Corporate Finance Topics Q3 2013 Investing in Growth
As the economy continues to improve, we believe corporate leaders must reassess capital allocation and develop a strategy to maximize returns. As the macroeconomic landscape continues to show signs of sustainable improvement, we believe corporate leaders must reassess capital allocation and develop a comprehensive strategy that will maximize returns. Building on our previous Corporate Finance Topic pieces, Q1 s 2013: The Year to Challenge the Do Nothing Strategy? and Q2 s Calibrating ROIC to Drive Shareholder Value, we now explore recent trends that signal a pivotal point in investor sentiment with regards to growth and capital allocation. In our prior pieces, 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, and proposed improving ROIC as a key driver of value. This current piece incorporates these ideas in the context of optimal allocation of a company s marginal dollar as we transition into the next phase of the economic cycle. As we highlighted in our Q1 piece, historically low debt costs combined with reasonable equity valuations make acting now a compelling proposition. Despite a recent rise in interest rates, the thesis for value creation remains intact. Figure 1. With interest rates still at historically low levels and valuations at reasonable historical levels, current market conditions present an opportunity for investing in growth August 2003 August 2013 10 yr US Treasury Yield 4.48% 2.74% A Bond Yield 5.38% 4.02% After-Tax Debt Cost (1) 3.50% 2.61% S&P 500 Index 993 1,664 Forward P/E 17.1x 14.2x NTM Earnings Yield 5.85% 7.06% NTM Accretion Spread 2.35% 4.45% (1) Assuming 35% tax rate. By analyzing stock price performance and total returns throughout the economic cycle, we are able to observe a meaningful progression in investor sentiment favoring growth stocks and an increase in allocation to growth investments capital expenditures or M&A by companies. Our assessment of optimal allocation strategy is based on the following factors: 2
1. Investor focus is shifting from dividends to growth. Based on our observation of S&P 500 companies over the past 10 years, EPS growth exhibits a strong positive correlation with both higher total shareholder return and premium valuation multiples. This trend, having been disrupted by the financial crisis in 2008 and subsequent global macroeconomic developments, is back on track, with recent data showing an increasing premium valuation for higher growth companies. Growth is being valued again. 2. Capital allocation trends signal increased focus on growth initiatives. As we examine capital allocation decisions over the past decade, we find that investments in growth (measured as organic capex and M&A as a percentage of allocable operating cash flows) are reverting to long-term averages after a significant slowdown during 2009 2011, signaling renewed focus on growth by corporate leaders and implying an increased confidence of these leaders in a sustainable economic recovery. In the recently released Bank of America Merrill Lynch 2013 CFO Outlook Midyear Update, U.S. financial officers gave the economy its highest score in five years and were significantly more confident about economic growth in 2013. 3. M&A is being well received. For companies that have benefited from costcutting or currency gains, organic growth will be harder to achieve and M&A may present a feasible alternative to drive growth going forward. Following several years of muted reaction by investors to acquisitions, since the beginning of 2012 significant M&A announcements have been well received, with a majority of announcements resulting in positive marketadjusted returns for the acquirer. Furthermore, large financings to fund acquisitions have been well received by the market. 4. Impact on future growth is important, in addition to ROIC, as a powerful metric to evaluate the allocation of capital to growth initiatives. As companies evaluate capital deployment options to enhance growth and work to reduce underperforming capital bases, ROIC over the life cycle of a project will provide a valuable guideline to maximize the impact of investments in growth initiatives. 3
1 Investor focus is shifting from dividends to growth Historical data shows that just as different asset classes outperform during certain stages of an economic cycle, so do companies that exhibit certain characteristics. One key example of this phenomenon is performance, measured as total return, of companies with differing characteristics (growth vs. return-of-capital focused). Analysis of the performance of the S&P Dividend Aristocrats vs. the broader S&P 500 Index suggests there is a strong relationship between periods of macroeconomic distress and performance of high dividend yield or value stocks, driven by investors seeking cash dividends from relatively safe investments. As conditions improve, however, we are seeing investor focus shift in favor of growth companies, driving total return and premium valuations for corporations that are able to achieve significant growth. Growth is being valued again. Recent trends observable in the total return differential between the Dividend Aristocrats and the broader S&P 500 indicate that demand for high dividend yield companies has subsided over the past 18 20 months (see Figure 2 below). This has occurred as investors reposition their portfolios in response to positive macroeconomic forecasts and expectations of higher interest rates. 