plenty of intangible assets. Many of Britain’s companies are powered by resources that cannot be seen or touched, including brand names, copyrights, employee training, franchises, goodwill, patents, and trademarks.

These types of assets often hold the key to success, so companies will spend whatever it takes to preserve and create more value from them. For established household names such as British American Tobacco (BATS) and GlaxoSmithKline (GSK), securing capital from banks to develop and maintain prized intangible assets isn’t generally much of an issue – both have a reputation for delivering on their investments, and plenty of other valuable resources to act as sweeteners for loans.

When it comes to lesser-known, intangible-heavy companies, options are far more limited. Take Redx Pharma (REDX), for example. Like many of its peers, the manufacturer of drugs treating cancer and fibrosis will be confident that its ideas can one day revolutionise the world with the right financial backing.

Unfortunately, lenders won’t always share that vision. Nurturing innovative breakthroughs through to the promised land is a risky, drawn-out process known for burning lots of cash and regularly coming up empty. Banks aren’t all that keen on accepting intangible assets as collateral against loans, either – a plot of land can be easily valued and sold on when a borrower defaults, software, recipes and other intangibles, less so.

Often, only management itself truly appreciates how much these non-physical assets are worth. That invariably means that up-and-coming healthcare and technology companies seeking out external sources to help maintain and develop their prized resources may likely find few volunteers and eventually have to put up the money themselves.

UK Companies with the most intangible assets

Source: Capital IQ

As the table above shows, industries that traditionally have lots of intangible assets include tech (Micro Focus), financials (HSBC, Prudential), consumer goods (Reckitt Benckiser, Unilever, Diageo), tobacco (British American Tobacco, Imperial Brands), oil majors (Royal Dutch Shell, BP), telecom (Vodafone), media and entertainment (WPP) and drug makers (AstraZeneca, GlaxoSmithKline).

Identifying cash hoarders

o far, we have established various different reasons why certain companies may need a bigger war chest than others. That prompts the question: how do we determine if one is potentially over-hoarding?

Unfortunately, despite what some so-called experts might say, there are no quick-fix formulas. To answer the question effectively, a bespoke analysis covering all ingoings and outgoings over a reasonable period is necessary. One-off events, such as a big investment, disposal or temporary shift in capital expenditure, distort figures from one year to the next, so results only become valid if we expand the timeframe of analysis, preferably over the 10 or so years of an average business cycle.

The ultimate goal is to discover how much cash the company is generally capable of churning out, versus how much it typically spends on the day-to-day running of the business (operating expenses), generating revenues (cost of goods sold) and improving and adding new assets (capital expenditure), etc.

Once this is done, consider if there are any big expansion plans on the horizon and if an unusual amount of liabilities creep up out of nowhere. Special attention should be paid to current liabilities, payments due within a year, and contingent liabilities, financial obligations that could crop up, depending on the outcome of a future event.

Certain ratios can sometimes assist with your research. For example, taking a look at average free cash flow over the course of the business cycle shows how much the company normally has left in its coffers to do as it pleases. In certain cases, the capital expenditure to operating cash flow ratio may come in handy, too, as it tells us what percentage of money generated from trading has been ploughed back into the business.

Beware, though: Various accounting tricks and huge divergences between sectors and individual stocks mean investors that base decisions on only certain metrics are more likely to get caught flat-footed. Taking short cuts is dangerous. Often, we can only truly get to the bottom of whether a company is not putting its resources to work properly if we spend time truly understanding a business.