(FROM THE WALL STREET JOURNAL 5/27/15)
By Vipal Monga, David Benoit and Theo Francis
U.S. businesses, feeling heat from activist investors, are
slashing long-term spending and returning billions of dollars to
shareholders, a fundamental shift in the way they are deploying
capital.
Data show a broad array of companies have been plowing more cash
into dividends and stock buybacks, while spending less on
investments such as new factories and research and development.
Activist investors have been pushing for such changes, but it
isn't just their target companies that are shifting gears. More
businesses sitting on large piles of extra cash are deciding to
satisfy investors by giving some of it back. Rock-bottom interest
rates have made it cheap to borrow to buy back shares, which can
boost a company's stock price. And technology-driven productivity
gains are enabling some businesses to do more with less.
As the trend picks up steam, so too has debate about whether
activist investors -- who take sizable stakes in companies, then
agitate for changes they think will boost share prices -- have
caused companies to tilt too far toward short-term rewards.
Laurence Fink, chief executive of BlackRock Inc., the world's
largest money manager, argued as much in a March 31 letter to
S&P 500 CEOs. "More and more corporate leaders have responded
with actions that can deliver immediate returns to shareholders,
such as buybacks or dividend increases, while underinvesting in
innovation, skilled workforces or essential capital expenditures
necessary to sustain long-term growth."
An analysis conducted for The Wall Street Journal by S&P
Capital IQ shows that companies in the S&P 500 index sharply
increased their spending on dividends and buybacks to a median 36%
of operating cash flow in 2013, from 18% in 2003. Over that same
decade, those companies cut spending on plants and equipment to 29%
of operating cash flow, from 33% in 2003.
At S&P 500 companies targeted by activists, the spending
cuts were more dramatic. Targeted companies reduced capital
expenditures in the five years after activists bought their shares
to 29% of operating cash flow, from 42% the year before, the
Capital IQ analysis shows. Those companies boosted spending on
dividends and buybacks to 37% of operating cash flow in the first
year after being approached, from 22% in the year before.
While billion-dollar stock buybacks draw headlines, dividend
increases also are a big factor, according to data from Moody's
Investors Service. At the 400 nonfinancial U.S. companies that
Moody's rates as investment grade, the median percentage of cash
spent on dividends rose to 11.9% of earnings before interest,
taxes, depreciation and amortization, or Ebitda, in the third
quarter of last year, from 9.4% in 2013, to the highest percentage
since at least 2005.
Companies ranging from the industrial conglomerate DuPont Co. to
Apple Inc. are sending more of their cash to their shareholders
after coming under pressure from activists. General Motors Co.
announced a $5 billion stock buyback in March after investor Harry
Wilson and four hedge funds called on the company to return cash to
shareholders.
It is it too early to know how -- or whether -- the shift will
affect the overall economy.
Some economists predict an investment reduction will mean less
growth and fewer jobs. "If investment falls, then you're losing
demand in the economy, you're losing expenditures, you're losing
economic stimulus," says Steven Fazzari, an economist at Washington
University. "That's hurting jobs."
Other economists say it is appropriate for companies to focus on
enriching shareholders, who can then decide where to deploy the
money. To the extent buybacks and higher dividends push up stock
prices, they can contribute to what economists call the wealth
effect, where rising asset prices make consumers feel wealthier and
more confident about spending their money.
Hedge funds run by activist investors contend companies waste a
lot of money that they should send to shareholders instead. One
such investor, Carl Icahn, says activism with a long-term focus
improves the economy by promoting efficient use of capital. "With
many, many exceptions, this economy today is being dragged down by
too many mediocre CEOs, and it's dangerous if profitability is
going down despite interest rates being at zero," he says.
Business investment ticked up in April but remains sluggish and
uneven. In recent years, corporate investment in capital goods,
beyond replacing and maintaining existing assets, has grown slowly.
While falling technology costs may account for some of the trend,
companies have been slow to return to higher investment levels
since the financial crisis. "One could argue that this has not been
a good recovery for investment," says Christopher Probyn, chief
economist for State Street Global Advisors.
Capital spending by businesses accounts for about one-eighth of
all spending in the U.S. economy. Historically, it has been an
important driver of long-term growth, as upgrades make workers and
companies more productive, says Michael Feroli, chief U.S.
economist at J.P. Morgan Chase & Co.
Money plowed into dividends and buybacks doesn't disappear from
the economy. Its recipients can spend it, too.
But Washington University's Mr. Fazzari says that most stock is
owned by the wealthy, who tend to save more of their income. By
contrast, he says, many kinds of business investment -- from
building construction to equipment maintenance and purchases --
involve payments to contractors and suppliers who pay wages to
middle and low-income workers.
Many companies have made changes while under no direct threat
from activists. General Electric Co.'s institutional investors had
long urged the conglomerate to scale down its large lending
business. In April, GE said it would sell off that business and buy
back $50 billion of its stock.
