By Peter Thiga
Cashflow from operations are a key driver of business activities in any ‘for-profit’ Company. After cashflow generation, the next logical question then becomes: What do you do with the cash? It is worth noting that capital allocation can make a tremendous difference to a company and its shareholders. For instance, at Berkshire Hathaway, Buffet took the cash generated from its textiles business and allocated it towards operations that would produce higher returns. This has metamorphosed Berkshire Hathaway from below par textile mills to a super successful conglomerate that we know of today. Along the way, the long-term shareholders reaped rich rewards from the decision made by Buffet. From that example we already have an idea of what a good capital allocation strategy looks like.
By contrast, many executive officers regularly invest in low-return projects, make ill-advised acquisitions, buy back their shares at exorbitant prices, etc. This kind of behavior erodes shareholder’s value over time. So before buying the stock of a particular company it is important to understand the capital allocation strategy. There are four things a CEO can do with the surplus cash:
Re-investing for organic growth (Ploughing back profits)
Acquisition of a company
Letting cash pile up on the balance sheet
Returning cash to shareholders as dividends.
Ploughing back profits (Re-investment)
Investing the cash organically means the CEO ploughs the excess cash back into the business for expansion purposes. For example, Apple re-invests cash into R&D to develop new products and services. Starbucks re-invests cash to open new stores in strategic locations in major cities. Starbuck understands the Chinese market so well that they can project the expected return while that not the case for Netflix when they invest in a movie, it can be very hard to predict whether it will be a huge hit or a miss. Generally, the more predictable results from re-investing are the easier the decision-making process for the capital allocator.
Acquisition of Companies
Generally, it is difficult to predict whether an acquisition will be successful or not. But that does not stop anyone from trying. Increased revenue growth and number of employees post-acquisition translates into higher pay for the CEO. So, the incentives for a CEO going into an acquisition is not necessarily aligned with shareholders' interests. Also, consultants tend to always be happy to draw up projections featuring lovely synergies to stand to pocket transactional fees from such deals. So due to these incentive-caused biases, the base rate for success is low. However shrewd capital allocators have created value through intelligent acquisitions models either vertical or horizontal acquisition. Horizontal acquisition focuses on business that in the same line of business. Coca cola buying another beverage maker (higher success rate since the acquirer knows the business) is a perfect example of horizontal acquisition. By contrast, vertical acquisition targets an adjacent business model the goal being to gain control and capture more profit across the value chain. For example, coke buys a bottler or flavor supplier. Both of these strategies stand to benefit companies that deploy them provided the allocator has a goal as to why an acquisition is necessary.
Balance sheet cash pile up
Some may opt for cash to sit on the balance sheet but this presents a question of opportunity cost. There are times when the market does not have much to offer while the company is sitting on cash in its balance sheet. If it sits in the deposits accounts, the minimum interest rate it stands to gather is 7%. The longer the cash is inactively being used, the more detrimental it is to the shareholders. For example, suppose the Management of a Company finds a $1million acquisition that will earn $500,000 every year for the next 20 years that will be an impressive 50% annualized return. But suppose the management had to sit on that $1million for 5 years before this splendid opportunity came along. The net annualized return will only be 7% on compounding basis.
Usually, this is management’s last resort. Dividends payout is viewed as a less favourable option since payout are taxed. This presents the aspect of double taxation. At the same time corporate tax is high. Let’s say they make corporate tax 0%, then does it make sense to give out higher dividends? If so, the recent trend toward lower corporate taxes should push dividends higher. Even if the corporate tax goes to 0%, companies still have to decide between a buyback (which is tax-free), and a dividend (which will be taxed in the hands of shareholders). So, buybacks will still retain their tax advantage over dividends.
While there is no one size fits all approach in capital allocation, at Kraft-Boron consulting we believe in employing an optimal mix of these strategies to achieve a risk adjusted return.
We have come from a tough year with many businesses struggling as a result of the Covid-19 pandemic. But as we adapt into the new normal, this is a time for businesses to rethink their capital allocation models, not as quick fixes but as long-term strategic frameworks that will drive the value of their businesses. Smart capital allocation decisions and strong execution are important for any company’s success. At Kraft Boron, we work with companies to deliver better capital allocation performance. We believe in working together with you to come up with a foundational capital allocation model that can serve as a bedrock but is flexible enough to leave room for adjustments.