GOLDEN HOARDS
There’s a record amount of cash in corporations worldwide, with an especially high proportion in Asian firms. Why?
By Tom Leander

A CFO’s job is never done. When Andrew Lin, CFO of Lite-On Technology, a Taiwan high-tech component manufacturer with US$5 bn in sales, took up his post three years ago, his first task was to restructure four related companies into a single unit. Lin saw the four-way merger as a chance to fix individual problems that hobbled the separate units, such as lukewarm working-capital management, poor handling of foreign-exchange exposure, and wasteful supplier relationships. He did – and not in a small way. He’s now sitting on more than US$1 bn in cash, up from a negative cash position when he first began. And now comes another problem – what to do with all that money.

“Cash doesn’t usually generate a very high return,” says Lin. “But when you invest in capital expenditure, the return is usually in double digits, more like 20%.” He adds: “I feel the pressure.”

If so, Lin is in good – and very global – company, because cash holdings in the world are at historic highs. For the US, Japan, the Euro zone, and the UK that figure for non-financial companies amounts to about 2.4% of GDP, or US$682 bn at year-end 2005, according to JPMorgan. It has not diminished appreciably since then.

How cool is cash?

In Asia, all the cash and cash equivalents on the balance sheets of large companies in eight economies – China, Hong Kong, India, Indonesia, Japan, Malaysia, Singapore, and Taiwan – amounted to the astonishing figure of US$1.2 trn in 2005, according to Thomson Financial. These are companies that earn US$1 bn or more in annual sales, including banks and other financial companies.

The amount is up US$200 bn for the same group since 2003. The biggest cash hoarders today seem to be in Malaysia, where cash and cash equivalents amount to 37% of total annual sales for those same companies. Indonesian companies tallied 29%, whereas Taiwanese companies chalked up 27%.

Moreover, CFOs everywhere – but especially in this region – have no intention of reducing their cash buffer. Asian CFOs in September said they planned to increase cash by 11%, according to the CFO Magazine Global Business Outlook Survey, conducted with Duke University. This figure was up from an expected 6% increase in June this year. Europeans saw the biggest jump in cash-holding expectations, to 10% in September, from 1% in June. Expectations of US CFOs also grew, to 3% from 2%.

“Economists are puzzled as to why business investment has not recovered even more,” says R Glenn Hubbard, dean of Columbia Business School in New York and former head of the Council of Economic Advisors in the George W Bush administration, “given enormous cash flow and liquidity and the extremely low cost of capital for almost any project at the moment.” He adds: “I think that reflects the fact that there was too much investment back in the 1990s and there’s risk aversion now.”

Traditional corporate finance theory holds that hoarding cash leads to value destruction, due to the opportunity cost of not placing that money in more lucrative investments. Despite the rate rises in the US, average interest rates in the Asia Pacific are at historic lows, and investing cash in short-term instruments like money markets cannot come close to returns provided in the equity and bond markets, or savvy direct investments. The MSCI Asia Pacific index (ex-Japan) reported a return of 47% for the period between April 2005 and April 2006.

Another way of looking at the value destruction problem: a high component of cash holding affects a company’s return on assets. Lite-On’s Lin says: “We have cash equal to 30% of our market cap or one-third of our assets. The more cash you have, the lower your return on assets, so our ROA is below 10%.”

Economists also point out that carrying too much cash results in agency problems, allowing management in large companies to create fiefdoms and indulge their investments without discipline. Under this theory, borrowing in the capital markets imposes discipline in the guise of investors seeking to protect the value of their capital.
Yet many CFOs in the region, like Lin, still prefer the cash hoard to the alternatives.

Fending Off Risk

Risk aversion is certainly the credible answer for Asia. Although the collapse of Asian currencies that followed the devaluation of the Thai baht in 1997 happened more than nine years ago, Asia’s CFOs still describe themselves as wary.