30.0% LEFT AXIS RIGHT AXIS 6.0% 20.0% Total Return Actual YoY GDP Growth 4.0% 10.0% 2% Growth 2.0% 0.0% 0.0% Figure 2. Total return differential of Dividend Aristocrats versus broad S&P Index (10.0%) (20.0%) (30.0%) 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 (2.0%) (4.0%) (6.0%) Other key indicators of the recent increase in investor appetite for growth are observable by examining trends in valuation multiples and total return of S&P 500 companies exhibiting growth characteristics over the last 10 years. Having experienced a downward trend for several years during this period, we have seen projected long-term growth expectations stabilize over the past few years. We also find that, with the exception of extraordinary market disruptions, S&P 500 companies in the top EPS growth quartile have consistently outperformed companies in the lowest EPS growth quartile. 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 4
40.0% LEFT AXIS RIGHT AXIS 12.0% Total Return Differential (Top Quartile Bottom Quartile) Actual YoY GDP Growth 30.0% 9.0% 20.0% 6.0% 10.0% 3.0% 0.0% 0.0% Figure 3. Total return differential of top quartile versus bottom quartile companies by EPS growth (10.0%) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Annualized (3.0%) Looking more closely at performance results over the last 18 months, we find that companies in the top EPS growth quartile had a median market-adjusted total return 17.4% higher than companies in the lowest EPS growth quartile. 16.0% 13.8% 12.0% 8.0% 7.8% 4.0% 1.9% 0.0% Figure 4. Market-adjusted annualized total return from 2012 to June 30, 2013 of top quartile versus bottom quartile companies by EPS growth (4.0%) (8.0%) (3.6%) Bottom EPS Growth Quartile 3rd EPS Growth Quartile 2nd EPS Growth Quartile Top EPS Growth Quartile 5
From a valuation perspective, results gained from analyzing the S&P 500 by deciles of EPS growth support the intuitive view that investors value growth and are willing to pay a premium both on a P/E and EV/EBITDA basis for growth companies. Our analysis shows a strong correlation between projected EPS growth and valuation multiples. NTM P/E 22.5x 20.0x R² = 0.78 1 17.5x 15.0x 10 9 8 6 5 4 3 2 7 12.5x Figure 5. NTM P/E multiples by deciles of LT projected EPS growth* 10.0x 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% Projected Long-Term EPS Growth *Numbered dots indicate deciles of projected growth 18.0x Total P/E Multiple Differential (Top Quartile Bottom Quartile) 16.0x 14.0x 12.0x 10.0x 8.0x 6.0x 4.0x Figure 6. Historical valuation multiple (P/E) differential between top quartile versus bottom quartile companies by LT projected EPS growth 2.0x 0.0x (2.0x) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 YTD 6
2 Capital allocation trends signal increased focus on growth initiatives We examined capital allocation trends of S&P 500 companies since 2005 to develop a better understanding of the cyclicality of capital allocation decisions. Through this analysis we see that, having gone through a significant period of retrenchment and balance sheet repair in the years immediately following the financial crisis, companies are reverting to investment trends that are more in line with historical levels. As expected, capital allocation decisions over the last several years have been heavily influenced by the macroeconomic landscape. By measuring capital deployment per category as a percentage of cash from operations, we are able to observe the evolution of a capital allocation cycle driven by a constant need to adapt to the ongoing economic cycle. The key phases of this cycle are as follows: Phase I. Minimize return of capital and cut back growth spending Return of Capital Figure 7. Capital allocation as a percentage of cash from operations S&P 500 return of capital from 2005 Q1 2013 Cash from Operations Net Share Repurchases Dividends Paid 2005 $792 29% 19% 2006 782 40% 22% 2007 835 53% 25% 2008 1,101 (5%) 20% 2009 1,328 (0%) 14% 2010 1,278 10% 13% 2011 1,538 18% 13% 2012 1,309 19% 20% Q1 2013 312 20% 21% 2005 Q1 2013 $9,276 18% 18% As seen clearly in the figure above, share repurchases were the first to be suspended, while percentage allocation to dividends was reduced substantially in response to the financial crisis in 2008. This marked the beginning of a period of retrenchment during which most companies would focus on repairing and/or strengthening their balance sheets. 7
Phase II. Focus on balance sheet repair Balance Sheet Repair Figure 8. Capital allocation as a percentage of cash from operations S&P 500 balance sheet repair from 2005 Q1 2013 Cash from Operations 2005 $792 2006 782 2007 835 2008 1,101 2009 1,328 2010 1,278 2011 1,538 2012 1,309 Q1 2013 312 2005 Q1 2013 $9,276 Debt Repaid/ (Issued) Increase/ (Decrease) in Cash (49%) (2%) (72%) 0% (86%) 12% (15%) 6% 50% 8% 28% 9% 22% 5% 0% 7% (6%) 10% (5%) 6% Figure 8 above shows the significant deleveraging that occurred in 2009 2011. The contrast between this period and the previous years illustrates the magnitude of the resources that were allocated toward balance sheet repair at the expense of return-of-capital and growth initiatives. It is worth noting that this deleveraging has taken place against a backdrop of historically low rates. Phase III. Ramp up return of capital as cash builds and economic uncertainty