The Knowledge Economy Cash Anomaly, Part 3: The exciting conclusion

2012/12/16 by 2 Comments

This is part 3 in a series.  Here are Part 1 and Part 2.

Tax Shields 

The organization of the knowledge economy is inclined towards creating great tax advantages.  Both start-ups and mature companies enjoy huge advantages that the resource economy does not enjoy.  Most investments can be expensed.  The companies grow fast enough that they create huge tax losses, even as they create extraordinary value for the owners.  Once they become mature global companies, their assets can be transferred almost costlessly to whatever jurisdiction offers the most favorable treatment.  Transfer pricing makes it almost impossible for authorities to tell where value was added.  Money generated off-shore can stay off-shore tax free indefinitely.  In contrast, resource economy companies have easily traceable assets, some of which require particular locations and may be quite literally fixed to that location.  Their assets are comparatively easy to tax, whatever form their assets take.

If this is the case, it follows that knowledge economy companies have huge tax shields from their operations.  To have these tax shields add value to the business, the CFO of a company needs a business that is low risk, earns the cost of capital after tax, and does not consume much management attention.  Investing in marketable securities seems like just the ticket.  The gain on securities allows the owners of the company to take advantage of the tax shields that would otherwise go unused.

Here is what we’ve been looking for all along.  A reason why cash is better off in the pocket of the company than in the pocket of the owner.  In addition, all the other reasons why a firm might hold so much cash are still active and valid.  Full use of tax shields would be a driving factor for keeping cash on the balance sheet.  The discount rate for tax shields is low and even if only gets used every few years, it adds to the wealth of the shareholders.  For a founder, cash on the balance sheet capitalizes an otherwise unused tax shield, provides diversification, defends the core business, and enhances the value of R&D investments by its mere presence.

The question for further study would be when we would expect to see these benefits diminish?  Can we empirically test which of these hypotheses are most important in guiding payout policy?

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The Knowledge Economy Cash Anomaly, Part 2

2012/12/16 by 2 Comments

This is a continuation of Part 1.

Option Value of Cash on the Balance Sheet

This theory of the cash anomaly posits that the returns from R&D are high, but also highly uncertain.  Every once and awhile, the R&D of a company will produce a really high value project that requires massive investment and possibly acquisitions to use in combination with the asset.  The problem with R&D as an economic asset is that it is very difficult to sell or even be exploited by organizations other than the organization that developed it.  Unlike discovering oil, it is not clear even after discovery of a project that another firm could develop the project to create economic returns.

Because exploitation relies on unique capabilities inside the firm that are only poorly understood outside the firm, their economic value is harder to forecast.  This violates the costless symmetric  information condition of efficient markets is violated, unlike the projects of old economy companies, where the market has a reasonable expectation that it will understand the value of the project.  This uncertainty introduces huge frictions if projects need to raise new capital. Therefore, if a company has R&D projects, the value of that project stream is greatly enhanced if the company also has a means of financing the projects that does not require subjecting those projects to the friction of market financing.  These frictions are both directly financial in the form of more returns to new investors and intermediaries, and also temporal.  In winner takes all markets, which many technology markets are, temporal costs are huge.

The option value of cash on the balance sheet could be huge, however, we would expect more tech companies to at least on occasion, expend all their cash and perhaps even borrowing capacity when they exercised options if this were the case.  This is common in growing technology companies.  Mature tech companies, rarely, if ever come close to expending their investment capacity.

I’m skeptical of this explanation.  Why does Google need to hold enough cash to buy Yahoo or Facebook in cash, if they are never exercise the option to do so?  When was the last time you heard that a company was undertaking a project with more than a billion dollars of expenditures in year one of the project?  These kinds of companies can make acquisitions with stock, invest over time out of future cash flows, and they even have relatively low cost borrowing capacity should it be required.

Cash Poor at Home

Recently, much has been made of the U.S. companies that are parking cash overseas to avoid the tax when they repatriate it.  Many companies are cash poor in their U.S. entity, but their consolidated balance sheet shows a lot of cash.  This cash can’t be repatriated for distribution without a large tax bill.  This is the worst of all possible worlds from a policy perspective, but it doesn’t seem to afflict tech companies as much as industrial conglomerates.

(BTW, Congress doesn’t need to capitulate to corporate demands for no tax on foreign earnings.  All it has to do charge the companies income tax on their cost of capital for any overseas investments, then true up when the companies bring cash home.  Particularly if the law slightly over estimated the cost of capital, or ignored the cost of capital on financial assets in the WACC calculation, so that repatriating funds usually triggered a small refund rather than a small bill, you could just sit back and relax and watch them all bring their cash home while still paying tax.)

Distress Costs

The final explanation I’ve heard offered is the idea that since most of the investments of a technology company are in workforce and R&D, the costs of financial distress are huge.  Not only that, but the costs of financial distress can manifest themselves long before bankruptcy is close.  If managers are cutting benefits or tightening R&D activites, and the costs are not properly captured by accounting frameworks.  New talent goes elsewhere, the best old talent leaves, R&D becomes less creative, less real economic capital employed stealthily decreases without the accountants noticing.  However, CFOs are smart, they know this–even if the accountants don’t.  They keep cash on the balance sheet, employee benefits generous, and 10% time meaningful.  This prevents the stealthy erosion of the real assets of the company, by the prospect of distress, which the intelligent and savvy workforce is acutely aware of even if they don’t conduct formal analysis.

