Crushed by ... Savings
It's America's other debt crisis: Companies don't borrow enough.
(FORTUNE Magazine) - Everybody knows that debt is a genuine crisis in the U.S. Consumer debt stands at $2.2 trillion, by far the highest ever, much of it on credit cards with staggering interest rates. The federal debt is $8.2 trillion, also a record by far and slated to rise another $400 billion or so this year.
Those are major worries. But America has another debt problem that you never hear about: the plight of the underindebted company.
Believe it or not, our corporations salt away too much cash and don't carry nearly enough debt. Many of the biggest and most famous -- Microsoft (Research), Cisco (Research), Intel (Research), and a lot of others -- could actually pay off their debt completely and still keep a ton of money in the bank. And while that sounds virtuous, it isn't. In today's global economy it could spell trouble.
Debt isn't a burden for a company the way it is for you and me. It's a choice. Every business requires capital, which can take two forms--equity (from owners) or debt (from lenders).
The cost of the capital (what the company pays the providers to use their money) differs, of course. With debt, it comes in the form of regular interest payments. The cost of equity capital isn't paid with a monthly check but is every bit as real: It's the return that investors demand for putting their money at risk.
Most companies use a combination of debt and equity, and finding the best mix is a deep field of study in which economists have won Nobel Prizes. But it's crucial to remember a basic point: Debt capital is cheaper than equity capital. The rate of return that equity investors demand is always going to be higher than prevailing bond rates. And while companies get a tax deduction for the interest they pay on debt, they get no tax breaks on equity.
So while the optimal mix of debt and equity--that is, the mix that will produce the lowest total capital cost--will vary by company, it will almost always include a sizable chunk of debt. Considering that the very essence of corporate performance is earning a return on capital that exceeds the cost of capital, corporate America has long been way underleveraged.
New research shows that the problem is especially pronounced today. That's bad, because in an era of global markets, equity investors can order from a worldwide menu of choices. They want only the very best investments, those companies with the widest spread between return on capital and capital cost. So achieving the lowest possible capital cost is becoming ever more critical. Yet U.S. companies are straying farther from that path.
As one example among many, consider Intel--a truly great company, but look at its capital. Debt is usually expressed as a percentage of total capital; 20% would not be unusual, and some companies have much more. But Intel's debt level is negative 9%. How? It has so much cash and marketable securities on hand that it could pay off all its debt with money to spare.
That may sound wonderful, but a company with no debt--or negative debt--is relying entirely on the more expensive form of capital, equity. Thus big, established, successful Intel bears a towering capital cost of 13.9%, which you might expect for a risky startup. By comparison, Procter & Gamble (Research) uses a healthy dose of debt and has a capital cost of only 7.4%.
For these and other giant companies, lowering capital costs by just a percentage point translates into billions of dollars of increased firm value. And they can move that way by borrowing money and using it to buy back stock, replacing equity capital with debt.
But let's not pick on Intel. Microsoft also has huge negative debt. So do Nokia (Research), Google (Research), Apple Computer (Research), Genentech (Research), Roche Holdings, Paccar, and many more, according to Stern Stewart, the only firm I know of that systematically analyzes net debt for thousands of companies. Its research shows that, amazingly, 25% of the Russell 3000 have no debt or negative debt.
The obvious question is why. The answer seems to be that managers like it that way. Low debt gives a company more of a cushion against financial shocks (and makes its stock price less volatile), which reduces stress for the CEO. Most of the time investors would gladly accept the extra volatility accompanying the extra value they get from replacing some equity with debt capital. But investors don't make the financing decisions.
Message to CEOs: Loosen up and borrow more! Your lives might get a little less comfortable--but in this case that's most definitely what you get paid for.