HOW COOL IS CASH?
Asian companies are sitting on mountains of money. Isn't it time they gave it back to their shareholders?
By Justin Wood

If CFOs ever suffered from such a thing as balance-sheet envy, then Bangalore-based Infosys would certainly give it to them. Not only does the US$540 million-a-year consulting and IT services firm have no debt whatsoever, it also holds enough cash to sink a battleship.

At the last count, on September 30, Infosys had US$278 million in ready money, which accounted for 47 percent of the company's assets. Its current ratio - defined as current assets divided by current liabilities - stood at 7.84, an extremely high figure given that most companies aim to have a current ratio of between one and two.

"We like to be cautious," explains Mohandas Pai, CFO of Infosys. "As a high-tech, high-growth company, we already have lots of business risk, so we don't want to add financial risk."

Some investors, however, think that Infosys is holding too much cash. As one Hong Kong-based fund manager at a large British investment firm notes: "The company's approach to risk is ultra conservative and limits the return on equity."

Rich and Shameless
Infosys isn't the only company in Asia where such accusations are made. In fact, many observers say that, compared to their peers in Europe, the US and Australia, hundreds of Asian firms are positively bloated with cash. From Quanta Computer of Taiwan to the Hong Kong Stock Exchange to PSA Corporation of Singapore to Malaysia's YTL Group, commentators say that Asian balance sheets are overloaded with liquid assets.

"It's clear that Asian companies carry much more cash than their counterparts elsewhere in the world," confirms Paul Coughlin, the Hong Kong-based head of corporate credit ratings at Standard & Poor's.

And it's the same story for many of the region's financial institutions too. Stephen Kam, an equity analyst at Merrill Lynch in Hong Kong, reckons that a lot of the banks in Hong Kong and Singapore also have high levels of cash. "Capital adequacy ratios for the sector average around 16 percent to 17 percent, whereas in Europe and the US it's closer to 8 percent," he points out.

The big question is, are Asian firms carrying too much cash? And if they are, should they give it back to their shareholders? Opinions are divided, for deciding how much cash is the right amount for a business is always more of an art than a science. On the whole, however, it seems that companies in the region would do well to lose some weight, for cash is all too often the enemy of shareholder wealth.

Balancing Act

According to traditional corporate finance theory, each firm has its own "optimal" cash level. Companies that are generating cash, so the theory goes, should hold onto enough of it to cover their short-term expenses and capital expenditure, plus also keep a little bit more in the bank as insurance against unforeseen events. Any extra cash the company makes over and above these needs should be returned to shareholders, either via dividends or share repurchases. If the company then discovers a new investment that it wants to make, managers should raise the necessary funds for that investment in the capital markets.

What companies shouldn't do, is stockpile cash today in the hope that they will find a use for it tomorrow. For one, it's expensive to hold cash thanks to its negative carrying cost - the difference between the return that companies earn on their cash and the price they pay for having the cash as measured by their cost of capital. For another, excess cash brings agency costs, whereby companies are tempted to engage in "empire-building" - a term that refers to managers who squander their cash on wasteful acquisitions and bad projects in a bid to boost their personal power and prestige. Raising funds in the capital markets, the theory says, brings greater discipline to investment decisions and so reduces agency costs.

Of course, theory is all well and good, but capital markets are far from perfect and companies can't always raise money when they want to, nor raise it at the right price. For example, companies with volatile cash flows can find it tough to raise funds at certain times, while small businesses often find the transaction costs of raising money prohibitively expensive at all times. What's more, highly complex companies like pharmaceutical firms argue that they suffer from asymmetric information - the capital markets don't understand their business and so mis-price their securities.

Given these market imperfections, some companies need to hold more cash than others, and so a more realistic model for determining a company's optimal cash level has emerged called the "trade-off theory". Simply put, the theory says that managers should arrive at an optimal level of cash by weighing up the costs of holding ready money - both the carrying costs and the agency costs - against the benefits.

Cash Helmet

When considered in the context of such theory, says Alan Thompson, Asia Pacific head of consultancy Stern Stewart in Singapore, Asian firms are "holding much more cash than they need to" and consequently are destroying shareholder value on a grand scale.

So why are they doing it? It isn't because the capital markets are shut. As Pieter Van Der Schaft, director of economic research at Barclays Capital in Hong Kong, notes: "There is massive excess liquidity in the Asian banking system. Good quality corporates can borrow very easily."

