Cash Stockpiles May Not Save Big Business

Wall Street serves as an ideal scapegoat for the deepening global recession, but the emerging consensus is that there's plenty of blame to go around. Certainly the banks that turbocharged their balance sheets, borrowing $32 for every $1 they owned, played their part. But families, too, doubled down on bad bets by turning houses into ATMs, and by 2007 averaged $121,000 in outstanding mortgage debt. Governments, particularly Western ones, immiserated future generations by selling trillions of dollars' worth of bonds. No one, it seemed, was immune to the allure of cheap credit.

The big exception to the spending spree? Corporations. Aside from the profligate financial sector, big business behaved quite responsibly over the past five years. They paid down debts, steered away from short-term financing and, most important, hoarded cash to prepare for rainy days. Now, with cloudy skies stretching to the horizon, cash-rich companies are being lauded by investors—an ironic turn of events, given that as recently as early 2007 many of the same investors considered cash to be an albatross. But will an overflowing bank account be enough protection against the worst financial meltdown since the Great Depression?

The cash wealth of the world's large corporations is truly impressive, and stands at record levels. By 2006, the average firm held 23 percent of its assets in cash, up from 10 percent in 1980, according to one academic study. For some firms, the numbers are breathtakingly large. Pharmaceutical giant Johnson & Johnson sits atop a $15 billion treasure chest. Microsoft has enough to buy Yahoo at full price—and in cash—and still have $4 billion left over. And at $38 billion, ExxonMobil's cash on hand is roughly equal to the GDP of Syria. "Companies are going into this recession much stronger than they went into the last recession," says Carsten Stendevad, head of financial strategy at Citigroup.

Balance-sheet strength has made the credit crunch easier to bear for many companies. So far, stock-market investors have shown a willingness to reward big savers; cash-rich companies have outperformed their peers by 4.3 percent since the credit markets seized up in mid-2007, according to a report by Stendevad and others in Citigroup's investment-banking division. "If you exclude banks and auto companies, we haven't seen many Fortune 500 companies in distress yet," says Stendevad, "despite the world potentially entering the worst economic situation in the last 70 years." He adds, "That's in part because of this preparedness." With the global economic outlook bleak, investors are willing to pay a premium for foresight.

Managers might be forgiven for wanting to say "I told you so." After all, if they had listened to the most vocal investors two years ago, today they'd be cashless and dependent on a credit market that's all but ceased to function. Back in 2006 and early 2007, when debt was cheap and the only requirement for a loan was a signature and a pulse, some analysts saw cash as a sign of needless caution, and companies with a lot of it traded at a slight discount. Activist investors pressured corporate managers to open the floodgates. Stock buybacks and dividends were quick ways to spend down those piles of cash and quickly lift a company's stock price, they argued. The activists won some victories. Chevron and other commodities companies, awash in surpluses, have spent tens of billions of dollars repurchasing stock. Microsoft has done the same. And since 2003, almost every company in the S&P 500 has raised its dividend payments.

Nonetheless, the corporate coffers grew fatter and fatter. Partly this was because of record profit growth—for 18 consecutive quarters between 2002 and 2006, corporate earnings grew at a double-digit clip. Chief executives simply couldn't find a way to spend it fast enough. Even Federal Reserve chairman Ben Bernanke lamented the "softening in demand" for business spending in early 2007. It was easier to burn cash in the 1990s, when the torrid pace of innovation and the spread of the Internet required companies to upgrade their information and communications technology. Of course, that left a lot of companies cash-strapped when the dotcom bubble burst, and corporate default rates surged to 10.6 percent in 2001. That was a powerful lesson, and served to accelerate corporate Darwinism—the executives left standing in 2002 had a profound respect for cash.

Kevin Warsh, a governor at the Federal Reserve, surmises that globalization may have played a role, too. When multinational companies earn profits overseas, they face a tax hit when they bring the money back into the United States or Europe. "Many companies have an incentive to leave those funds with their foreign subsidiaries," Warsh said in a 2006 speech. That encouraged managers to park foreign earnings in overseas money-market funds indefinitely. Indeed, the facts bear him out: multinational firms became much more cash-intense more quickly than domestic-only companies.

Whatever the reason for the buildup, CEOs are now happy to have their cash cushions. But do they have enough to weather the storm? Mark Zandi, chief economist of Moody's, says they don't. In normal times, cash is meant to be spent, but in this environment, it's more like an insurance policy against catastrophe. That makes corporate cash reserves less like a checking account and more like China's $2 trillion foreign-currency hoard, which protects against a currency collapse. The parallels don't stop there: China, Brazil and other large emerging markets have followed sound policies in the past decade, building up reserves and adopting prudent economic policies—just like Fortune 500 companies. And just like China and Brazil, good behavior hasn't immunized them from the financial contagion spreading around the globe. "Most nonfinancial businesses did all the right things coming into this downturn," says Zandi. "But they've been overwhelmed by how bad things have gotten—how bad the collapse in sales has been, how tight credit has become."

The situation is worse at the bottom of the corporate pyramid. Some smaller companies, especially those targeted in leveraged buyouts, are saddled with debts that may go unpaid now that the economy is crumbling, and there's little chance they'll be able to woo new lenders any time soon. But even AAA-rated businesses like ExxonMobil would pay a hefty premium to borrow should they need to, says Zandi, and they worry that the premium could grow even larger. Worries like that cause even cash-rich companies to wish they had more of the green stuff, and they're cutting jobs and investment to avoid tapping into whatever they already have. "If they run out of cash, they're not sure where they can turn to," says Zandi; the troubles in the financial sector make their piles look puny in comparison. So while conventional wisdom holds that cash is now king, it lacks the magisterial authority to make problems disappear.