But there is one more reason…

In part 3, I will outline how holding cash creates economic value, regardless of and in addition to, all these explanations.  Go to Part 3.

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Is a dollar worth a dollar on a tech company’s balance sheet?

2012/08/21 by 1 Comment

Previously, dear reader, you and I have discovered that robotics companies are firmly entrenched in the knowledge economy and their assets look like other knowledge economy companies’s assets.  Robotics companies only hold only a limited amount of real assets but lots of financial assets.

As a related question, what is the value of the cash (and financial assets) on the balance sheet to investors?  There might be several issues with holding so much cash.  Particularly, money in a company should be employed making more money, ‘earning or returning’ as the saying goes.   Are there valid reasons to hold so much cash?  And if so, how should we value the cash that knowledge economy companies hold?

Cash Is King! (Or at least a founding father)

Bottom line up-front:  Valuations are always wrong.  What’s interesting is how they are wrong.  Assuming a dollar is worth a dollar is as good a rule as any, but is almost always wrong.  Nobody is really sure which way (too much or too little) it is wrong.  Below, is an elaboration of some of the issues with valuing cash which may come into play when valuing particular companies.  (And you thought that at least cash of all things had a fixed value  —  don’t we all wish!)

There are various criticisms of excess cash on the balance sheet, below are some of the most common.

1)  Holding the extra cash reduces returns, i.e. to buy into the business you have to buy a pile of cash beyond what is ‘necessary’ to run the business.  Further, the rate of return on cash has been essentially zero and certainly below inflation lately, so holding the portfolio the stock represents of a highly profitable business, plus cash must necessarily produce a lower expected return than just the business.

2)  Because of agency problems, management may be incentivized to use the cash to reduce volatility or ‘save’ the business if it falls on hard times, even if the investors could get a markedly higher rate of return in the market.  From an investor’s point of view this would be systematically wasting money.  Employees, customers, management, and trading partners might have a very different view.

3)  Holding lots of cash is said to signal that the company does not have profitable investment opportunities commensurate with the cash that it is generating and the company’s growth may slow in the future.  Further, holding lots of cash signals that you don’t know, or are ignoring, the traditional Anglo-Saxon business administration.  English speaking investors generally expect management to maximize monetary returns over the forecasting horizon and put shareholder interests ahead of all others.

Some countervailing points that you will often hear are along the following lines. 

A)  Although holding cash reduces returns, for a volatile security like a fast growing knowledge economy company, having cash on the balance sheet dramatically reduces volatility.  If investors want more exposure to the underlying business for the same initial investment, lever-up.  Since we are talking about cash holdings, buying on margin is almost a perfect antidote to management’s lackadaisical cash management policies if you feel that way.  [But seriously, who is their right mind thinks you need to lever-up when buying tech stocks?]

B)  Although management might ‘burn’ cash saving a failing business, which would be better redistributed to investors, more likely, they are going to have the flexibility to engage in acquisitions and new ventures without having to deal with the whims of the security markets.  [Has anyone seen a rational market lately?  Please let me know.]

Or has anyone read the Wall Street Journal?  Tech companies are routinely attacked for having their fixed life fund investors exit—Groupon and Facebook each got front page hatchet jobs over the past two days with nary a mention that these funds had been planning to sell now for, oh say, 8-10 years!  Talk about journalistic malpractice.  Would you want to go to the public markets in that environment?  I sure wouldn’t.  If I was management, I’d say that if investors are that irrational, I’ll keep the cash and do what they should have done with the money.

C)  Finally, although cash on hand may sometimes signal that the companies are running out of investment opportunities, it certainly signals to would be competitors that the said company is in a position to stick around for a long time and bitterly contest any erosion of their market position.  This may greatly enhance the value of the underlying business asset.

D)  This is a successful tech company.  It is run by the founders, for the founders (i.e. management).  If you don’t want the privilege of investing and taking whatever returns the founders deign to give, please step aside and allow the next investor to purchase stock.  But this isn’t really a justification.  Founders are investors too, especially once the company goes public, with theoretically the same motivations as other investors since their stake is highly liquid.

Further research on technology companies and their cash management policies should address the following issues:

I)     Are there structural reasons beyond the creation of new businesses and defense of existing businesses for technology/knowledge companies to hold lots of cash?  It does not occur to me that there is anything about a maturing knowledge business that seems to require massive amounts of cash.  Law firms and accounting firms do not seem to hold too much cash, but they are also typically private and can make much more drastic changes than public companies.

II)   Are there frictions between the interests of various classes of investors?  Particularly when there is a founder controlled/managed company, cash on the balance sheet is probably as good to them from a control perspective as cash in the bank and better from a tax perspective.  Should investment banks or others creating the classes of stock have new mechanisms to deal with this?

III)  What are the true limits on investment opportunities?  My firsthand observation has been that the greatest constraint on growth of robotics companies is management attention.  It may be that most technology companies have massively profitable investment opportunities, but management attention is engaged on current projects and hiring into the management circle is not that easy.  What is the needed resource to change this?  How can cash be used to obtain this resource?  Can it?  Is passion required?

IV)  Are there ways that management could resolve some of the market frictions that require them to hold lots of cash?  The public markets seem to mercilessly abuse tech companies—no they don’t look like utilities, but the highs and lows that they are pushed to seems unjustified—there just doesn’t seem to be enough new information about their future prospects to justify either one.  Can management take steps to make access to public markets, particularly debt markets more reliable?  Could banks make money by providing massive, typically undrawn, lines of credit that would provide much of the same protections to management?

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