Strong cash levels continue for the industry, driven by solid profitability and revenue growth, particularly overseas, and consistent working capital performance. Cash balances for the technology companies involved in this review have remained in record territory, at approximately $250 billion as of the first quarter of 2008. This figure is consistent with the overall balance during the last five years, in which industry cash balances have fluctuated in the $240 billion−$260 billion range, a significant increase from the early part of the decade. Fitch estimates that more than $100 billion of cash is located overseas.
As the IT industry continues to maintain solid growth rates, Fitch believes total cash balances will likely increase, with a greater share of cash and investment positions being located overseas due to non-U.S. regions achieving higher growth and generating an increasing percentage of free cash flow. Fitch continues to expect that as technology companies evaluate their capital structures for the long term, they may consider debtfinanced acquisitions, increasing stock-repurchase programs and higher dividends. These initiatives could require the issuance of debt in the U.S., depending on the location of a company’s cash position or the location of any potential acquisition. However, in the near term, Fitch expects industry cash to remain at current levels or increase as the state of the credit markets requires a prudent approach to utilization of excess liquidity. Longer term, Fitch believes a technology company’s cash balance components and location will become increasingly important for liquidity and leverage analysis, whereby a partial net debt analysis may have to be weighed for companies issuing debt in the U.S. for tax efficiency reasons while cash overseas grows. Fitch believes that a company's track record of keeping cash on hand, its cash conversion cycle trend, and the importance of maintaining cash holdings to weather economic cycles will continue to be significant considerations in the overall analysis.
Additional usages of cash could be for capital spending and other post-employment benefits (OPEB) expenses. While pension and health care expenditures generally affect many industrial corporations, IT companies, for the most part, do not have legacy defined-benefit plans and, consequently, do not have to be concerned about dedicating future cash flow for significant cash pension obligations. Additionally, capital spending as a percentage of revenue is not expected to increase significantly from current levels as outsourcing initiatives continue, and capacity utilization for some technology segments remains below optimal levels.
Location of Cash
As cash balances for the technology industry have increased significantly over the past decade, reaching record highs in 2007 at approximately $265 billion, Fitch continues to consider the various geographic locations of a company’s cash position as well as the portfolio breakdown of the cash and marketable securities for its liquidity analysis. As international expansion continues, companies generate more cash overseas. For example, six of the 10 largest technology companies by cash balance provide some disclosure around the location of their cash and investments. Of a total $83.4 billion of cash and short-term investments at these six companies, Fitch estimates that $55 billion−$60 billion is domiciled outside of the U.S. As a result, a substantial amount of cash may be essentially unusable for share repurchases, dividends or domestic acquisitions, as the cash would face significant taxes upon repatriation. As a result, companies with large cash balances may turn to external funding sources to conduct these actions. For example, a substantial amount of Hewlett-Packard Company’s (HP) $11.7 billion of cash is located outside the U.S., and Fitch believes the company will issue a significant amount of debt to fund its acquisition of Electronic Data Systems Corporation (EDS). Fitch expects increased international acquisition activity as companies look to deploy overseas cash and to gain global share.
Cash Components
The portfolio breakdown of cash and short-term marketable securities has been fairly constant over the past ten years, with the top 10 companies (by cash balance) holding approximately more than 50% of their cash as short-term investments. Short-term investments are generally comprised of fixed-income securities that mature between three months and one year, and typically consist of highly rated, highly liquid government and corporate debt. However, some companies include longer-dated securities if the securities are very liquid and if the company intends to use the securities for purposes of liquidity. Cash and cash equivalents are highly liquid investments that mature in three months or less. Recently, the percentage of cash in the portfolio has increased, which indicates that companies may have grown more conservative around their investments, given the significant reduction of liquidity in certain securities markets over the past several months. Many companies provide annual (and some quarterly) breakdowns of what comprises their cash and short-term investments balances. The disclosure is not uniform, and the level of detail differs.
Many companies also have long-term investments, which are generally longer-dated fixed income, as well as marketable and non-marketable equity securities. Fitch notes that these securities are significantly less liquid then those classified as short-term investments, but believes that a portion of their value could be monetized in a distressed situation. While Fitch analyzes the breakdown of the various debt and equity portfolios, it generally includes only the aggregate sum of cash and short-term investments when discussing a technology’s cash position, while recognizing that clearly the longer-term investments are not as liquid as cash.
