Distress Costs, Cash in the books and Value Investing

Cash on the books is always a great sight to see. Ample cash on the books though sometimes becomes an eyesore. Questions and concerns begin to rise regarding the use(or misuse) of the powder keg the management is sitting on. During a hammering, value investors cut from the Graham cloth swoop in screaming “bargain” and eyesight set clearly on that cash in the books.

But it is important for us to also understand that not all dollars are made equal, not all industries function similarly and not “all” inordinate amounts of cash is necessarily high. The traditional wisdom stands good still for the old economy companies. However it fails to explain the unusual circumstances for the knowledge companies.

The factor of intangible assets

Intangible assets play an important role in the economic well being of modern day knowledge companies. For a pharma company, the knowledge of the drugs, molecules, well trained manpower, research pipeline et al. are the veritable intangible assets in its balance sheet. A few years ago, Infosys created a big hullaballoo by discussing the prospect of including its human resource capability in its balance sheet (as fixed cost).

Quite surprisingly, the grey area of finance and economics mix with subjectivity of human perspective mix quite well when evaluating these intangible assets. How will you value the presence of Ajay Piramal as the new manager of one of your investee companies? How will you weigh the enormous goodwill a brand like American Express or MasterCard commands?

The scenario is quite like the old philosophical adage- if a tree falls in the forest and noone is there to hear it, did it really fall? When there is no one to value or place a premium on an intangible asset of the company, is it really of any value(in accounting terms)?

But it is of value. It is of supreme value to the company itself. It is the very blood of economics for these knowledge based companies. The fact is market too realises this. In 2000s, about 30% of Pfizers valuation was based on its R&D expenditures.

However if the company is sold to an outsider, it will be difficult to put a dollar value to it. Hence in absence of such a “clear” signal, the company has to take the onus on itself to protect its intangible assets at all costs. Necessarily, all the expenditures needed to maintain it is also of paramount importance.

To take this point a bit further, any contingency which develops in this department also has to be satisfactorily met at all times. Thus quite a many company, desire to take debt in their books to bolster their cash levels and choose to pay off the interest cost out of their cash flow.

This added burden of tax also provides a tax shield, as long as return on capital of the business is more than the cost of debt.

Distress Costs

But imagine if a company is in a net cash position and yet it is facing an intangible asset distress. For starters consider a near-complete wipeout of an IT company’s human resource by a man-made accident. For old economy companies a distress originating from debt is analogous to distress originating from intangible assets for knowledge based companies.

The possibility of such distress has to be matched with a distress cost for an owner-manager of a knowledge company. As a result, the distress cost arising from a distress(be it debt based or intangibles based) will be the financial impact of that default weighed appropriately by the probability of it occurring .

In light of such circumstances, a rational owner manager will seek to maintain enough liquidity at all times to comfortably sail through such distresses. This also explains why some companies have very high cash in their books without thinking about either distributing it, or investing it in other businesses. It is not up for distribution or investment because it IS already invested- it is invested in the core operations itself.

Thus the key takeaway from this discussion is:
1. Don’t judge the high cash in the books position by comparing it with other current assets. It is to often to fund the intangible assets/it distress of the company.
2. A cash bargain it is when, the holding cash in the books significantly outstrips the market capitalization and the distress cost of its intangible assets.

This in peripheral way also explains why a particular industry can horde significant amount of cash while the other industries don’t.
Consider the following table.

Cross Sectional Analysis

While all the industries save for the last, are knowledge based companies all of them have different average cash to net sales ratio. For a ratings business, the chances of meeting with a distress is pretty low(due to inherent economic advantages), whereas for the IT industry (a fragmented, highly competitive sector) the chances as well as the costs must be very high indeed.

However for an Indian railway wagons business, its intangible assets are pretty light. It has to have a huge and big pipeline of technology innovations to have something otherwise. As a result, an outsider can properly value its assets and thus the cash needed to tide over an intangible assets distress is pretty minimal.

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