It is an article of faith that US companies have more than $2 trillion of cash on their balance sheets, which they would splurge on hiring and capital expenditure (and foolish M&A transactions) the moment the regulatory and tax framework in the US was "enabling", whatever that means. How much of this cash is real, and how much is as mythical as Cerberus, the multi headed hound that guards the gates of the underworld? (not the hedge fund of that name, which had seen better days prior to dabbling in the US auto sector. Since then, it is the returns that have become mythical).
What is Real Cash on a Corporate Balance Sheet?
Before we proceed further, let us define what exactly cash on balance sheet means. It is not the item "cash and marketable securities", the first item reported on the asset side of a US balance sheet. For instance, for the quarter ended 30th June 2011, International Business Machines (IBM) reported cash and cash equivalents of $11.7 billion.
The company also reported unfunded post retirement liabilities of around $11 billion, which shows no signs of going down. It reported shareholder equity of $23.2 billion supporting a balance sheet of $113 billion (if the reported goodwill of $25.6 billion was stress tested for impairment, the reported equity would be lower). Total debt was around $30 billion, of which $24 billion ($6.1 billion to non investment grade entities) was used for funding customers to secure sales mandates. Would you classify the cash as cash that can be used for undertaking capital expenditure, or is it merely an accounting entry from not fully funding retirement obligations?
It is not our case that cash does not exist on corporate balance sheets. Take a look at Qualcomm (QCOM). At the end of the second quarter of 2011, the company had cash and marketable securities of $10.7 billion. Its $35 billion balance sheet was supported with $26.3 billion of equity. Even if the company borrows for capital expenditure/R&D expenses, it would still be underleveraged. So, the cash that is on the balance sheet is in excess of what is required for meeting essential expenditure (R&D and capital expenditure), debt servicing under stress conditions, meeting statutory requirements and funding underfunded obligations. The cash on Qualcomm's balance sheet is real. As is the $28 billion on Apple's (AAPL) balance sheet, the $43 billion on Cisco's (CSCO) balance sheet and the $53 billion on Microsoft's (MSFT) balance sheet.
What are the key differences between cash on Qualcomm's balance sheet and IBM's balance sheet and how does it help us to clearly define what exactly cash on balance sheet means?
- No unfunded or underfunded liabilities exist. If they exist on a corporate balance sheet, subtract the amount from the cash shown on balance sheet.
- Every business requires a certain minimum amount of cash as a risk management tool incase there is a delay in converting receivables to cash. This cash must be subtracted from cash displayed on the balance sheet as this is not available for other purposes.
- The outstanding debt must be serviced with operational cash flows under stress conditions. If the outstanding debt is in excess of what can be serviced, the excess debt should be subtracted from cash. For many companies, that would lead to a negative cash balance.
- All essential expenses, such as essential operational and maintenance expenses, insurance costs and research and development expenses can be met without leveraging the balance sheet beyond prudent levels. If the requisite expenses would require excessive leveraging, the excess debt must be subtracted from cash.
- All assets, particularly financial and real estate assets on a balance sheet have been correctly valued. In the case of a financial institution, that implies not much Level III assets. Another red flag for potential overstatement is goodwill and intangible assets. If the asset valuation is overstated, or liabilities are understated, the permissible debt of the company, post the asset and liability restatement that can be serviced under stress conditions falls. One way to check if the asset and liability values are correctly stated is to check, over a certain period in the near past, if the return on capital employed (RoCE) is greater than cost of capital
- Any marketable securities or cash held against clearly defined non debt liability (such as technical provisions of an insurance company) must be subtracted from cash and marketable securities, unless the asset side of the balance sheet clearly has a category for "client assets".
- For companies with financing subsidiaries, whether for providing vendor financing or other financing, clear estimate of likely losses must be obtained. The analyst must check for the possibility of hiding of bad loans or stating the loans at inappropriate values. All loss estimates must be subtracted from cash. Then assess if the debt of the financing entity, under stress conditions, can be met by maturing assets, or the liabilities can be rolled over because a debt financier would be convinced that the company is solvent.
- The cash flow from operations is not falling. Fall in operational cash flows could be (though not necessarily) a bad sign. It could mean that the working capital cycle is getting lengthened, either due to stress at the customer end or the bargaining power of customer has increased and hence he is able to secure a longer credit period. It could also mean inventories are not getting converted to sales. Lengthening working capital cycles come with increased credit risk which require higher amount of cash for ensuring smooth operations.
