Passing the buck-Greenback- 8th August 2002

Stephen Ellis - The Australian

US investors want dividends, not promises

AFTER all the hand-wringing over the tech crash, now comes the anguish over tech cash. The most successful US technology companies are drowning in money, much generated in the 1990s.
Now prospects aren't looking so bright, their owners would like some of that money back.
Until recently, fast-growing US companies successfully argued to shareholders that any free cash generated by the business should be retained, since it could generate higher returns internally than were available elsewhere.
This reasoning is why Microsoft has never paid a dividend. The argument was compelling: are you really smarter than Bill Gates when it comes to re-investing the dollar he just made for you?
But now that the technology sector is out of favour, a handful of large companies that piled up huge quantities of cash in the past (and in many cases continue to do so) are coming under pressure from institutional investors to release some of it.
Microsoft's extraordinary $US39 billion ($74 billion) hoard, which grows another $US2 billion or so every quarter, is well known. But it is trailed by plenty of others with cash and liquid investment positions that are almost as impressive.
Intel has $US10 billion in cash alone. Cisco has $US9 billion of cash, plus another $US12 billion in investments (though how much of the latter is liquid these days is open to question).
Other technology firms that notched strings of hefty profits in the 1990s have also built up cash positions that are large relative to their operations. Oracle has $US6 billion in cash, Sun $US5 billion, Dell $US4 billion, EMC $US2 billion, and Veritas $US2 billion.
Out of all the above firms, only Intel presently pays a dividend -- a nominal 2c a share per quarter.
In possessing big piles of cash at the end of a decade-long economic upswing, the technology firms are hardly alone. Plenty of firms in cyclical capital-intensive industries also try to build up reserves during the good times to protect themselves against downturns, when their high-fixed-cost businesses eat cash.
The US auto makers are a classic example. GM currently has $US18 billion on hand, while Ford has $US16billion. But in each case, that stash could be totally dissipated if the firm faced two or three really bad years. The US airlines would love to be able to do the same thing, but seldom enjoy the margins during good times needed to cushion against the bad.
Big technology companies are quite different. Their business models are not particularly fixed-cost or capital-intensive (although some hardware firms are a partial exception) and involve fat gross margins.
Software firms, in particular, are able to throw off massive quantities of cash relative to sales if they have the right product at the right time. And most large-cap technology firms are able to cheaply downsize in the face of a downturn -- their key assets are brands, intellectual property and people, rather than capital equipment or costly inventories and distribution channels.
So there is no particular operational imperative to conserve cash. Rather, until recently, the reasons that tech companies have put forward for not paying dividends have had more to do with a track record of high rates of internal return, the need for ``strategic flexibility'', and R&D.
And, not least, with tax.
But strategic flexibility (or, more crudely, having enough cash to buy up others or at least hold the whip hand in a merger) is no longer a favoured argument; too much shareholder value has been destroyed in acquisitions by the likes of Cisco and even Microsoft.
And investors are also increasingly questioning huge R&D programs that many big companies have under way, in the absence of quantifiable results.
In fact, now the pressure is on from investors to start paying dividends, the tax argument is by far the best defence available to technology executives.
The US may have one of the lowest proportions of tax to GDP of the rich countries (among traditional OECD members only Japan and Australia are lower), but its income and corporate tax systems are highly complex and include distorting features such as double taxation of dividends. Dividends are taxed at the effective corporate rate of about 35 per cent, and then again at the average federal-state personal rate of around 40 per cent, leaving only about 40 cents of every dollar in the hands of the shareholder.
(Paul Keating abolished double taxation of dividends in Australia in 1987, encouraging companies to focus on generating franked payouts to shareholders. It's plausible that this is one of the reasons Australia's equity market largely escaped the US excesses of the late 1990s.)
While the US tax system remains skewed towards capital gains (taxed at a federal rate of 20 per cent), US technology companies will always be able to effectively argue that they should hold the cash they generate -- purely in the interests of their shareholders, of course.
Given the tax environment, share repurchase schemes are one relatively tax-efficient way to return cash to investors. But few companies are aggressively accelerating their repurchase schemes at present.
Any time large amounts of surplus cash are left idle in the hands of management, shareholders rightly worry about what might happen to it. Assuaging these fears is one of the most important tasks that the big technology companies have right now. So far, they are doing a poor job.


Back