Best Use Of Corporate Profit (Cash): Case Studies
Chuck Carnevale | Dec 12, 2012 05:30AM ET
I recently authored two articles showing that, all other things being equal, a stock that pays its shareholders a dividend generates a higher total return than a stock with similar growth characteristics that doesn’t. This is based on the reality that stock prices follow earnings in the long run, and it is this relationship that generates the capital gain component of total return. Therefore, if there is a dividend it will provide the shareholder the additional return from the income component (dividends). Links to the articles can be found here and here.
Both of these articles generated a rather lively comment stream. However, very few of the comments actually discussed the concept of the dividend providing additional return. Instead, the comments denigrated into exhaustive discussions about whether or not a company would grow faster or not by not paying a dividend. In other words, the discussions did not talk about the return augmentation the dividend provided, rather, the debate focused on whether companies should pay dividends or not. This led then to discussions about reinvesting into the business, and share buybacks, et cetera. These are entirely different subject matters which inspired me to write this article.
Consequently, the focal point of this article is to discuss, and try to answer the very important questions, regarding what is the best use of corporate profits. Should a company retain their profits and reinvest in itself, should a company buy back their stock, should they use it to fund acquisitions, reduce their debt or pay dividends? These are all important questions, and the comment threads on my previous articles suggest that many investors have very strong feelings about these matters. Fortunately, I have the absolute perfect answer to these questions. Drum roll, please.... the simple answer to all these questions can be stated in two words-it depends.
The point is that all of these uses of corporate cash flow can be the best use under the appropriate circumstances. On the other hand, all of these capital deployments can also be the absolute worst utilization of corporate cash flows. And the correct answer can be different for virtually every company out there, and the correct answer for any specific company can be different today than it is tomorrow. Accordingly, the reader should understand that there is an almost infinite array of circumstances and situations that would dictate a different answer for each situation. Consequently, this article will only present some general guidelines and concepts about when each of these capital deployments makes sense, and when they don’t.
The Capital Deployment Pecking Order
An article in the Wall Street Journal on February 27, 2012 by Maxwell Murphy titled The Pros and Cons of Stock Buybacks interviewed two prominent Wall Street personalities with strong views on the subject of buybacks. They were Whitney R. Tilson, founder and managing partner of T2 Partners LLC, and Gregory V. Milano, cofounder and chief executive of Fortuna Advisers LLC. Here is a link for anyone interested in reading the whole article. The reason I share this article is because Mr. Milano described a concept that he referred to as a capital deployment “pecking-order theory” as follows:
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“Many believe capital deployment should follow a "pecking-order theory" that prescribes that managements should apply their cash flow, in order of priority, to fix their balance sheet if overleveraged, fund organic investments, pay dividends, fund acquisitive growth and, only when there is additional cash left over, to distribute it via share repurchases. While this may seem theoretically sensible, in practice it leads to buying back more shares when the market value has increased significantly in response to stronger cash flows.”
I believe this quote perfectly addresses many of the issues, and opinions of those who believe that dividends actually represent a drag on the company’s potential to grow. Notice that dividends came in third place after deleveraging the balance sheet and investing in organic growth. With this article, I will provide a brief introduction on each of the cash flow deployment options based on the pecking-order theory introduced above.
Fix The Balance Sheet (Reduce Debt)
The old adage that you can’t go bankrupt if you don’t have any debt equally applies to corporations as it does for individuals. On the other hand, applying the appropriate amount of leverage can also be a beneficial way for corporations to increase their returns. The level of interest rates is also a big factor; the lower the rates are the more attractive it is for corporations to borrow. This includes issuing bonds and notes and/or establishing credit lines, etc. But perhaps most importantly, the company’s cash flow generating abilities and levels capable of amortizing debt is a critical consideration.
Furthermore, a corporation can have a good reason for taking on debt, such as to fund a strategic acquisition (more on that later). However, depending on the individual company, it’s important to never let your debt reach a level that becomes unmanageable. Consequently, using corporate cash flows to reduce debt is more often than not a good use of corporate cash. On the other hand, this doesn’t mean that the corporation must use all of their cash flow to pay down their debt. In fact, it is not uncommon to find companies that deploy their cash flows across all of the “pecking order” options.
The following F.A.S.T. Graphs™, fundamentals analyzer software tool, will look at two companies where one might want to deleverage and the other doesn’t need to. The first graph looks at Clorox & Co. (COST ) is an imprudent use of their corporate cash. I believe their shares are significantly overvalued (fair value $67, current price $98) in the marketplace today, and therefore, if I were a shareholder I would not be comfortable with this utilization of their cash. Instead, I would much prefer a more generous dividend.
Summary And Conclusions
Corporations have numerous options and uses for the profits they generate. However, there is no right option that applies in all situations. The decision of what a corporation should do with its excess earnings and cash flows depends on the company’s management and board carefully assessing all of the options before them. Sometimes the best use is to invest all of its excess cash directly in itself, other times it might make more sense to pay dividends or buy back shares. Strategic acquisitions can also be a good use of corporate earnings and cash. However, none of these options apply at all times and in all cases.
On the other hand, very large multinational blue-chip companies facing average long-term prospects for growth often find that paying a dividend is a very attractive and important option with which to reward shareholders by. Many investors prefer investing in dividend paying stocks and eschew investing in a company that doesn’t pay one. Moreover, these income seeking investors tend to be long-term shareholders that trade infrequently. Perhaps this explains why many of the blue-chip dividend paying stocks has a very low beta. Lower volatility would seem to be the trait of a company that has a very low turnover of its shares. Corporate management and boards would certainly favor less volatility with their shares.
Therefore, at the end of the day investors must rely on the integrity and skills of the management teams running their respective companies to make the proper decisions regarding capital allocation. Furthermore, in many, if not the large majority of cases, the correct capital allocation decisions will often be a blend of the many options available. In other words, many companies will pay a dividend, buy back shares, commit to capital expenditures (CAPEX), pay down debt, and even make acquisitions all at the same time. And at other times, the same companies may only engage in a few of these capital allocation options at any given point in time. The decisions should always be based on management’s judgment of what the best use of their capital for the benefit of their shareholders would be.
Disclosure: Long CLX, MCD, HPQ and INTC at the time of writing.
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