“It’s related to the destruction done to balance sheets in the late part of the ‘90s,” says Clive Standish, CFO of UBS, the Swiss financial institution. Standish ran UBS’s Asia Pacific unit until 2005 before becoming group CFO. He notes that the criticism lobbed at companies stemmed from the misuse of available leverage. The mistakes and the drubbing that followed produced a huge defensiveness.

Now, Standish says: “While there’s still a lot of leverage available, corporates want to be more self-sufficient and strong. And the whole governance process is stronger.” He adds: “People are a lot less willing to take risks. This is a sort of counterintuitive process.”

In research for the International Monetary Fund, Roberto Cardarelli and Kenichi Ueda agree that risk aversion is high on the list of why companies are holding on to so much cash. But they also say that expected benefits or costs of cash holdings are changing because of shifting economic conditions. These include lower interest rates, higher sales, and profit volatility as the global market faces intensifying uncertainty. Another key reason: a larger share of intangible assets in corporate balance sheets. Firms with more intangible assets are likely to hold more cash given the higher cost of external finance for intangibles, which are typically volatile in value.

An alternate view pins high cash holdings on globalization and its effect on wages. JPMorgan’s Jan Leoys, a London-based analyst, notes that corporations are in an unaccustomed period where they are free of pressures that have been exerted on them by civil society, such as labor bargaining and high corporate taxes.

In a study published last April, “Corporates in the Sweet Spot,” which examined the corporate savings in the G4 countries, Leoys notes that “ongoing subdued labor cost growth reflects slack that still exists in labor markets, especially in Japan and the Euro area.” He adds: “It is also possible that increased pressure from globalization, and increases in indirect costs such as pensions, have pushed down growth in wage compensation.”

Buy – Carefully

Loeys says that the greatest danger of the high cash holdings is that it might lead to ill-thought-out M&A, leading to an M&A boom that would eventually lead to the destruction of far more value than simply holding the cash.

And, indeed, the M&A market is bound for a record year, though it’s not clear that the irrational buying that Loeys fears has emerged. According to research company Dealogic, an active M&A market globally pushed bids to US$2.76 trn in the first nine months of the year, a record high driven by an increase in hostile offerings. The average for deals in this period grew 11% to US$191m compared with the same period in 2005. The jump in hostile deals, analysts said, can be attributed in part to record levels of liquidity and increased shareholder activism, pressing management teams to do something with all that money.

But this is hardly making CFOs rash. David Henshall, CFO of Citrix Systems, a Florida-based software company that projects US$1.2 bn in revenues this year, says that the company’s cash war chest of around US$900m is within range of being an “appropriate cushion”, as it continues its policy of acquisitions of “bolt-on” companies (it has made six acquisitions in the last four years). In its most recent acquisition, Citrix acquired Orbital Data, a small Silicon Valley player in the WAN optimization market, for US$50m in cash.

In the past six months, the company also bought back about 2m shares. Henshall says the cash will continue to be used for ‘occasional’ acquisitions and technology licensing. His strategy is to hold cash for immediate action when the opportunity presents itself. He says: “The software industry is evolving. There’s a need for companies to look at an exit strategy, to sell to a larger business.” He adds: “We want to be aggressive, to be looking at new technology.”

In Henshall’s view, cash is a key element in bringing the company to a step change. Citrix’s revenues in 2005 reached US$909m, up from US$741m in 2004. Henshall’s goal is to get above US$1 bn per year in revenue. “We use the billion dollars for a tangible number as a first phase, a measuring point along the way. It puts us in a slightly different category, and proves that we have a sustainable strategy. But we plan to take it well beyond.” He notes that there have only been a few dozen major software companies that have been able to break though the US$1 bn per year threshold. But, he adds: “To get to the next US$1 bn we’re going to have to be smarter.”

Are Ye Productive?

Columbia’s Hubbard argues that there’s been a fundamental change in productivity and that this, in part, has led to higher profits and greater cash holding. Some CFOs do buy the productivity argument. John Bailey, the director of finance of Columbia Sportswear, a US-based company with US$1.1 bn in net sales, said, when interviewed in April, that his company had cash holdings of about US$130m. One reason that figure is relatively high is better management of working capital, partly due to greater transparency that technology can deliver to the mundane art of managing the cash conversion cycle. “We use our working capital more efficiently,” says Bailey, “and now we’ve had a lot of excess cash. We’ve seen the savings, and have been able to grow our business and add brands, and not increase staff levels.”

