Corporate Finance Topics Q Calibrating ROIC to Drive Shareholder Value

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1 Corporate Finance Topics Q Calibrating ROIC to Drive Shareholder Value

2 We believe that driving shareholder value through optimizing return on invested capital ( ROIC ) should be a consistent focus for corporate leaders. As a follow-on to our Q Corporate Finance Topics piece, 2013: The Year to Challenge the Do Nothing Strategy?, we further explore the connection between shareholder value creation and ROIC. In our prior piece, we noted that conservative capital structures and large amounts of excess liquidity positioned corporates well to execute on significant strategic or return of capital initiatives. Considering a business as a portfolio of earning assets operating subsidiaries, real estate, cash, etc. offers a helpful paradigm to consider value creation. Each asset earns a return, which when combined, results in the business s ROIC. In this piece, we first highlight the importance of ROIC in determining shareholder value over time. We then analyze the impact of excess cash on ROIC to show that many corporates are holding cash in amounts that are well in excess of what our data suggests is the optimum level to maximize shareholder value. Excess cash has been in the spotlight for several years and continues to be in 2013, as evidenced by a recent wave of activist focus driving capital structure realignment and business reorganization. As part of our piece, we assess several characteristics of corporates that may justify holding excess cash and note that the companies that hold the most cash often do not exhibit these characteristics. Executive Summary 1. Total shareholder return is highly correlated to change in ROIC. Based on our observation of S&P 500 companies 1 performance over the past five years, improvement in ROIC exhibits a strong correlation with total return. These firms also tend to have the highest valuations, on a P/E basis, and lower relative cash balances. 2. Corporate cash balances remain elevated. We revisit the S&P 500 cash accumulation charts that we ve seen many times over the past several years to reiterate that cash balances remain at historically high levels, both on an absolute and relative basis. 3. There are various corporate characteristics that may justify holding excess cash. There are many potential reasons for management to build cash reserves. Some of the most common rationales include: the need for growth capital, high projected cash flow volatility, high fixed charges, limited access to capital markets, and tax inefficiencies associated with repatriating offshore cash. 4. However, companies with the highest cash balance often do not reflect these characteristics. Typically, these companies hold a significantly larger multiple of historical cash flow volatility, have lower gross debt levels and are able to fund growth with operating cash flow and/or capital market access. 1 Data set includes 395 of the current S&P 500 constituents, with insurance companies, banks, broker dealers and REITs removed. Firms with less than five years of trading history are also excluded. Analysis based on five years of data from January 1, 2008 through year end

3 5. Consistently calibrating a portfolio of earning assets to drive ROIC is critical to long-term value creation; and reducing the level of low-yielding cash on the balance sheet is one of the simplest ways to improve ROIC. ROIC can be enhanced by either (i) improving operating performance; or (ii) reducing underperforming capital bases. A periodic review of all assets should be performed that includes an analysis of separating subsidiaries, growth initiatives and return of excess cash. Excess cash balances are arguably one of the most underperforming capital bases; redeployment of excess cash towards growth initiatives or return of capital can have a significant impact on ROIC. 1 Total shareholder return is highly correlated to change in ROIC. When we looked across the various potential drivers of total return (ROE, EPS accretion, ROIC, etc.), ROIC was the metric with the strongest correlation to total return. We segmented the S&P 500 constituents 2 into four quartiles based on annualized total returns over the past five years and noticed a clear and very strong positive correlation between total return and change in ROIC. As illustrated in Figure 1, the higher the change in ROIC (1.5% for top quartile vs. -3.6% for bottom quartile), the higher the annualized total return (15.8% for top quartile vs. -8.5% for bottom quartile). We also noted that the companies with higher total returns generally had (i) lower levels of cash as a percentage of market capitalization; (ii) similar or lower levels of cash as a multiple of cash-flow volatility (as measured by two standard deviations of cash flow); and (iii) higher P/E ratios. 20% 1.5% Five-Year Annual Total Return Five-Year Change in ROIC 2% 15% 15.8% 1% 10% (0.5)% 0% 7.1% 5% (1.7)% (1%) 0% 1.7% (2%) (5%) (3%) (3.6)% Figure 1. Five-Year Annualized Total Return vs. Change in ROIC Over Past Five Years Source: FactSet (10%) Top Return 2nd Return 3rd Return (8.5)% Bottom Return Cash/Market Cap 6.8% 6.9% 8.0% 13.0% Cash/CFO 3 Volatility (2 Sigma) 1.9x 1.4x 2.1x 2.0x NTM P/E 15.4x 13.9x 13.3x 12.3x (4%) 2 Data set includes 395 of the current S&P 500 constituents, with insurance companies, banks, broker dealers and REITs removed. Firms with less than five years of trading history are also excluded. Analysis based on five years of data from January 1, 2008 through year end Quantities represent medians of each respective quartile. 3 Represents cash flow from operations. 2

