February 19th, 2013
in Op Ed
by Edward Harrison, Credit Writedowns
Many of the largest technology companies are making so much money that they are rapidly accumulating cash on their balance sheets. While one could argue that this cash should be stripped off the balance sheet for valuation purposes, I would argue that the cash is worth less than face value because having excess cash on the balance sheet is an invitation to wealth-destroying acquisitions. The excess cash should be returned to shareholders as quickly as possible in the form of dividends or share buybacks to prevent such an outcome.
First, there are the technology companies and their cash. Let’s look at a few of these cases.
- Cisco Systems (NASDAQ:CSCO) had total assets of $92.6bn at the end of October. Of that total, $45bn was cash and short-term investments, $3.7bn was long-term investments, another $20.4bn was goodwill, and 3.4bn was intangible assets. That means 71% of Cisco’s tangible assets are non-business assets.
- Google (NASDAQ:GOOG) had total assets of $93.8bn at the end of December. Of that total, $48.1bn was cash and short-term investments and another $18.0bn was goodwill and intangible assets. Google also has $1.5bn of long-term investments. That means 65% of Google’s tangible assets are non-business assets.
- Apple had total assets of $196bn at the end of December. Of that total, $39.8bn was cash and short-term investments. Apple (NADAQ:AAPL) only has $5.8bn of goodwill and intangible assets on its balance sheet but it also has a massive $97.3bn in long-term investments, which for the purposes of this discussion, we should consider funds that could be paid out to shareholders. That means Apple has $137.1bn of assets on its balance sheet that it is not deploying toward its businesses that investors are due. That is 72% of tangible assets.
Many of the big tech names have balance sheets like this.
Now think about this in the context of Rio Tinto (NYSE:RIO), the commodities company that wrote down $35bn in assets this past quarter. As FT Alphaville noted that Citigroup (NYSE:C) wrote:
Interestingly the company has spent $110bn on capex and net M&A (acquisitions less divestments) over the past ten years and this compares to the company’s current market cap of around $115bn. Rio has paid around $18bn in dividends and buy backs less the rights issue is positive $4bn. At least in theory the company could have adopted this strategy [of distributing the firm's entire market capitalisation value to shareholders] in the past and perhaps avoided ~$35bn in impairments.
That is serious shareholder value destruction.
More often than not, mergers destroy value for the acquiring firm. Capital is lost that could have been returned to shareholders. This is certainly what David Einhorn is afraid of with Apple – that they will find a non-productive use of capital. And I think history would say he’s right to be worried. What is Apple going to do with all that cash? Couldn’t shareholders find a better use for it? Or is Apple’s in-house hedge fund so good?
I say the larger the cash on the balance sheet as a percentage of tangible assets, the more that cash should be discounted because of the prospect of it being used non-productively. Maybe Apple’s $137.1bn of cash and investments is actually only worth $100bn, maybe less. What you want to see in any company is that firm re-investing cashflow from operations in the business and to the degree it has more cash flow than it can possibly re-invest, it should distribute substantially all of that money to shareholders as soon as possible. Apple’s not doing that and none of the other large technology companies are doing that.
This is an agency problem. The managers in large companies have incentives to grow their corporate empire because they are compensated based on that. Meanwhile shareholders just want higher returns on equity. When a company reaches a certain size, it becomes harder and harder to maintain growth rates. That comes into direct conflict with the managers’ desire to increase their fiefdom. So usually, the managers go down the road of making dodgy acquisitions and wasting shareholder money to maintain growth when they should be returning that money to shareholders, who are the real owners of the company.
The reason dividends exist is to prevent this kind of wastefulness. They are a check on the corporate managers. And it is only because shareholders lack real power in changing executive decision making that we have not seen more of a return to dividend-based investing.
Two years ago I asked When will large cap tech stocks start paying dividends? using Cisco and Microsoft (NASDAQ:MSFT) as examples of how value is destroyed by having excess cash on the balance sheet. Investors should be concerned that this is where Google and Apple are headed.