We look at the "cash on balance sheet" thesis through the lens of General Electric (GE), one of the corporations mentioned to be swimming in a pool of cash. We take that opportunity to briefly assess the credit strength of the company.
GE's Credit Story
Before we say anything about General Electric, we must state that all items on GE's balance sheet should be taken with more than a pinch of salt. The SEC filing section of GE's website states:
As a result of GE's restatement of its financial information in its amended 2005 Form 10-K, readers should no longer rely on our previously filed financial statements and other financial information for the years and for each of the quarters in the years 2001 through 2005. Readers should also no longer rely on our previously announced results for the first three quarters of 2006.
The rest of this piece gives GE management the benefit of the doubt on stated numbers, but the above statement from the GE website testifies that we certainly don't have history on our side. And the statement does not mention the pre-Sarbanes-Oakley phase when master earnings manipulator Jack Welch was at the helm of affairs.
GE is one of the finest industrial companies ever built. Resting on the laurels of decades of ingenuity, management excellence (before Jack Welch), and hard work, the company has a number of firsts to its credit since the late 19th century when Thomas Edison brought a number of patent holders together under the fold of the company. Today, GE is a leader in the area of aero engines, power plant technology, health care systems and transportation systems besides being a strong aspirant in the area of green energy. But GE also owns a gigantic financing firm, GE Capital, which consumes a chunk of the company's equity and exposes the company to huge losses.
But for the financing business, we would be sanguine about credit investments in GE. This is despite the fact that GE's earnings will be severely crimped in the near term as societies all across the world deleverage and look for cheaper, if less than perfect, solutions. The signs are already there as GE's industrial earnings growth has been achieved by cost cutting rather than revenue expansion. But GE will survive the weak prospects for capital goods sector in the medium term just as General Motors (GM) did and managed to remain profitable every year during the Great Depression. The numbers coming out of Siemens AG (SI), one of GE's leading competitors, is also a pointer to weak near term earnings for the big industrial players, notwithstanding the often unwarranted enthusiasm for emerging market prospects.
GE Capital: the faster the disposal the better the GE Credit Story
GE Capital has far outlived its purpose during its glory days under Jack Welch for managing GE's quarterly earnings as well as taking advantage of two decades of easy money policies of the US central bank. Going forward, GE Capital can have only a debilitating effect on the GE credit story. Even providing vendor financing to GE's aviation, energy services and transportation services customers is not a very good idea because it comes with humongous amount of credit risk, which might have been manageable in the past but are unlikely to remain so.
Far better to sell equipment at lower price provided the customers arrange their own financing from banks. And if prospective lenders are not enthused, it is foolhardy for GE to rush in where angels have declined to tread. And the other businesses of GE Capital such as real estate lending/equity investing, consumer lending etc, which do not involve vendor financing, are even more out of place in GE's balance sheet.
As on 30th June 2011, GE has invested $76 billion of equity in GE Capital. This is far more than the $52 billion of equity to support businesses such as Aviation, Health Care, Energy and Transportation Services.
Expected Portfolio Losses at GE Capital
Real estate Equity and Debt Investments
GE Capital owns a real estate portfolio of $23.7 billion. This portfolio yielded 6% in the latest quarter and even less earlier. Since the prospect of capital appreciation of this portfolio in the medium term is low, any rational third party will not buy this portfolio at less than an yield of 15%. That would imply a portfolio valuation of $9.5 billion, a $14.2 billion hit to the carried value. Since most of this portfolio is located in US and Europe (and originated in the happy days before the 2008 crisis) and where the economies are likely to grow anaemically, vacancies are likely to increase which would lower portfolio yield even further.
On the real estate debt front (again, mostly originated in the halcyon days of yore), the company distinguishes between two categories- non earning receivables and non accrual receivables. The later category is $8.8 billion higher than the former and from what one can make out from the corporate presentation, (the disclosure can be much better) the likely losses have not been provisioned for. Assuming the company has a recovery of 75% on this pool, the losses due to real estate debt not provisioned for would be $2.2 billion.
This means that the company's real estate debt and equity exposure could cause it further grief to the tune of $16.4 billion.