Credit Implications for High Cash Levels
Since 2004, technology industry debt has risen nearly 80%, or $91 billion, to $205 billion as of March 31, 2008. Total cash and marketable securities were virtually unchanged in that same period, with a balance of $246 billion at March 31, 2008. This increase in debt with relatively flat cash balances is the result of technology companies increasing leverage (e.g., leveraged buyout, recapitalization, debt-financed share repurchases) or deploying their cash and free cash flow towards share repurchases and acquisitions. However, the industry continues to have a net cash position (in excess of $40 billion) with relatively low gross leverage of approximately 1.1 times (x), both of which Fitch believes indicate that further debt-financed activities are likely to continue; however, if cash location is the main debt issuance driver, then the industry may continue to maintain a net cash position for the intermediate term.
The technology industry has experienced ongoing strong and growing free cash flow generation over the past several years, with free cash flow remaining near 10% of revenues since 2004, compared with the low- to mid-single digits in prior years. The growth in free cash flow since 2004 has stemmed largely from strong top-line growth underpinned by continued profitability, stable capital expenditure trends and good working capital management. Strong top-line and profitability growth at large companies, such as eBay Inc., Google Inc., Oracle Corporation, Microsoft Corporation, HP and Apple Inc. has helped fuel the growth. This increase was partially offset by declining free cash flow at semiconductor and communications equipment companies. Since 2005, companies have spent more than 150% of free cash flow on share buybacks and acquisitions, a marked increase from previous years. Companies have incurred debt to finance this, and total leverage has increased to 1.1x, from 0.8x in 2004, as the significant EBITDA growth in this period has partially offset the higher debt. Despite this increase, Fitch views current industry levels as low and believes that, on the whole, technology companies are retaining financial flexibility, given growth in EBITDA, significant free cash flow and large cash balances.
As a result, Fitch believes that technology debt balances will continue to increase over time, as cash spent on acquisitions and share buybacks will continue to exceed free cash flow. Although leverage could increase slightly from current levels, a significant spike is not expected. First, higher debt balances will continue to be offset by EBITDA growth, especially if acquisition spend outpaces share buybacks. Additionally, Fitch believes that companies are keen to maintain their liquidity and financial flexibility, given prior experiences with over-leverage, as well as tightened credit markets.
Clearly, certain companies have more flexibility at current ratings in how they deploy their excess cash. Companies that generate significant amounts of free cash flow have historically distributed a majority of the excess cash for stock repurchases, acquisitions and dividend payments, and Fitch expects this to continue. Fitch does not anticipate debt reduction beyond existing maturities, with a high probability that many maturities will be refinanced. Technology companies, especially the IT distributors, must also balance the aforementioned cash usage activities with maintaining adequate liquidity to support working capital needs: Fitch believes most companies in this review can grow in excess of 5% without Fitch-defined working capital (changes in accounts receivables, inventory, accounts payable and accrued expenses).
Stock Repurchases
After general curtailing of stock repurchases during the 2000−2003 IT slowdown to focus on balance sheet improvement, companies returned to buybacks in 2004. Given the strong operating environment in recent years, combined with (in some instances) the limited availability of attractive acquisitions, many technology companies have significantly increased the size and pace of buybacks. Cash deployed for buybacks almost doubled every year from 2004−2006, and remained at a high level in 2007, with $73 billion of net repurchases. Fitch expects buybacks to remain a substantial use of cash for technology companies. While some companies may become more protective of their cash amid the current economic slowdown, Fitch believes that currently depressed equity prices will drive a continuation of large buybacks. large hardware companies, such as Dell Inc., HP, International Business Machines Corporation (IBM), Sun Microsystems, Inc. and Texas Instruments Inc. have increased their stock buybacks rapidly in the past several years. The activities of these companies dictate the dynamics of the overall industry; they were responsible for nearly 40% of technology buybacks in 2007.
After repurchasing $7.8 billion in fiscal 2006 and $10.9 billion in 2007, including a $1.8 billion accelerated share repurchase (ASR), HP announced an additional $8 billion authorization in November 2007, and repurchased $6.2 billion in the subsequent six months. IBM spent $18.8 billion in 2007 on share repurchases, including a $12.5 billion ASR. In February 2008, IBM expanded its repurchase program by $15 billion, and anticipates spending up to $12 billion for the full year. Furthermore, many smaller technology companies have been implementing or increasing share repurchase programs over the past two to three years, including Anixter International Inc., Computer Sciences Corporation (CSC), EDS, Seagate Technology LLC, Tyco Electronics Ltd., Xerox Corporation and Eastman Kodak Company.
Fitch believes the large, well-capitalized companies mentioned above have capacity within the current ratings for these announced increased share buyback programs or even increased dividends, assuming no other changes in corporate strategy. These companies all generate substantial free cash flow, with HP and IBM at the high end exceeding $8 billion annually. The smaller companies, which lack the same scale and cash generating capability, must be cautious around their use of cash for repurchases and ensure that they have adequate liquidity. As operating earnings and cash generating capability increase, companies have more flexibility for repurchases. Lastly, Fitch believes that companies that lack tax-efficient vehicles to repatriate overseas cash will increase their U.S. debt balances in order to raise domestic cash to repurchase shares.
