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Calibrating ROIC
to Drive Shareholder Value
As a follow-on to our Q1-2013 Corporate Finance Topics piece, 2013: The Year
to Challenge the Do Nothing Strategy?, we further explore the connection between
shareholder value creation and ROIC. In our prior piece, we noted that conservative
capital structures and large amounts of excess liquidity positioned corporates well
to execute on significant strategic or return of capital initiatives.
Considering a business as a portfolio of earning assets operating subsidiaries,
real estate, cash, etc. offers a helpful paradigm to consider value creation.
Each asset earns a return, which when combined, results in the businesss ROIC.
In this piece, we first highlight the importance of ROIC in determining shareholder
value over time. We then analyze the impact of excess cash on ROIC to show that
many corporates are holding cash in amounts that are well in excess of what our
data suggests is the optimum level to maximize shareholder value. Excess cash
has been in the spotlight for several years and continues to be in 2013, as
evidenced by a recent wave of activist focus driving capital structure realignment
and business reorganization. As part of our piece, we assess several characteristics
of corporates that may justify holding excess cash and note that the companies
that hold the most cash often do not exhibit these characteristics.
Executive Summary
1
1.
2.
Corporate cash balances remain elevated. We revisit the S&P 500 cash
accumulation charts that weve seen many times over the past several
years to reiterate that cash balances remain at historically high levels,
both on an absolute and relative basis.
3.
There are various corporate characteristics that may justify holding excess
cash. There are many potential reasons for management to build cash reserves.
Some of the most common rationales include: the need for growth capital,
high projected cash flow volatility, high fixed charges, limited access to capital
markets, and tax inefficiencies associated with repatriating offshore cash.
4.
However, companies with the highest cash balance often do not reflect these
characteristics. Typically, these companies hold a significantly larger multiple
of historical cash flow volatility, have lower gross debt levels and are able
to fund growth with operating cash flow and/or capital market access.
Data set includes 395 of the current S&P 500 constituents, with insurance companies, banks, broker dealers and REITs removed. Firms with
less than five years of trading history are also excluded. Analysis based on five years of data from January 1, 2008 through year end 2012.
5.
1
Total shareholder return
is highly correlated
to change in ROIC.
When we looked across the various potential drivers of total return (ROE, EPS accretion,
ROIC, etc.), ROIC was the metric with the strongest correlation to total return.
We segmented the S&P 500 constituents2 into four quartiles based on annualized total
returns over the past five years and noticed a clear and very strong positive correlation
between total return and change in ROIC. As illustrated in Figure 1, the higher
the change in ROIC (1.5% for top quartile vs. -3.6% for bottom quartile), the higher
the annualized total return (15.8% for top quartile vs. -8.5% for bottom quartile).
We also noted that the companies with higher total returns generally had (i) lower
levels of cash as a percentage of market capitalization; (ii) similar or lower levels
of cash as a multiple of cash-flow volatility (as measured by two standard
deviations of cash flow); and (iii) higher P/E ratios.
20%
15%
1.5%
15.8%
1%
0%
10%
(0.5)%
7.1%
5%
(1%)
(1.7)%
1.7%
0%
(2%)
(3%)
(5%)
(3.6)%
(8.5)%
(10%)
Cash/Market Cap
2
2nd Return
Quartile
3rd Return
Quartile
Bottom Return
Quartile
6.8%
6.9%
8.0%
13.0%
1.9x
1.4x
2.1x
2.0x
NTM P/E
15.4x
13.9x
13.3x
12.3x
Source: FactSet
Top Return
Quartile
Data set includes 395 of the current S&P 500 constituents, with insurance companies, banks, broker dealers and REITs removed. Firms
with less than five years of trading history are also excluded. Analysis based on five years of data from January 1, 2008 through year
end 2012. Quantities represent medians of each respective quartile.
(4%)
2
Corporate cash balances
remain elevated.
We have consistently seen data that tells us cash balances are reaching all-time
highs. That continues to be true today, as illustrated in Figure 2. Cash balances
are not only high on an absolute basis, but are also high on a relative basis
(as a percentage of market capitalization). As compared to 2007, relative cash
balances at the end of 2012 were ~63% higher.
$1,400
$1,200
$983
$1,000
$800
$1,222
$1,102
$786
$734
$600
$400
$200
$0
2009
2010
2011
2012
$8.8
$7.1
$8.7
$9.7
$10.4
% of Market Cap
7.2%
8.9%
13.8%
12.7%
12.1%
11.7%
There are several reasons that may drive a corporate to hold excess cash,
and we have highlighted five in Figure 3.