Commercial Lending and Leasing Portfolio
This portfolio contains loans and leases to mid size companies, mostly in the indebted and slow growing economies of US and Europe. For the $5.6 billion impaired loans as on 30th June 2011, provision for losses was only $1.7 billion. This portfolio should have a heavy quantum of general provisions, for losses the portfolio is certain to witness next year. So, for specific provisions for loans that have already turned sour and general provisions for loans that are likely to turn sour soon, at least $8 billion of additional provisioning is required.
Consumer Finance Portfolio
It is GE Capital's $119.6 billion consumer portfolio that is really scary. Of the $40.7 billion of non US mortgage portfolio, 27% (linked to negative amortization loans, ultra high LTV loans etc) would have to be written down. The allowance for losses carried by the company for this portfolio is only around $4 billion. This means, at least $6 billion of additional provisions are required for the really terrible bit of the portfolio and perhaps, conservatively, another $1 billion for the rest of the portfolio, implying a total requirement of $7 billion for non US mortgages.
The $63 billion retail unsecured credit ($50 billion in US and Western Europe) is likely to be another horror show. The $1.2 billion provisions against this holding will prove grossly inadequate for covering losses. The data disclosed on the portfolio is inadequate for assessing what the ultimate losses would be. Even if one assumes a 10% delinquency in the portfolio (which is quite low considering the socio economic status of the borrower and considering the stubbornly high unemployment rate), at least $4 billion of addition provisions would be required. Wait for another 12 months to witness this portfolio unravelling.
Airplane and Aircraft Engine Loan and Lease Portfolio
GE Capital has a $12 billion loan and finance lease portfolio and a $33 billion operational lease portfolio. No break up was provided on the credit quality of the airlines involved in the loan and lease deals. But this portfolio will definitely witness unpleasant credit events. Firstly, the credit quality of the airline industry is not pretty. Secondly, the operational leases have huge lease renewal risks, particularly since new fuel efficient planes are coming into the market.
An intelligent guess is that these leases will not be renewed unless GE Capital takes a substantial haircut on the lease rentals. Finally, all the leases come with huge residual value risk, whether the residual values are guaranteed by GE Capital or not. Assuming just a 2.5% loss on the portfolio (will prove to be a gross under estimate), the loss from GE Capital's airline portfolio would be roughly $1 billion.
The difference between carried value and fair value of GE Capital's investment portfolio is almost $600 million. Considering a cushion for further diminution in value on the almost $19 billion portfolio, it is safe to set aside a loss of $1 billion.
Prudent Leverage Levels for GE Capital
As on 30th June 2011, GE Capital presented a leverage ratio of 5.8. After adjusting for the $77 billion "cash" on GE Capital's balance sheet, the adjusted leverage ratio was stated to be 4.3. We have, in the sections above, estimated that GE Capital will take a hit of $37 billion on its asset book. For a portfolio such as GE Capital, a leverage ratio beyond 4 cannot be considered prudent. That implies GE Capital would need to get its debt down to $315 billion.
That amount is $135 billion higher than current outstanding debt. After the $37 expected loss is knocked from cash, GE Capital would have cash of $40 billion on its book. If this cash is used to pare down debt, the outstanding debt would still be $95 billion higher than prudent levels. That implies GE needs to infuse $95 billion of cash into GE Capital to get its debt down to prudent levels. Of course, all this is not a precise science, but the cash infusion estimate is more likely to be lower than what is ultimately required rather than the other way around.
The Temporary Liquidity Guarantee Program (TLGP) was a program adopted by the Federal Deposit Insurance Corporation (FDIC) and came into effect on October 13 2008 to help financing companies borrow amounts that the free market was not willing to lend to them considering the less than stellar asset quality of the firms. GE Capital was one of the biggest borrowers under the program. At the end of June 2011, GE Capital had outstanding amount of $256 billion under the TLGP program.
So, How Much of GE's Cash on Balance Sheet Is Real Cash?
GE's non finance business has shareholder equity of $52 billion, cash of $24 billion and a debt level that is prudent without considering the financing business. The non financing business would probably need at least $10 billion of cash for ensuring prudent operations. The rest of the cash, $14 billion, is inadequate for the requisite infusion of $95 billion into GE Capital, as we had estimated in the previous section. Considering the fact that the non financing business can at best take in additional debt of $10 billion without being imprudently leveraged, inquiring minds might want to know where exactly the cash on GE's balance sheet is.