The Best Use Of Corporate Profits [ANALYSIS]

I have recently authored two articles showing that, all other things being equal, a stock that pays its shareholders a dividend generates a higher total return than a stock with similar growth characteristics that doesn’t. This is based on the reality that stock prices follow earnings in the long run, and it is this relationship that generates the capital gain component of total return.  Therefore, if there is a dividend it will provide the shareholder the additional return from the income component (dividends).  Links to the articles can be found here and here.

Both of these articles generated a rather lively comment stream.  However, very few of the comments actually discussed the concept of the dividend providing additional return.  Instead, the comments denigrated into exhaustive discussions about whether or not a company would grow faster or not by not paying a dividend. In other words, the discussions did not talk about the return augmentation the dividend provided, rather, the debate focused on whether companies should pay dividends or not.  This led then to discussions about reinvesting into the business, and share buybacks, et cetera.  These are entirely different subject matters which inspired me to write this article.

Consequently, the focal point of this article is to discuss, and try to answer the very important questions, regarding what is the best use of corporate profits.  Should a company retain their profits and reinvest in itself, should a company buy back their stock, should they use it to fund acquisitions, reduce their debt or pay dividends?  These are all important questions, and the comment threads on my previous articles suggest that many investors have very strong feelings about these matters.  Fortunately, I have the absolute perfect answer to these questions.  Drum roll, please…. the simple answer to all these questions can be stated in two words-it depends.

The point is that all of these uses of corporate cash flow can be the best use under the appropriate circumstances.  On the other hand, all of these capital deployments can also be the absolute worst utilization of corporate cash flows. And the correct answer can be different for virtually every company out there, and the correct answer for any specific company can be different today than it is tomorrow.  Accordingly, the reader should understand that there is an almost infinite array of circumstances and situations that would dictate a different answer for each situation. Consequently, this article will only present some general guidelines and concepts about when each of these capital deployments makes sense, and when they don’t.

The Capital Deployment Pecking Order

An article in the Wall Street Journal on February 27, 2012 by Maxwell Murphy titled The Pros and Cons of Stock Buybacks interviewed two prominent Wall Street personalities with strong views on the subject of buybacks.  They were Whitney R. Tilson, founder and managing partner of T2 Partners LLC, and Gregory V. Milano, cofounder and chief executive of Fortuna Advisers LLC. Here is a linkfor anyone interested in reading the whole article. The reason I share this article is because Mr. Milano described a concept that he referred to as a capital deployment “pecking-order theory” as follows:

“Many believe capital deployment should follow a “pecking-order theory” that prescribes that managements should apply their cash flow, in order of priority, to fix their balance sheet if overleveraged, fund organic investments, pay dividends, fund acquisitive growth and, only when there is additional cash left over, to distribute it via share repurchases. While this may seem theoretically sensible, in practice it leads to buying back more shares when the market value has increased significantly in response to stronger cash flows.”

I believe this quote perfectly addresses many of the issues, and opinions of those who believe that dividends actually represent a drag on the company’s potential to grow. Notice that dividends came in third place after deleveraging the balance sheet and investing in organic growth. With this article, I will provide a brief introduction on each of the cash flow deployment options based on the pecking-order theory introduced above.

Fix the Balance Sheet (reduce debt)

The old adage that you can’t go bankrupt if you don’t have any debt equally applies to corporations as it does for individuals. On the other hand, applying the appropriate amount of leverage can also be a beneficial way for corporations to increase their returns.  The level of interest rates is also a big factor; the lower the rates are the more attractive it is for corporations to borrow.  This includes issuing bonds and notes and/or establishing credit lines, etc.  But perhaps most importantly, the company’s cash flow generating abilities and levels capable of amortizing debt is a critical consideration.

Furthermore, a corporation can have a good reason for taking on debt, such as to fund a strategic acquisition (more on that later). However, depending on the individual company, it’s important to never let your debt reach a level that becomes unmanageable.  Consequently, using corporate cash flows to reduce debt is more often than not a good use of corporate cash. On the other hand, this doesn’t mean that the corporation must use all of their cash flow to pay down their debt. In fact, it is not uncommon to find companies that deploy their cash flows across all of the “pecking order” options.

The following F.A.S.T. Graphs™, fundamentals analyzer software tool, will look at two companies where one might want to deleverage and the other doesn’t need to.  The first graph looks at The Clorox Company (NYSE:CLX), where a case is easily made suggesting that The Clorox Company (NYSE:CLX) is in need of deleveraging their balance sheet as debt represents 101% of capital. However, a review of the company’s financials shows that lately they have been reducing long-term debt. Furthermore, the company generates strong operating cash flows and has increased their dividend for 35 consecutive years.

In contrast to Clorox & Co., Accenture Plc (NYSE:ACN) is currently paying a generous dividend, and has the luxury of no long-term debt. Obviously, this company has no reason to consider the deleveraging option.

Fund Organic Investments (reinvest in the business)

Very fast-growing companies are typically very capital hungry.  In other words, they need to use the vast majority of their earnings and cash flows to fund their rapid growth.  Consequently, it is very common to see high growth companies not pay a dividend. Therefore, funding organic growth is arguably the best use of their earnings and cash.  This is especially true if the company’s capacity to produce its goods or services is lower than the potential future demand for their products or services.  Logically, companies in this situation need to increase their capacity in order to meet future demand and exploit their full profit potential.

On the other hand, if a profitable corporation, perhaps one that operates in a small niche, has excess capacity that exceeds the demand for their products or services, it would make no sense for them to continue to invest to create greater capacity.  Companies in this situation might be best served to return profits to shareholders via either dividends or share buybacks (both will be covered later).

The moral of the

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