>FINANCIAL STRATEGY: POSITIONING FOR RECOVERY (CITI)

■ Corporate Valuations Shifting to Growth
In the aftermath of the Lehman bankruptcy last September, firms around the world embarked on drastic steps to preserve liquidity. Companies undertook deep cuts in capex and operating expenditures, a near halt of share buyback programs and the fastest increase in dividend cuts in fifty years. During this period of extreme volatility in capital markets and uncertainty in the global economy, investors rewarded firms that demonstrated strong financial flexibility — valuations of companies with higher on-balance sheet liquidity than their industry peers outperformed those with below-industry liquidity by 15.7% (Figure 1). Similarly, firms with a stronger ability to fund capex with internal cash flow and less risk of refinancing outstanding liabilities compared to industry peers also outperformed. Thus, enhancing corporate liquidity and preserving financial flexibility was the optimal financial strategy for most firms.

With prospects for the global economy stabilizing and a sharp resurgence in capital markets, extreme risk aversion is abating. As a consequence, there are signs of increased investor risk appetite and growth has returned as a key driver of equity valuation. Figure 1 shows a decomposition of P/E multiples for non-financial companies that belong to the MSCI Global Index (as of December 2005). It displays the PE multiple as the sum of two parts — the base component that reflects the value of the existing earnings stream, and a growth component that captures the value of the expected future earnings growth. Prior to the crisis, MSCI constituent companies typically derived two-thirds of their value from their current earnings stream and one-third from expected growth prospects. Since October 2008 and continuing into the spring of 2009, the expected value of growth essentially disappeared as investors focused primarily on survival. As valuations and market confidence have rebounded over the past few months, the importance of growth has returned sharply. In fact, given the relatively low current earnings of many companies, the growth premium is a bigger component of the P/E multiple than ever before, accounting for 40% of overall value. These valuation dynamics imply that it is now time to adjust corporate financial strategies to focus on future growth once liquidity and balance sheet risks have been addressed.

■ Widening Gap Between Strong and Weak
The past year has been challenging for companies across all industries and geographies and the economic and financial stabilization is welcome news universally. But the past year has had a very asymmetric impact on firms – in most sectors the gap between strong and weak players has widened considerably. This in turn is creating strategic opportunities for industry leaders.

To illustrate this widening gap, we analyzed the financial metrics of companies in the MSCI Global Index on an industry-adjusted basis. For each industry, we calculated the 25th percentile, median, and 75th percentile of various financial metrics. These numbers were then aggregated across industries to reflect economy-wide patterns

■ Capital Deployment Lessons From Past Cycles
As companies begin to re-focus on growth strategies, they will have to carefully allocate financial resources in a way that capitalizes on strategic opportunities created by the crisis without undermining their financial flexibility. Clearly, a large part of this question will be company and industry specific. Yet a review of capital allocation decisions over the past few cycles provides interesting insights for today’s decision, even if the optimal path to earnings growth will look very different today compared to the past.

Consider how US companies have pursued capital deployment over the past two decades. For much of the 1990’s and through 2004, US companies deployed about twice as much of their cash flow towards capex and M&A as they did for capital distribution (Figure 5). After 2005, however, US companies spent as much on dividends and share buybacks as they did on capex and M&A. As a result, US companies have spent a lower fraction of their cash flows on investing in growing the business in the past 5 years than at any other point in the last 20 years. The increase in share buybacks has been particularly pronounced for large firms — between 2003 and 2008, share buybacks accounted for one-third of EPS growth for the largest 100 US firms.

European and Asian firms followed a somewhat similar investment pattern although they deployed more capital towards capex and M&A than for capital distributions compared to their US peers (Figure 7). Since European and Asian firms generally do not report quarterly results, any pullback in capital deployment would only be apparent once full year 2009 financials are released next year.

■ Implications for Corporate Finance Strategy
The current economic and capital markets environment suggests that it is time to reconsider many of the financial policies that companies across the globe have adopted over the last twelve months. As economic indicators have improved and capital market conditions have resumed normalcy, strategies centered on preserving or improving liquidity may no longer be optimal for some companies. At the same time, it would be premature to dismiss the possibility of downside economic risks. Hence, companies need to balance the investor focus on growth with the prudence of maintaining a strong financial flexibility and profile.

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