4 2 Corporate cash balances remain elevated. We have consistently seen data that tells us cash balances are reaching all-time highs. That continues to be true today, as illustrated in Figure 2. Cash balances are not only high on an absolute basis, but are also high on a relative basis (as a percentage of market capitalization). As compared to 2007, relative cash balances at the end of 2012 were ~63% higher. $1,400 S&P 500 Cash Balances (bn) $1,200 $1,102 $1,176 $1,222 $1,000 $983 $800 $734 $786 $600 $400 $200 Figure 2. S&P 500 Aggregate Year-End Cash Balances Source: FactSet $ Market Cap ($bn) $10.2 $8.8 $7.1 $8.7 $9.7 $10.4 % of Market Cap 7.2% 8.9% 13.8% 12.7% 12.1% 11.7% 3 There are various corporate characteristics that may justify holding excess cash. There are several reasons that may drive a corporate to hold excess cash, and we have highlighted five in Figure 3. Operating cash flows are volatile and a larger cash cushion is insurance against a downturn Volatile Cash Flows Projected cash needs such as M&A, R&D, CapEx, and dividends are high relative to projected cash flow Cash Requirements Significant portion of cash balance is held offshore and cannot be accessed tax-efficiently Off fshore Cash Common rationales firms use to explain high cash balances Market Access High Leverage Cash is being used to offset high gross leverage Figure 3. Reasons for Holding Excess Cash Debt and/or equity markets may not be open when cash is needed 3

5 4 However, companies with the highest cash balance often do not reflect these characteristics. We again segmented our S&P 500 data set into four quartiles, based on cash as a percentage of market capitalization over the past five years, and then analyzed whether a correlation existed between cash balances and the reasons we highlight above. In Figure 4 we show that the companies in the two higher quartiles: 1. Held the highest amount of cash as a multiple of cash flow volatility (as measured by two standard deviations of cash flow) 2. Had very similar cash requirements as the lower quartiles 3. Had lower debt balances than the lower quartiles 25% % Cash/Market Cap 21.6% 20% 15% 10% 10.3% 6.1% 5% 2.6% Figure 4. Five-Year Cash/Market Capitalization s Source: FactSet 0% Top Cash 2nd Cash 3rd Cash Bottom Cash Cash/CFO Volatility (2 Sigma) 3.9x 2.3x 1.6x 0.7x Agg 5yr (CapEx+M&A+R&D+Div)/ Agg 5yr CFO 100% 100% 97% 104% Gross Debt/Enterprise Value 17.9% 14.4% 19.5% 23.0% With respect to market access, we analyzed debt issuances by BBB and BB companies in the depths of the financial crisis and note that there were only two months without BB issuances (Sep 08 and Nov 08). Finally, with respect to offshore cash balances, while it s difficult to discern the amount of cash held offshore by each of our constituents, there is certainly evidence that many companies are accumulating significant offshore cash balances. However, prudent capital management requires a continual assessment of breakeven economics vs. expected offshore cash usage. For example, if a company would incur 15% incremental tax on repatriated cash but could earn a 7% return on that cash for its shareholders (either by reinvesting in the business domestically or returning capital to shareholders) vs. leaving the cash abroad and earning 1%, the break-even period would be under three years. The probability of that cash being put to better use abroad within that time period should be assessed, and if the probability is low, the benefits of cash repatriation should be evaluated. So while the quartiles we analyzed often do not exhibit many of the characteristics that may justify holding excess cash, what they do show is a negative correlation between the amount of cash held and (i) total return and (ii) P/E multiple as illustrated in Figure 5. 4