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Hig
Common rationales
firms use to explain
high cash balances
Market Access
Figure 3. Reasons
for Holding Excess Cash
3
is be
ing u
high
s
gros ed to off
s lev
erag set
e
3
There are various corporate
characteristics that may
justify holding excess cash.
2008
$10.2
Cash
Source: FactSet
2007
Market Cap ($bn)
hL
everag
e
4
However, companies with
the highest cash balance
often do not reflect
these characteristics.
We again segmented our S&P 500 data set into four quartiles, based on cash
as a percentage of market capitalization over the past five years, and then analyzed
whether a correlation existed between cash balances and the reasons we highlight
above. In Figure 4 we show that the companies in the two higher quartiles:
1.
2.
3.
% Cash/Market Cap
21.6%
20%
15%
10.3%
10%
6.1%
5%
2.6%
0%
Top Cash
Quartile
2nd Cash
Quartile
3rd Cash
Quartile
Bottom Cash
Quartile
3.9x
2.3x
1.6x
0.7x
100%
100%
97%
104%
17.9%
14.4%
19.5%
23.0%
7%
15.5x
6.6%
6%
5.4%
5%
4.7%
4%
13.8x
14.1x
13.5x
12.9x
2%
13.0x
1.4%
1%
12.5x
12.0x
0%
Top Cash
Quartile
Source: FactSet
2nd Cash
Quartile
3rd Cash
Quartile
Bottom Cash
Quartile
Companies with lower cash balances over the past five years generally performed
better (with the exception of the lowest quartile) on a total return basis over that
time period. There is a similar, but slightly weaker, correlation with cash balances
and P/E multiple; companies in our data set with lower cash balances generally
exhibited rising P/E multiples. Based on our data set, optimal cash balances can
be triangulated between cash as a percentage of market cap (5%7%) and cash
as a multiple of cash flow volatility (1.5x1.9x two standard deviations).
5
Reducing the level
of low-yielding cash
on the balance sheet
is one of the simplest
ways to improve ROIC.
2.
ROIC =
1
2
Many corporates have made significant efficiency improvements over the last five
years with a commensurate increase in profit margins as they strive for earnings
growth. In addition to increasing profitability through operational efficiency and
increased asset utilization, in Figure 6, we consider four methods of achieving
ROIC improvement by focusing on high-performing assets in the portfolio.
Refocus on highest ROIC segments
Figure 6. Alternatives
for ROIC Improvement
5
14.5x
14.0x
13.6x
3%
15.0x
Sale
Spin-Off/
Split-Off
Growth
Initiatives
Excess
Cash
Sale of
subsidiaries
or assets with
lagging ROIC
Spin-off/split-off
of subsidiaries
with lagging ROIC
Capital
expenditures
and M&A focused
on highest ROIC
projects
Invest proceeds in
share repurchases,
or higher ROIC
businesses
Corporate Finance Topics, Q2 2013
High cash balances that primarily earn interest income over the medium to long term
are arguably one of the most underperforming capital bases. This has been further
exacerbated by all-time low interest earned on cash balances over the past few years.
The impact to ROIC of a reduction in cash for a hypothetical company in the top cash
quartile (as a percentage of market capitalization) indicates meaningful improvement
is achievable through a rebalancing of the capital structure.
In order to further examine what benefits cash reduction would generate for a top quartile
company, in Figure 7 we consider the impact to ROIC for a hypothetical company.
Hypothetical Company
Cash
$16.2
Market Cap
$75.0
Cash/Market Cap
21.6%
Total Capital
$50.0
EBIT
$5.0
ROIC
6.71%
Cash Reduction
Cash/Market Cap
ROIC
% Improvement
21.6%
6.71%
Second
$9.4
10.3%
8.12%
21.04%
Third
12.4
6.1%
8.71%
29.72%
Bottom
14.6
2.6%
9.22%
37.36%
Top
Conclusion
For more information,
please contact:
Souren Ouzounian
Head of Americas Corporate Finance
souren.ouzounian@baml.com
(646) 855-5300
Amir Mirza
amir.mirza@baml.com
(646) 855-4331
Jay Bliley
jay.bliley@baml.com
(646) 855-4666
Philip Turbin
philip.turbin@baml.com
(646) 855-4708
Leonard Chung
leonard.chung@baml.com
(310) 209-4062
Gus Garcia
g.garcia@baml.com
(646) 855-4680
6
Assumes total capital and market cap are reduced by the amount of cash reduction; ROIC calculations assume 1% pre-tax interest income
on cash and 35% tax rate.
05-13-0344