Dividends
Common stock dividends are atypical for the technology industry as companies usually reinvest cash flow into the business. Approximately one-third of the reviewed companies currently pay a dividend to common shareholders. For the most part, technology companies have not issued one-time dividends that could lower financial flexibility (with Microsoft being an obvious exception, although the $32.6 billion 2004 special dividend did not have a significant impact on the company’s liquidity). Fitch is comfortable with the current dividend policy for the stronger and better-capitalized companies such as HP, IBM and Texas Instruments Inc., and believes strong cash flow can support minor increases.
Acquisitions
A third potential use of excess cash balances is for acquisitions, which became a more prevalent means of deploying cash as the IT environment and company balance sheets stabilized and strengthened. Companies are also turning to acquisitions to enhance organic growth rates, which are slowing as the industry matures. In 2004, technology acquisitions accounted for approximately 16% of free cash flow. By 2007, this had increased to 83%. Prior to 2007, technology companies in aggregate were spending more on share buybacks than on acquisitions. However, this trend reversed in 2007, as share buybacks of $73 billion was exceeded by $78 billion of acquisition spend, which includes the $29 billion leveraged buyout of First Data Corp. Fitch believes acquisition activity will continue for the intermediate term, as the strategic buyer seems to have resurfaced as leveraged buyout firms are challenged in today’s credit markets.
Fitch views acquisitions positively vis-à-vis buybacks, given the incremental EBITDA and potential product and geographical diversification associated with most acquisitions. Fitch expects acquisitions to remain a major use of cash, given excess cash balances and the desire to augment organic growth rates. Additionally, depressed valuations amid the recent financial markets turmoil could provide opportunities. Fitch expects that acquisitions will increasingly focus on international markets as a way to diversify and gain share. First, the recent weakness in the U.S. dollar and slowdown in the U.S. economy have illustrated the benefits of geographic diversification. Additionally, as previously mentioned, many companies generate substantial cash overseas, which cannot be tax-efficiently repatriated and is therefore best deployed for international acquisitions. Fitch expects excessive cash balances will be utilized, at a minimum, for tuck-in acquisitions to complement current operations. The software and IT hardware companies have been the most active in recent years. Fitch expects this will continue.
The larger, well-capitalized companies have flexibility in their ratings to make significant acquisitions, given large cash balances and strong free cash flow. Even large debt-financed acquisitions can be completed without a ratings impact in some instances, under the assumption that debt will be repaid via free cash flow soon after. Recent examples include Oracle’s $8.5 billion acquisition of BEA Systems, Inc. and HP’s proposed $13.9 billion acquisition of EDS. Dell has recently begun a targeted acquisition strategy designed to enhance specific business areas. The company spent $2.2 billion acquiring five companies in fiscal 2008 (ended Feb. 1, 2008). Oracle has spent more than $27 billion on acquisitions over the last four years, largely to build out its enterprise applications business. HP has also escalated its M&A program, pursuing software acquisitions that complement its product offerings. The company spent almost $7 billion on acquisitions in 2007, significantly more than it had in previous years.
Increased Capital Spending
Fitch believes the least likely use of cash is for increased capital spending, as capacity utilization and other metrics are still below optimal levels. Since 2003, although increasing in absolute dollar terms, capital expenditures have remained in the range of 4%−5% of sales, after companies began scaling back in 2001. These levels are not expected to increase in the near term as capacity is sufficient for various demand scenarios. Further, semiconductor companies, such as Advanced Micro Devices, Inc. (AMD) and Texas Instruments, which historically have spent 25%–30% of revenue on capital expenditures for next-generation semiconductor fabrication facilities, have begun scaling back on their capital spending after completing large builds while slowly embracing an outsourcing model utilizing semiconductor foundries. As outsourcing of various semiconductor manufacturing continues and as hardware IT equipment is utilized more efficiently, it is possible the long-term capital spending may decrease as a percentage of revenues even as demand grows, indicating industry free cash flow may rise as a result of this lower capital spending.
No Significant Pension Funding Obligations
Most technology companies are not burdened with significant pension obligations. Companies such as HP, EDS and Motorola, Inc. have relatively small pensions, and any necessary cash requirements for these plans could easily be funded from strong cash positions, free cash flow, other liquidity sources and an ability to reduce stock repurchases, if needed, to support pension funding, as IBM has previously demonstrated. As a result, cash commitment requirements for these companies, if any, are manageable and are not expected to increase in the intermediate term, increasing the likelihood for more “shareholder-friendly” cash uses.