The company said it chose to plow the proceeds into buybacks
because it already had made substantial acquisitions and has
invested sufficiently in its existing businesses.
U.S. Steel Corp. isn't buying back stock. But Chief Executive
Mario Longhi has imposed a new analytical framework under which
every proposed project must be linked to the value it could create
for shareholders. The more disciplined approach sets a higher bar
for R&D, which used to get a green light if it could simply
boost production, says Mr. Longhi.
U.S. Steel is under pressure from cheaper imported steel and has
a high cost structure because its blast furnaces are expensive to
turn on and off, says Mr. Longhi. The need to keep the company lean
and viable, he says, led to the changes.
Keeping activists at bay, he says, is a side benefit. "If an
activist decides to look at our company, I don't think they're
going to find a lot of room," he says.
Years of uncertain global demand and revenue growth, combined
with corporate-governance changes that have made it easier for
dissident shareholders to campaign for board seats, have opened the
door to investors with ideas for boosting stock prices.
The number of activist campaigns annually has risen 60% since
2010. Last year there were 348, the most since 2008, according to
data provider FactSet. An additional 108 were launched in this
year's first quarter. Activist funds now control nearly $130
billion in assets, more than double the amount they had in 2011,
according to hedge-fund tracker HFR, giving them the war chests to
target even the biggest American corporations.
Activists say they are strengthening companies that tend to
overspend and holding managers responsible to their ultimate
owners, the shareholders.
Network-equipment maker Juniper Networks Inc. came under
pressure last year from Elliott Management Corp., a New York-based
hedge fund. The fund criticized Juniper for spending $7 billion on
acquisitions and nearly $8 billion on R&D when its stock price
had underperformed the Nasdaq Composite Index by 63 percentage
points between the company's 1999 initial public offering and Nov.
4, 2013.
In February 2014, in an agreement with Elliott that avoided a
potential board fight, Juniper appointed two new directors and
announced a plan to repurchase stock and cut costs. The company
reduced its head count by 7% and repurchased $2.25 billion of stock
last year. This year it appointed two more directors after a joint
search, and it plans to buy back almost $2 billion more in stock
through 2016. The company paid its first-ever dividend last year.
It has borrowed money to fund some of the buybacks and
dividends.
In early 2012, New York investment firm Clinton Group Inc. took
a stake in teen-fashion retailer Wet Seal Inc. and began urging a
share buyback. In February 2013, the company disclosed it was
cutting jobs and expenses and would repurchase $25 million of stock
after appointing four Clinton representatives to its board.
This January, Wet Seal closed two-thirds of its stores and filed
for bankruptcy protection. In court documents, executives cited a
broader drag on teen retailers as well as missteps that alienated
core customers.
Others contend the buyback ultimately hurt the company. "If we
had rewound and . . . they hadn't done the buyback, that would have
given them substantially more flexibility," says Jeff Van Sinderen,
an analyst at B. Riley & Co. "In those situations, $25 million
dollars can go a long way."
The debate over R&D spending flared up at chemicals maker
DuPont amid pressure from activist Nelson Peltz and his Trian Fund
Management LP.
On May 13, DuPont won a proxy fight for board seats, in part by
arguing that Trian's suggestions to cut costs and break up the
company would get in the way of scientific breakthroughs, a concern
that struck a chord with some shareholders and academic
commentators. Trian had questioned whether DuPont's current system
of R&D can be successful, but said it wouldn't eliminate such
spending entirely.
Among other moves, DuPont increased its quarterly dividend in
April and has pledged to repurchase about $4 billion in stock after
a planned spinoff of its performance-chemicals business.
The choice between investments and shareholder returns isn't
simple. Apple, for example, has paid out more than $64 billion to
shareholders through dividends and stock buybacks since mid-2013,
when Mr. Icahn began pressing the company to stop sitting on so
much of its cash. Last month, the company boosted its dividend by
11% and increased its buyback plan by $50 billion, to $140
billion.
But Apple also has long pursued a disciplined approach to
R&D that has yielded much bigger payoffs than companies that
spent far more. Nokia Corp. outspent the iPhone maker on R&D by
a 4-to-1 ratio over the decade starting in 2001 but still ended up
an also-ran in the cellphone market it once dominated.
"The history of corporate America is littered with a long line
of companies that relinquished their leading industry position and
spent enormous resources attempting to reinvent themselves and
ultimately failed," activist fund Starboard Value LP wrote in a
letter to Yahoo Inc. in March as it pushed for a
multibillion-dollar buyback at the technology company.
Yahoo later decided to buy back $2 billion in stock.
The surge of activism has sharpened the debate about the
fundamental purpose of a company. Does it exist to satisfy
shareholders or does it have an imperative also to try to build for
the long term?
The answer is far from settled. If the activists are right, they
are stopping companies from throwing good money after bad.
"If they aren't, then we have to worry about the impact," says
Yvan Allaire, the executive chairman of the Institute for
Governance of Private and Public Organizations. "It has to be a
fairly significant impact on the economy.
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