By Chad Karnes
One of the major themes pushed by the financial networks and advisors the last few years is that corporate balance sheets have never been better. Is this really true?
The usual suspects look at the amount of cash sitting on the sidelines and proclaim, as one popular financial newspaper boasted, "U.S. firms build up record cash piles." Inevitably, they draw the erroneous conclusion that corporate balance sheets are stronger than ever.
Indeed, corporations have cash balances that have risen since the financial crisis, but it is not because of an improving corporate balance sheet.
Quite the contrary, corporate balance sheets are growing their cash balances from sources not near as robust and sustainable as assumed.
Short-Term Decision Making is High-Risk in the Long Term
The first chart below from the Federal Reserve shows that total corporate credit market liabilities (read: debt) have actually skyrocketed since the financial crisis, in spite of all the chatter of a better corporate balance sheet.
This chart shows the total debt non-financial companies have taken on has increased by over $2 trillion in five years, up to a record $9.4 trillion at the end of 2013.
The shaded gray areas show previous recessions and that companies in comparison had only $7.3T in total debt liabilities at the height of the financial crisis.
Are Corporations Really Using Cash Wisely?
Corporations have taken on the most debt ever in order to buy back shares, as the next chart, this one from Reuters/Thomson One, shows.
In 2013, corporations announced buybacks that were the second-largest in history, which on the surface may seem like a good thing, but there are at least three problems with this strategy.
First, these corporations are buying back their shares at P/E ratios approaching the upper end of the historical spectrum (buying high and selling low). A better strategy would have been to buy back shares when they were 50% lower in price, in 2009 or 2010, instead of now after such a robust rally. This is no different than an investor buying stocks at elevated levels right now, instead of in 2009 or 2010 at much cheaper prices.
Companies are now paying 20X-plus for their shares today, instead of investing in other opportunities that offer better valuations, such as acquisitions or internal growth.
Secondly, as the graphic displays, corporations have a knack for chasing the markets' returns, as the last time they bought such a large amount of shares was at the previous major market top in 2007. A peak in share buybacks has been associated with the major market tops of the past.
General Electric (NYSE:GE) is an excellent example of this, as it bought back shares around $25 in early 2008, at the beginning of the financial crisis, only to sell shares to Warren Buffett and other insiders below $10 later that year. Someone should have been fired for that investor calamity, as clearly the shareholder got hosed, as GE used investor money to buy high (at $25) and sell low (at $10).
Third, companies are choosing to put their balance sheets at risk by taking out a collective $2T more in debt to buy back almost as much in shares the last four years.
They are swapping debt for equity, driving leverage on their balance sheet up to levels never-before seen. This is a short-sighted strategy that puts the balance sheet at significant risk when interest rates rise and/or another slowdown in the economy occurs. Most companies don't have the ability to ever fully repay their debt balances, and are counting on a continued "roll" of their debt year to year. This will become a major issue when interest rates inevitably rise.
Apple (NASDAQ:AAPL) is one such company, issuing $17B in debt in early 2013, the first time it had issued debt in a very long time and the largest public debt deal up to that time. Apple used to have zero debt, but now boasts one of the largest debt balances of all publicly traded companies. In the same period, its cash balance has only grown $2B. Verizon (NYSE:VZ) topped the Apple deal with a mind-boggling $49B issuance in late 2013, almost doubling the debt on its balance sheet, but these are just two of a seemingly infinite number of companies issuing record debt the last few years.
Writing Record Long-Term Debt to Fund Short-Sighted Decisions
The final chart that shows balance sheets are actually deteriorating instead of improving is gathered from the latest data out of the Federal Reserve, and shows just how wrong those are who claim U.S. corporation balance sheets are much improved.
In reality, corporations have been lulled by all-time low bond yields to issue a record amount of debt, so much so that they are issuing it at a much faster rate than they are actually growing their cash and liquid asset reserves.
The analysis above shows that corporations' balance sheets certainly are not better off today than they were during the financial crisis. In 2009, corporations owed only $4.4T in debt. Today, they owe over $6.4T, growing debt at a rate of 10%/year. In 2009, the same companies held $1.4T in liquid assets (cash). Today, they hold only $1.7T, resulting in only a 5% annual growth rate.
Long-term debt has grown $2 trillion, but liquid assets have only grown $0.3 trillion as debt outpaces cash.
Don't believe what you hear in the mainstream media. Corporate balance sheets have actually deteriorated since the financial crisis as they take on record amounts of debt in order to provide short-sighted and temporary gains to shareholders.
Disclosure: No positions.