Why Companies Now Favor Cash

Cheap and plentiful credit has powered the U.S. economy for decades. But since the financial crisis of 2008, America has gone on a drastic debt diet. Just as families are paying down credit-card debt and building up cash reserves, businesses large and small are learning to operate in an environment where cash once again is king.

The economic shift has been dramatic; bank lending has dropped at a frightening rate. In 2009 the banking system notched the largest decline in loans in the history of the Federal Deposit Insurance Corporation. Meanwhile, the amount of commercial and industrial loans outstanding has fallen 19 percent since the fall of 2008—back to the level of late 2006. Even the financial sector, which shoveled debt into the economy the way foie gras farmers funnel food into the mouths of geese, has cut way back on debt. Since mid-2007, investment bank Morgan Stanley has reduced its leverage ratio by half.

During the late, lamented credit bubble, both companies and individuals spent and invested based on expectations of what they could borrow. Now they're hoarding cash. The savings rate, near zero in 2007, rose to 3.3 percent in January. At the end of last September, the 376 members of the S&P 500 that aren't utilities or financial firms had a record $820 billion in cash in their coffers, up more than 20 percent from the year before, according to Standard & Poor's.

The conventional wisdom holds that the pullback in credit is a hindrance to recovery. And for many businesses, especially small ones, the inability to roll over old debt or open new lines of credit can put a crimp in expansion plans. But the economy isn't fueled by debt alone. After all, last year the economy experienced a sharp turn, from shrinking at a rate of 6.4 percent in the first quarter to growing at a rate of 5.9 percent in the fourth quarter—all while private-sector credit shriveled. More broadly, the embrace of cash (and the shunning of debt) could be beneficial. During the go-go years, it was common to hear theorists talk about the "discipline of debt." On paper, high debt loads force managers (and homeowners) to make tough, swift decisions to stay solvent. Default, and you lose the company (or the house). In reality, rather than scrimp, overextended borrowers are more likely to walk away from mortgages, or push companies into Chapter 11 bankruptcy protection. Americans are now discovering that cash exerts a superior discipline. The real discipline of cash may be that it causes executives, consumers, and investors to think twice—and to think about the long-term consequences—before spending. The need for instant gratification is part of what created the current mess.

The ability to adapt rapidly remains one of America's competitive advantages. And since the onset of the financial crisis, both consumers and businesses have embraced the new reality. After digging themselves out of $20,000 in debt in 2007, Susannah Fater, her husband, David—a district manager at Staples—and their four children did something radical: they became an all-cash household. "Bills like groceries, gas, and allowance are taken out every month and put into envelopes so that we know exactly where we are financially," says Susannah.

Consumer-oriented firms have pivoted rapidly to service new pay-as-you-go consumers like the Faters. ELayaway.com, based in Tallahassee, Fla., and founded in 2005, offers its 75,000 customers the ability to buy products on installment plans (up to 13 months) from 1,000 merchants, including Apple and Amazon.com. The typical purchase is an electronics item with an average cost of $440 and a four-month payment term. Cofounder Sergio Pinon notes the rise of a category of customers eLayaway calls "planners," who pay for next winter's snowblowers this summer.

Texas electricity provider First Choice Power in January launched a prepaid service called Control First. "In Texas, there are about a million households who have slim credit or no credit at all," says company president Brian Hayduk. Without requiring a deposit or credit, customers are permitted to prepurchase a set amount of electricity—say $100 per month. The company installs a smart meter that lets people know how much they've used—which spurs customers to manage their energy use more intelligently.

The rise of the cash economy has made businesses hesitant to make the type of capital expenditures they used to fund with debt—big-ticket items like factories, expensive equipment, and new buildings. But it has made them more receptive to companies that offer efficiency and saving with little money down. At Boston-based EnerNOC, revenues nearly doubled last year. EnerNOC has two lines of business. On behalf of electric utilities, it enlists companies that agree to reduce electricity use at times of peak demand in exchange for cash payments. And it installs submeters to measure buildings' energy consumption in microscopic detail, and then suggests ways to reduce demand. "We sell the software and guarantee we'll identify energy-savings opportunities worth twice what they pay us on an annual basis," says CEO Tim Healy. "It's very capital-light." In 2009 the number of company employees rose from about 330 to more than 400, and it projects revenue growth of $75 million (nearly 40 percent) in 2010.

Before the deluge, companies and investors chose the easy path of gaining returns by using their balance sheet— they'd borrow money to pay a dividend, or to purchase another company. But financial engineering has given way to business engineering. Kohlberg Kravis & Roberts, the huge leveraged-buyout firm that minted profits through financial maneuvers during the credit boom, has built up a staff of in-house retail executives who work with companies it owns, such as Dollar General and Toys "R" Us.

Just as there are fewer no-money-down mortgages in the housing market, many of today's buyouts are significantly less leveraged. Coal company Consol Energy on March 15 announced a $3.5 billion deal to buy natural-gas assets from Dominion Resources. Consol said it would raise $4 billion to buy and develop the gas fields—likely split equally between cash and debt. Since transactions that use less debt and more cash are less likely to go belly up, the greater use of cash is a basis for a more stable, more rational financial system. Stephen Kaplan, a professor at the University of Chicago business school, notes that returns are poor for buyout funds that make highly leveraged acquisitions during credit booms. When cheap debt is available on easy terms, "they do more marginal deals."

Of course, a fine line separates conservation from hoarding, and careful saving from miserdom. For many financial executives, the wholesale collapse of the credit markets in the fall of 2008 induced the same reaction that the anti-drug movie Scared Straight used to create among teenagers. "There's a greater focus on liquidity and the preservation of cash for the unexpected than you had in the past," says Seth Gardner, executive director of the Center for Financial Excellence at Duke University's Fuqua School of Business, and a former executive at Cerberus Capital.

Yet there are signs that corporate America is beginning to loosen the purse strings. Investment in equipment and software rebounded at an 18.4 percent annual rate in the fourth quarter of 2009. And S&P analyst Howard Silverblatt predicts that companies will start deploying their record cash piles on stock buybacks, dividends, and capital expenditures once they're convinced the recovery is real. In 2009 snack giant PepsiCo's cash holdings nearly doubled. On March 15, PepsiCo said it would raise its dividend 7 percent and buy back $15 billion in stock by the spring of 2013. Such moves, which function as a kind of stimulus, are helping to put some fizz back into the economy.

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