6 7% 6% Annualized Total Return NTM/PE 6.6% 5.4% 15.5x 15.0x 5% 4% 4.7% 13.8x 13.6x 14.1x 14.5x 14.0x 3% 13.5x Figure 5. NTM P/E and Five-Year Annualized Total Return for Cash/ Market Capitalization s Source: FactSet 2% 1% 0% 12.9x 1.4% Top Cash 2nd Cash 3rd Cash Bottom Cash 13.0x 12.5x 12.0x Companies with lower cash balances over the past five years generally performed better (with the exception of the lowest quartile) on a total return basis over that time period. There is a similar, but slightly weaker, correlation with cash balances and P/E multiple; companies in our data set with lower cash balances generally exhibited rising P/E multiples. Based on our data set, optimal cash balances can be triangulated between cash as a percentage of market cap (5% 7%) and cash as a multiple of cash flow volatility (1.5x 1.9x two standard deviations). 5 Reducing the level of low-yielding cash on the balance sheet is one of the simplest ways to improve ROIC. In deconstructing ROIC, the two main drivers of improvement are: 1. Increased operational performance for a given capital base; or 2. Reduction of underperforming capital bases ROIC = (EBIT + Interest Income) (1 Tax Rate) Average Capital Employed Excluding Goodwill 1 2 Operational Performance (EBIT) Underperforming Capital (Low yielding assets) Many corporates have made significant efficiency improvements over the last five years with a commensurate increase in profit margins as they strive for earnings growth. In addition to increasing profitability through operational efficiency and increased asset utilization, in Figure 6, we consider four methods of achieving ROIC improvement by focusing on high-performing assets in the portfolio. Refocus on highest ROIC segments Sale Spin-Off/ Split-Off Growth Initiatives Excess Cash Sale of subsidiaries or assets with lagging ROIC Spin-off/split-off of subsidiaries with lagging ROIC Capital expenditures and M&A focused on highest ROIC projects Return excess cash to shareholders or invest in higher ROIC businesses Figure 6. Alternatives for ROIC Improvement Invest proceeds in share repurchases, or higher ROIC businesses 5

7 High cash balances that primarily earn interest income over the medium to long term are arguably one of the most underperforming capital bases. This has been further exacerbated by all-time low interest earned on cash balances over the past few years. The impact to ROIC of a reduction in cash for a hypothetical company in the top cash quartile (as a percentage of market capitalization) indicates meaningful improvement is achievable through a rebalancing of the capital structure. In order to further examine what benefits cash reduction would generate for a top quartile company, in Figure 7 we consider the impact to ROIC for a hypothetical company. Hypothetical Company Cash $16.2 Market Cap $75.0 Cash/Market Cap 21.6% Total Capital $50.0 EBIT $5.0 ROIC 6.71% Significant ROIC improvement possible while still maintaining adequate cash cushions to drive shareholder value ROIC Improvement from Cash Reduction 4 Cash Reduction Cash/Market Cap ROIC % Improvement Top 21.6% 6.71% Second $ % 8.12% 21.04% Figure 7. Impact Upon ROIC for a Hypothetical Company Conclusion Third % 8.71% 29.72% Bottom % 9.22% 37.36% As we look at the performance of individual corporations, it is clear that consistently improving ROIC over time is a key driver of value. We note that a company s portfolio of assets must be actively managed into perpetuity. Consistent deployment of capital and ongoing reduction of underperforming capital bases should form a permanent part of a company s strategy. For more information, please contact: Souren Ouzounian Head of Americas Corporate Finance souren.ouzounian@baml.com (646) Jay Bliley jay.bliley@baml.com (646) Leonard Chung leonard.chung@baml.com (310) Amir Mirza amir.mirza@baml.com (646) Philip Turbin philip.turbin@baml.com (646) Gus Garcia g.garcia@baml.com (646) Assumes total capital and market cap are reduced by the amount of cash reduction; ROIC calculations assume 1% pre-tax interest income on cash and 35% tax rate. 6

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