For Brian Cahill, managing director in Asia for Moody's, a credit rating agency, much of the blame for the region's obsession with cash lies with the Asian financial crisis of 1997/98. "Companies have seen how quickly access to the capital markets can vanish, and they worry about refinancing risk," he notes. "For that reason, they tend to be more conservative, to have less debt, more cash and to value their liquidity very highly."

And in some cases that's no bad thing, says Dominic Barton, head of the Seoul office of consultancy McKinsey & Co. In a book published this year, called Dangerous Markets: Managing in Financial Crises, he argues that currency and banking crises are increasing, both in frequency and in magnitude. "We are living in volatile times," he stresses, "having more cash on your balance sheet than theoretical financial analysis would suggest is prudent."

At Infosys Technologies, Pai certainly prefers to err on the side of caution. His yardstick for liquidity is to have enough cash on his balance sheet to cover "an entire year's worth of expenses and capex even if we don't earn a single rupee of revenue during that year".

However, that caution comes with a price. Pai says the returns he earns on his cash are about 6.5 percent. And yet, with a weighted average cost of capital of 17.17 percent, the money mountain at Infosys is destroying value.

Still, Pai says he's prepared to take that cost on the chin. Infosys has stated clearly that it aims to earn a minimum return of twice its cost of capital on capital employed (ROCE), and a return of three times its cost of capital on invested capital (ROIC) - which obviously excludes cash. Last year, the company leapt over those hurdles with ease, earning a ROCE of 54.4 percent and a ROIC of 83.1 percent.

"We think investors are happy with that," says Pai.

Show Me The Money
Nonetheless, while risk aversion explains a surfeit of cash at Infosys, it doesn't at many other Asian companies.

One popular explanation for excess cash, says Thompson at Stern Stewart, is that it gives managers the flexibility and speed to make acquisitions as and when they see fit. But he thinks such claims are nonsense, given that companies "with good investment ideas can almost always raise money". Instead, he believes that managers hoard cash for other reasons.

"It's all about governance," Thompson sighs, referring to the agency costs associated with excess cash. "Going to the capital markets imposes discipline on companies and their investment plans. Unfortunately, many firms in Asia actively stockpile cash just so that they can circumvent that process of discipline and avoid the scrutiny that goes with it."

Henri Servaes, a professor of finance at London Business School, is another who believes that agency costs go a long way to explaining why companies with cash don't give it back to their shareholders. He recently completed a paper - due for publication in The Journal of Financial & Quantitative Analysis next year - together with Jan Mahrt-Smith, also of London Business School, and Amy Dittmar of Indiana University in the US, which investigates cash holdings in relation to corporate governance.

In their paper, the three academics analyze 11,000 companies from 45 countries to see how much cash they hold. They then divide the countries into two groups - one with strong shareholder rights, and one with weak rights, as measured by factors such as shareholder voting power and the legal protection investors have against the expropriation of company assets by managers.

The results are dramatic: firms in countries with the lowest level of shareholder protection hold almost 25 percent more cash than firms in countries with the highest level of shareholder protection. They examined many other factors too, such as the level of development of the capital markets in each country but found no clear patterns.

Given that corporate governance standards in many Asian countries - particularly places like Indonesia, South Korea and Thailand - are lower than elsewhere in the world, Servaes' results go a long way to explaining why regional cash holdings are high. Shareholders in such countries, it seems, simply lack the necessary power to force firms to disgorge their cash.

And why are companies so reluctant to give cash back to shareholders? Servaes says the answer is simple. "Managers like to hold lots of cash because it reduces pressures on them to perform," he says. What's more, he adds, having lots of cash "lets managers waste their funds on projects that serve to increase their personal status and influence, but have a negative impact on shareholder wealth."

Cash Dispensers

So how should companies react to claims that they have too much money? At the very least, managers should examine their companies through the filter of financial theory and work out what their optimal cash level is. By building a model of the firm's future cash flows, its capital expenditure plans, maturing liability payments and other cash needs, a firm can easily work out how much cash it requires. Any extra should then be given back to shareholders.

That's exactly what Teoh Tee Hooi did. As CFO of Singapore Airlines, the S$9.5 billion (US$5.4 billion) travel company, he and his finance team have worked hard to find the perfect trade-off between maximising shareholder returns whilst maintaining a healthy level of liquidity.

