Buttonwood
Companies on a borrowing bingeMar 29th 2005
From The Economist Global Agenda
SourceAmerica’s companies are cash-rich, right? Then why have they started borrowing again?THE Family Buttonwood having callously decided to go skiing over Easter, your correspondent was left scrabbling solo at the coalface. And a good thing it was, too. With time to devote to such previously unmined treasures as the Federal Reserve’s fourth-quarter Flow of Funds figures, released earlier in March, and the commentaries on them, Buttonwood now has her very own conundrum to pose. If companies have streamlined their operations, strengthened their balance sheets, made money hand over fist and are sitting on loads of cash, why have they hit the moneylenders again?
For those who are unversed in these mind-numbing statistics (no shame in admitting this: it suggests that you have a life), non-financial companies’ borrowings during the last quarter of last year were running at a seasonally-adjusted rate of $428.5 billion a year. That was their highest level since the second quarter of 2000, and short-term borrowings have increased by about another 8% so far this year.
But why? Corporate profits have been booming. Companies have stacks of the ready lying about: at the end of last year, non-financial firms in the S&P 500 held some 14% of their assets in cash or cash equivalents, according to Rochdale Securities, a New York broker-dealer, and it shows no signs of abating so far this year. Of course, the borrowing and the cash are not necessarily located in the same companies. But the aggregate picture seems a bit puzzling at first glance.
The curious thing is not so much that companies should have started borrowing but that it took them so long to do so. Economic growth is solid and demand is holding up (though consumer confidence slipped for the second time in a row this month and higher interest rates should eventually take their toll). Yet firms seem oddly unconfident, choosing to hold a high proportion of assets in an essentially unproductive form rather than investing more assertively in future expansion.
Their bosses have been doing the sorts of things that cash-rich firms do: pampering their own shareholders and trying to win over others. They paid more generous dividends in 2004 than the year before and are set to move up a notch in 2005. They bought back $395 billion-worth of their own shares. (Yahoo!, which said last week that it planned to allocated $3 billion to buying back its own shares, is just the most recent of many.) And a substantial proportion of the merger-and-acquisition wave that started last year has been cash deals.
But a sea change slowly began to take place in the middle of last year. The growth in profits began to slow. Capital expenditure, which had been recovering gently since 2002, increased substantially between the third and fourth quarters. And the “financing gap” between what a company needs to invest internally and the free cash it has available to do it with—which had shown more cash than need for it for a record five of the preceding six quarters—began to yawn. To fill the gap, companies began to borrow more, especially at the short end of the spectrum.
Will the borrowing continue? Probably. Capital spending has not dropped off this year, as some thought it might with the expiration of the “bonus depreciation” tax break in 2004. Orders for capital goods (excluding defence equipment and aircraft) have risen by about 22%, at an annual rate, in the three months to February. Inventories are close to record lows as a percentage of sales and need to be replenished. So there is plenty of investment still to be done.
Even at these stronger levels, however, capital expenditure is not keeping pace with the cash on companies‘ balance sheets. But conditions for borrowing money will never be better. Interest rates are still low and spreads very tight, especially for quality borrowers, but rates are clearly heading up. Companies that keep large cash balances at a bank may be assured the finest terms from that lender. And with mergers and acquisitions rife all around, many are simply locking in liquidity now to keep their options open.
Why does renewed borrowing matter, other than to the companies themselves? First, because corporate borrowing on any serious scale is likely to push up interest rates even further than Alan Greenspan will, and to help widen credit spreads. The absence of companies from the credit markets for so long is one reason why rates have stayed so low and spreads so tight until now, reckons Richard Berner, Morgan Stanley’s chief American economist. What could short-circuit this scenario? The Fed could tighten so sharply that it discourages companies from undertaking the capital expenditure and inventory replenishment they need, he says. Or a sharp spike upwards in the price of oil could slow world growth.
It is possible, too, that companies will look elsewhere for something to take the strain, perhaps by cutting back their stock-repurchase programmes, for example. It is hard to know just how that would affect the markets. Certainly shareholders are demanding return now, and buybacks should produce higher earnings per share, but it is unclear whether they always create value for investors in the long term. Many repurchased shares are held in the company’s treasury and emerge later as part of employee compensation schemes, which avoids diluting existing shareholders but does not in itself produce higher earnings per share. And even where it does, such increases need to be accompanied by a positive cashflow spread above the cost of capital in order to produce long-lasting increases in a company’s value, points out Rafael Resendes, co-founder of the Applied Finance Group, which provides services to institutional investors.
Buttonwood will return to these and other thoughts the week after next. The intervening days she will spend not on the ski slopes, hélas, but swotting vicariously for GCSE exams—and just possibly digging out the dirt on share buybacks through history.
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