hinders M&A/growth initiatives (see Figures 7 and 9) During this phase of the cycle, we see growth in share repurchases and dividend payments. We also begin to see a tapering off of capital allocation toward balance sheet repair as companies successfully improve their balance sheet. Phase IV. Invest in growth as economic conditions improve Growth Spending Figure 9. Capital allocation as a percentage of cash from operations S&P 500 growth spending from 2005 Q1 2013 Cash from Operations 2005 $792 2006 782 2007 835 2008 1,101 2009 1,328 2010 1,278 2011 1,538 2012 1,309 Q1 2013 312 2005 Q1 2013 $9,276 *Projected S&P 500 LT EPS Growth as of August 2013. CapEx Acquisitions, Net Projected S&P 500 LT EPS Growth 45% 20% 12.1% 54% 31% 12.0% 55% 27% 12.6% 44% 22% 10.9% 31% 11% 10.3% 35% 13% 10.6% 35% 13% 10.9% 45% 18% 10.3% 41% 12% 10.7% * 41% 18% The final phase consists of growth expenditures returning to historical averages, fueled by improving market dynamics and investor confidence. It is worth noting that although the dollar value of capex remained relatively constant throughout the crisis, the proportion of operating cash flows allocated to growth initiatives dropped substantially, particularly on the M&A front. 8
Given current positive investor sentiment toward growth as evidenced by premium valuations for growth and positive reactions to M&A now is a critical time for corporate leaders to reevaluate capital allocation policies and reposition businesses for growth. 3 M&A is being well received We analyzed trends in investor reaction by measuring market-adjusted stock price returns of U.S. public acquirers one day after acquisition announcements (for M&A transactions greater than $1 billion). Although the target has historically benefitted from stock price appreciation on announcement, results show that since the beginning of 2012, investors have also been supportive of acquirers during M&A transactions, as evidenced by a majority of positive reactions and positive market-adjusted return for acquirers stock prices. 2009 2010 2011 Median 1-Day Adjusted Reaction from Announcement 2012 2013 YTD 2.0% 80% 1.0% 1.0% 40% 0.0% 0% (1.0%) (0.5%) (0.6%) (0.3%) -40% Median (0.5%) (0.6%) (0.3%) 1.0% Mean (1.2%) 0.1% (0.1%) 2.9% Total Acquisitions % With Positive Reaction % Positive Reaction for Transf Acq 59 99 120 206 46% 44% 46% 62% 35% 43% 50% 67% Figure 10. Market-adjusted price reaction of U.S. public acquirers one day after announcement for M&A transactions greater than $1 billion LEFT AXIS Median Market- Adjusted Reaction RIGHT AXIS (1) Transaction value is at least 20% of the Enterprise Value of the acquirer. % Positive Reaction (All Transactions) % Positive Reaction (Transformative Acquisitions (1) ) Source: Dealogic We also observe that recent large equity financings to fund acquisitions have been well received by the market. 9
4 Impact on future growth is important, in addition to ROIC, as a powerful metric to evaluate the allocation of capital to growth initiatives. When considering capital allocation alternatives, ROIC provides a useful metric to evaluate potential investment opportunities. As mentioned in our previous Corporate Finance Topics piece, consistent deployment of capital and ongoing reduction of underperforming capital bases should form a permanent part of a company s strategy. We have shown that increasing ROIC over the long term is strongly correlated with driving shareholder value. Analyzing the ROIC of a particular investment throughout the life cycle of the project can help corporate leaders better understand the future impact of capital allocation decisions that factor in expected revenue growth, margin impact, and changes in capital needed over time, thereby allowing them to maximize the performance of their asset portfolio over the longer term. When evaluating capital allocation decisions, it is important to note that ROIC may go through periods of volatility, especially when it is at elevated levels. While it is sensible to examine a negative trend in ROIC, if a decrease is attributable to other benefits, such as growth initiatives, or a reduction in overall business risk, a temporary decline can be viewed positively. When considered in the context of growth initiatives, ROIC should be managed for the medium- to long-term, while ensuring a decline does not result in metrics that are significant outliers versus peers. 5 Conclusion As the economic recovery gains momentum, and monetary policy expectations increasingly point to a rise in interest rates, now is a critical time for corporate leaders to reevaluate their capital allocation alternatives. In the years following the financial crisis, investment in growth, especially M&A, had been significantly curtailed as companies sought to strengthen their balance sheets and navigate an environment of economic uncertainty. As we enter a new phase of the economic cycle, investors are increasingly rewarding growth, and repositioning businesses for growth will be a key step toward creating shareholder value. For more information, please contact: Souren Ouzounian Head of Americas Corporate Finance souren.ouzounian@baml.com 646.855.5300 Jay Bliley jay.bliley@baml.com 646.855.4666 Leonard Chung leonard.chung@baml.com 310.209.4062 Amir Mirza amir.mirza@baml.com 646.855.4331 Philip Turbin philip.turbin@baml.com 646.855.4708 10
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