Back in 1999, Singapore Airlines took a good look at its balance sheet and concluded that it was carrying too much ready money. In the three years since then, the company has returned just over S$1 billion of cash to shareholders via a share repurchase program. It has also returned a further S$609 million through a capital reduction exercise, whereby the par value of the company's shares was reduced from S$1 to S$0.5. And that's on top of paying a regular interim and annual dividend.

"The repurchase program and the capital reduction are part of a restructuring of Singapore Airlines' balance sheet over the medium term," says a spokesman from the company's treasury department. "We wanted to return surplus cash balances to shareholders and increase our debt to reduce the company's weighted average cost of capital."

In the process, the group's liquidity position changed from net liquid assets of almost S$2.5 billion in March 1999 to net debt of S$650 million in March 2002, with items such as aircraft purchases adding to the change.

Observers applaud the airline's actions. "The decision to disburse cash was a good one," says Jesvinder Sandhu, senior investment analyst at OCBC Investment Research in Singapore. "[The airline] had too much cash on its balance sheet and the share repurchase was a sensible way of giving it back to shareholders in a tax-free way."

At Singapore-based Pacific Internet, a US$76.4 million-a-year internet service provider, the management team carried out a similar appraisal in November 2002. Up until now, the company - which floated on Nasdaq in the US in early 1999 - hasn't returned any cash to its shareholders, concentrating instead on building a regional presence across Asia and Australia. Recently, however, Pacific Internet turned cash flow positive. In the first nine months of this year, for example, its bank balance grew from US$13 million to US$16.3 million.

According to Nancy Tan, CFO of Pacific Internet, she and her colleagues met to discuss the possibility of returning a portion of that cash to shareholders by starting to issue a dividend. As it happens, they decided against it.

"We're a young technology company that is growing very fast and we still have lots of good investment opportunities, particularly in China," she explains, "so we decided that paying a dividend doesn't make sense for us right now."

What's more, she adds, if the company were to pay out its cash, it would be tough to raise new funds. On the one hand, Pacific Internet leases rather than owns its infrastructure so the firm has few fixed assets against which to raise debt. On the other, given current sentiment towards internet companies, the equity markets are equally closed.

"Internal financing makes the most sense for us," she concludes. Clearly, with good growth prospects, but limited opportunities to raise money, the trade-off equation at Pacific Internet favors a strong cash position.

Cash as Negative Debt

Interestingly, the experiences of both Singapore Airlines and Pacific Internet highlight another important aspect of setting cash levels - the need to do so in conjunction with overall capital structure. After all, cash is the opposite of debt and should be thought of in those terms.

Adrian Crockett, a liabilities strategist in the debt capital markets team of Deutsche Bank in London, notes: "Although liquidity management is often thought of as separate from capital structure, we believe that it's a mistake to try to separate the two topics."

So, rather than carry cash on their balance sheets, many companies could instead raise debt if and when they needed new funds. To that end, Crockett advises companies to identify two capital structures: one which the company aims to maintain most of the time, and a second, fall-back position should the company need to raise new funds.

Such thoughts aren't lost on Manuel Bengson. As group treasurer of Ayala Corporation, the US$511 million-a-year Filipino telecoms-to-real-estate-conglomerate, he is only too pleased to substitute expensive cash with cheap debt. In particular, he relies heavily on committed bank credit facilities which he can draw down as and when he needs to.

Bengson calculates that his cost of carrying cash is about 6 percent, whereas the cost of a committed bank line is just 50 basis points. "Because we live in a so-called emerging country, if you are holding cash, you pay a fantastic cost for it," he says.

Needless to say, Bengson has built sufficient flexibility into Ayala's balance sheet so that the company is quite able to take on more debt at a moment's notice. But that's not all. He's also taken care to diversify his funding sources as much as possible, including fixed and floating rate notes in both pesos and dollars, as well as convertible and exchangeable bonds. Not only does that guarantee that Ayala can't be held to ransom by a particular segment of the capital markets, it also means that Bengson has masses of opportunities to turn his short-term bank loans into longer-term borrowings should the need arise.

At Infosys, Pai is also looking at alternatives to carrying cash, although debt isn't on the agenda. One promising option is the possibility of taking out an insurance policy against certain event-specific liquidity risks. While such a policy might dent his ability to create balance-sheet envy, it would certainly make investors happier.

Justin Wood is executive editor, South-east Asia, for CFO Asia, based in Singapore