The Knowledge Economy Cash Anomaly: Part 1
2012/12/09 2 Comments
The academics disclaim knowledge of a definitive answer as to why companies in the knowledge economy hoard a such a disproportionate amount of cash. The problem is that the chart below has two branches where our classical understanding would only expect one.
The companies that form a cluster heading up close to the Y-axis are the traditional economy companies. They are everything from utilities to content companies to retailers–some of them quite high-tech. Basically, they have the real assets that they need to their business and a little bit of cash and securities to get them through the shocks of the next couple of months.
This is what financial economists expect companies to look like: orderly, well managed institutions that collect cash from operations and distribute the operating profits out to shareholders and debt holders. Since these companies have access to relatively liquid and efficient capital markets, they have no need to hold onto cash. Good investment projects can simply be financed through issuing new securities or retaining more future earnings.
Robotics companies and tech companies on the other hand horde massive amounts of cash–spreading out along the X-axis in the chart above. Many of these companies, already profitable, could forego revenues for over a year. And, oddly enough, the most profitable and most successful of these companies hold the most financial assets. Nobody quite understands why companies do this. The previous discussion, Is a Dollar Worth a Dollar on a Tech Company’s Balance Sheet?, reviewed some of the arguments for and against the value of cash on a company’s balance sheet.
Holding Cash Is Usually Bad
Most investors feel that excess cash in the company is a temptation to value destroying misadventures by management. Particularly if management has incentives to grow gross profit, management can grow gross profit by deploying the company’s cash in less than profitable ways. The classic example of this overpriced acquisitions. Say you were the CEO of HP and you wanted to grow profits. You might have heard about this company called Autonomy. So you decide to buy it at market price plus a huge control premium. Your profits go up, because you have HP + Autonomy’s profits together. You get a bonus. But your shareholders get hosed.
If the shareholders wanted to buy Autonomy, they could have owned it without paying the control premium. Unless these so-called synergies show-up (and synergies are what go up the banker’s chimney after Santa Claus comes down–see I learned something in business school), there is no reason to pay the control premium. The control premium just gets pocketed by the previous owners and the bankers with all that value lost to the shareholders of the acquirer–those are your shareholders.
Conversely, if the company disgorges the cash, and you and your management team go to the market to raise new debt or equity to finance the purchase of Autonomy, Instagram, or any of another thousand bad acquisitions–the financial market has a chance to tell you that this is a really bad idea. But if it is a good acquisition, the market will easily provide you with the money. So all in all, investors tend to discount cash on the balance sheet and reward paying it out where they can reinvest it. So why would companies hold all this cash?
Many tech companies are owned or controlled largely by single individuals or small groups. The company represents a substantial portion–if not substantially all–of the wealth of the these founders. Since they control the company, they are willing to take steps to decrease the risk to the company that are not economically maximal to diversified shareholders.
Consider this hypothetical: Google and Apple are locked in winner take all product war for a small market that is worth $2Bn in market capitalization to Google now, but will go entirely to Apple in year unless Google spends $3Bn. If all of your wealth is in Google and you couldn’t easilty get it out, you might be willing to have Google spend $3Bn to save $2Bn in wealth. Your loss is now $1Bn instead of $2Bn. However, if you are a diversified investor and own both Google and Apple, you want Google to let the business go and refund you the $3Bn. You still have your share of the $2Bn in your portfolio and the chance to invest your share of the $3Bn somewhere else to earn a return.
|Founder Payout||Diversified Common Shareholder Payout|
|Spend money to protect Failing Business||-1||-1|
|Do Not Spend Money to Protect Failing Business and Payout Cash||-2||+3Bn|
Less sinister, the company may just be conducting tax free diversification on behalf of the founder. The effective corporate tax rate is below the individual tax rate, especially on capital gains. While this is tax efficient for a founder, it may not be tax efficient for other investors. The harm is probably not as stark as the example above, but it does raise the question about who the firm is being run for and rubs our Anglo-Saxon sensibilities about the primacy of the shareholders the wrong way.
The story here is that only Apple or Microsoft would ever even think about entering search knowing that Google has the largest market share, the best technology, and is sitting on $45Bn in cash. If you want to take search from Google, you are playing a long game and an extremely expensive game. It will fight hard and it has the resources to do this. Potential competition is scared off, increasing the ability of the company to earn rents in on its primary operations. While closely related to concentrated ownership story, this is actually favorable to the common shareholder if this is true. Services like Siri, Wolfram Alpha, and IBM’s Watson cast some doubt on this story, but perhaps at least in the example of general consumer search it is mostly true.
The defensive effect need not be 100% effective to be worthwhile. This effect is an extra return on the cash that shows up in operations, not financing, because of accounting rules. Additionally, the company always has the cash, so there is option value. In our example, if Bing every really started to rule search, Google could decide not to fight, and either sell or wind down search operations. They still have $45Bn to distribute even if the value of operations falls to zero, but the option to fight is inherently valuable. With the cash to execute this option, it becomes more valuable, or credible.
to be continued… Next up, option value of IP and distress costs
Jump to Part 2