In his view, the excess cash is also a condition of the company’s stage of maturity. “When a company is growing at a 20% to 40% clip, you absorb working capital,” he says. But as the rate of growth slows, cash accumulates because the company is no longer pouring it back into the business. Bailey says that the company has considered share repurchases.

Like Bailey, Lite-On Technology’s Lin has made better management of working capital a key strategy for improving the business. Lite-On merged four publicly-listed companies – Lite-On Electronics, Lite-On Technology, Silitek, and GVC – to form the new Lite-On Technology in November 2002. Lin had worked as a banker, consultant, and market analyst before being tapped to restructure the company’s financial operations.

“As a consultant, I did a lot of cost cutting,” says Lin. Classic cost control – from cuts to the travel budget to demanding the use of paper cups – garnered an 8.9% drop in operating costs, equal to US$60m. Then Lin turned to purchasing, and consolidated 300 vendors to 30. “If you go from 30 suppliers to, say, four, those four are getting something in the magnitude of ten to 12 times the business. The price negotiation becomes very simple.” He adds: “This preempts a lot of resources: I don’t have to manage 30 suppliers.”

After this, he says, he put his focus on the cash conversion cycle. “When I came, we calculated 34 days, which is not bad. In six quarters we improved to 21 days.” Lin says that 13 days of working capital was worth about US$200m.

Greater discipline in the company’s hedging against foreign exchange rates also improved cash balances – and prevented losses experienced by Lite-On’s peer companies. “Because your accounts receivable and accounts payable are all in different currencies, this creates a positive or negative position in every currency. All those sales and purchasing guys, they don’t key the figures into the system, and that creates problems. They’re just guessing.” Lin’s solution was to install a uniform ERP system and simply press the company’s sales and operating guys as hard as possible. “I asked, ‘Have you keyed in your invoice today? I repeat, have you keyed in your invoice today?’”

He became an evangelist for cost cutting. “I said to the staff: ‘If you lower your sales, general, and administrative costs by 1% (something like NT$1.5 bn at the time), that would translate into 60 cents of earnings per share. We’re trading at 15 times multiple, and that would translate into NT$9 of our share price.’ And then I said: ‘You guys own a lot of shares in your company.’” The result? “When I came, we had negative cash flow. Now I’m sitting on more than US$1 bn,” Lin says.

Now for the Hard Part

Having too much cash seems a good problem to have, but that does not make finding the solution any easier. Lin sees local barriers to deploying excess cash. “Most Taiwanese companies have been very, very profitable. But in the Taiwanese mentality, they [the company officers] don’t really have in mind an optimal capital structure.”

In this respect, their thinking can be contradictory and self-defeating. He says that most companies save cash for potential M&A, but M&A activity both inside Taiwan and cross-border has been limited. That’s because many Taiwanese companies are tightly held by their chairman, who want to retain 80% to 90% of their companies. In the local market, unlike the US, companies have no tax incentive to take on debt. Added to this, he says: “Global liquidity has also contributed. You see private equity and hedge funds chasing similar targets. But there are very, very few targets that you can chase.”

Lin also finds share buybacks unattractive. “In Taiwan, there’s a signaling effect in buybacks. The investment community will react the first and second time, but that’s about it.” He adds: “It’s probably related to the Taiwan market being such an underperformer.” He notes that even making the argument to investors that a 1 bn share buyback would improve ROA wouldn’t make much of a difference. “Most people,” he says, “follow ROE.”

So what’s a CFO to do? For now, his answer is rueful. “Probably, the situation will take care of itself,” he says. “If you recall 2000, there was a ton of cash [in companies]. But the tech crisis took care of that.” Something similar could happen again, he says, “once we’ve started to take the dive.”