The Looming CapEx Catastrophe
This year will see one of the largest shifts in capital deployment in the history of the modern corporation. A buoyant U.S. earnings season provided confirmation: Alcoa (a good indicator of corporate confidence) reported three consecutive quarters of sales growth and forecast a 12% rise in global aluminum demand.
This is only part of the story however. Analysis shows the world’s large firms are currently enjoying an average of 10% growth in their top-line revenue, and have recovered 95% of their prior sales peak (which came in Q3 of 2008). Margins are back to pre-recession levels and, more meaningfully, the top performers on the S&P 500 are already earning higher revenues than at any point in their history.
This is more than an interesting statistic, it is an important psychological milestone; managers will now be much more comfortable with riskier investment decisions than they would have been even six months ago. And this is borne out by our analysis that shows firms have boosted CapEx significantly upon passing peak revenue levels in past business cycles. On top of all this, firms certainly have cash to spare; corporate liquidity buffers have hit historic highs.
Under Pressure to Spend It
Beyond the record results, executives are also feeling constant pressure from bankers and investors to make investment decisions or return “excess cash” to shareholders through dividends or buybacks. As we’ve said before, buybacks and dividends are useful tools but managers should be careful of following the herd. Bankers thrive (and sell) on momentum, and their cash management advice won’t necessarily have your firm’s best long-term interests at heart.
Secondly, although we strongly believe in investing for long-term growth (if we have a mantra at CEB, that would be it), we are cautious about too much optimism. The key is to generate “principled” long-term growth; senior executives should not fall for the, “this deal is different fallacy” and spend the firm’s funds on a high-risk, high-return bet just because “it feels right” or – even worse – because we’re now all working in a “new economy”.
And the stakes are extremely high. Not only is there a risk of misspending the firm’s cash, our research on what causes large corporations to stop growing shows that it is precisely these investment decisions that put firms most at risk of catastrophic declines in their revenue growth (this slide gives more detail; download the pdf here).
There will doubtless be executives looking to make one big bet to impress both colleagues and the boss, but the potential risk far outweighs the benefits. As the slide above shows, mergers or acquisitions that aren’t a good strategic fit can destroy 10% to 15% of a firm’s market capitalization. Similarly, an overly excited focus on a new “strategic direction” will prevent managers from listening to their core customers or allow a competitor to slip unnoticed into their core market. Losing sight of the core can destroy almost 20% of a firm’s entire market cap.
Seven Steps to Effective Cash Allocation
To handle this looming investment bonanza correctly, executives should not act until they have established a robust framework to ensure all cash allocation decisions are objective. We’ve pulled together the following advice, based on what we see the best companies doing.
- Use a rolling liquidity plan to create a shared senior vision for risk tolerance and prevent “rule of thumb” analysis: Create one slide that shows short-term uses of liquidity, the “risk” buffer, and the remaining investment “headroom”.
- Make capital availability and deployment part of the same plan: Sources and uses of capital should be dealt with in the same presentation, preferably on the same slides.
- Consider long-term flexibility ahead of short-term investor returns and optimal cost of capital by carrying less debt than peers: In your next interaction with the board, explain the limits of “text book” finance, which typically puts short-term profitability – achieved through leverage – above long-term risk mitigation.
- Relate cash decisions back to strategy using a common, recognizable framework: Bullet point a set of simple decision stage gates, e.g. strategic alignment, dilution impact. Use this list for all cash decision making.
- Distinguish between local and international cash: Audit the location of cash and the relative cost of deploying cash sitting in different locations. Communicate your findings in Board and investor presentations.
- Return cash to shareholders using methods that reflect your long-term balance sheet goals: Model the impact of different cash deployment options such as buybacks and dividend decisions on your stock price. Don’t allow peer group behavior to guide your decisions; choose the option right for the company.
- Communicate the capital plan clearly to investors: Include a slide in investor presentations that covers internal and external plans for cash deployment and your reasoning.
More detail on each of these pieces of advice is available to CFO Executive Board clients, Treasury Leadership Roundtable clients, Finance Leadership Exchange clients, and FLEx-Elite clients. All CEB clients should contact me or leave a comment below if they wish to discuss this further.
And best of luck – this year could be a bumpy ride.