Cash in Fashion

With interest rates likely to rise in the months ahead, it's time to give props to the cash-rich and debt-poor companies out there. While the Fed's stance on easing interest rates in the past may have lulled many into thinking that leveraging on the heels of rock-bottom borrowing rates was a sound strategy, that boomerang is starting to whip its way back. Fiscal prudence is back in vogue, baby. Be ready. Be green.

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By Rick Aristotle Munarriz (TMF Edible)
April 25, 2002

The best cushion is a cash cushion.

I know, the notion of greenbacks reigning supreme may seem outdated. The way Alan Greenspan and his Fed cronies kept whacking at borrowing costs, it was almost embarrassing to be debt-poor during the golden age of refinancing. Whether you were looking to trade in your car for a new set of wheels or add that patio deck you've always wanted, cheap money shouted from the collateralized rooftops. In many cases, you listened.

But what if you were publicly traded? What if all you saw was cash-rich companies get punished with ever-shrinking yields on idle funds while the borrowers were slapping on the fruits of leverage like tanning oil on a beach day? Wouldn't you too follow J. Alfred Prufrock out to the shoreline?

I hope not. See, the days of the Fed getting down on the interest-rate dance floor are toast. While you won't get any two economists to agree on when Greenspan will begin raising lending rates or how high the Fed will ultimately go, the direction of borrowing costs is practically a given.

So what, you say? Well, if you fancy the debt-heavy, an up-tick in interest rates will create a double-edged sword. As those high on debt find their interest payments inching higher at every financing juncture, those with greenbacks to spare will be greeted with larger interest checks. Do you realize that a shift in interest-related overhead in any given industry creates pricing flexibility for those rolling in money while tightening the screws on those living on borrowed time?

Consider the ultimate cash pi�ata, Microsoft (Nasdaq: MSFT). With $38.7 billion in cash and short-term equivalents, the company's finances have more than a passing interest on interest. If the software giant were to earn a 3% yield on its liquid fuel, that would translate into $1.2 billion in pre-tax profits. On a per-share basis, every 100 basis points in interest-bearing power tacks on an extra nickel in post-tax earnings.

Short-term rates have been rocked hard over the past few quarters. Vanguard's popular Prime Reserves (Mutual Fund: VMMXX) money market fund is yielding less than a third of what it was at the start of last year. Let the tide shift back with an equal vengeance and we're looking at an extra quarter per share in Microsoft's annual earnings.

In the case of cash-heavy Apple (Nasdaq: AAPL), the impact is even greater. Every full interest point that the company is able to squeeze out of its net cash holdings is worth an extra $0.11 a share in earnings before taxes.

While Gateway's (NYSE: GTW) fundamentals are having a cow, the company expects to close out the year bloodied but with a billion bucks to spare in the bank. Analysts expect the troubled box maker to lose $0.08 a share next year. While analysts are quick to plug hunches into projection models, they often gloss over the impact of interest rates. In Gateway's case, it's an oversight that can prove to be consequential. If interest rates were to creep 300 basis points higher, meaning, for example, that the company is able to earn 6% on its cash balance next year as opposed to just 3%, it's a whole new ballgame. Next year's loss would become a penny-a-share profit.

By definition, short-term investments have near-term maturities. So if higher interest rates are there to be had, they will be marked up sooner rather than later. It's a bit different for long-term debt. Companies who were lucky enough to lock into last year's low rates should be able to milk those cheap rates for years -- if not decades. However, you still have to deal with adjustable rate credit lines and the fact that debt is a piper that eventually begs to be paid and the further you go out on the yield curve, the wilder the pitches get.

Let's take a closer look at the harder side of Sears (NYSE: S). Saddled with $18 billion in long-term debt, the retailer had to pay $292 million in net interest expense payments this past quarter alone. Reduced by the company's 34% tax rate, that's still a huge $0.59 a share hit for the March period's profit showing. Analysts expect the department store chain to earn $4.80 a share this year. If Sears was debt-free that figure would be 50% higher. Sears woe buck?

Granted, retailers love to shop on credit. Even the mighty Wal-Mart (NYSE: WMT) has $15.7 billion in outstanding IOUs. You have to cut through the strip malls and head out to the suburban shopping centers to find specialty retailers like Hot Topic (Nasdaq: HOTT) and Abercrombie & Fitch (NYSE: ANF), which avoid debt like last year's fashion line. But opportunities exist in competitive industries in which not all of the balance sheets are created equal.

We covered Microsoft, in a software sector in which companies have plumped themselves senseless with cash through high-margin operations but also by hitting the market up for more money through stock offerings not because it had to, but, gosh darn it, because it could. The bankable asset-rich like Oracle (Nasdaq: ORCL) and Siebel Systems (Nasdaq: SEBL) have little to fear with their juicy cash hoardings. However, can the same be said for Computer Associates (NYSE: CA) after paying out nearly a billion dollars in interest over the past three years?

In the commoditized field of gold, it's worth noting that Barrick Gold (NYSE: ABX) sports about as much in long-term debt as it does in cash and short-term equivalents while top rival Newmont Mining (NYSE: NEM) closed out 2001 with more than four times as much debt as it did cash. Which company is better suited to cope with a higher interest rate environment? Barrick, naturally.

Business is a footrace. When you create a scenario where the nimble grow wings while the debt-laden get shackled with extra leg weights, the disparity widens all the way to the finish line. Who will have to raise prices to keep up with the higher overhead? Who will be able to lower prices thanks to its cash-filled sandbags? Who will lose customers in the process? Where will they turn? If you've tried to single out winners and losers in any industry and given balance sheets little more than a cursory glance, look again. Cash and debt levels are potent financial concentrate -- just add interest.

So you have Intel (Nasdaq: INTC) and Advanced Micro Devices (NYSE: AMD) duking it out in the microprocessor space. While each company is quick to point out the superiority of their personal computer chips, fiscal scrutiny is far more objective. Both companies closed out the March quarter with $1.1 billion in long-term debt. However, Intel also brings $10.8 billion in cash and short-term equivalents to the table. AMD, on the other hand, can pony up just $1.3 billion. So who has the real pricing flexibility in a price war? If Intel were to challenge AMD to see who could hold their breath underwater the longest, who would be the last one standing?

Something borrowed can also be something blue. Go green instead.

Rick Aristotle Munarriz doesn't keep a whole lot of cash in his wallet at any given time. What a hypocrite. Rick's stock holdings can be viewed online, as can the Fool's disclosure policy.