Business investment has lagged other components of the economy for several years and some analysts are wondering if companies will ever open their wallets for anything more than dividends and buybacks. The age of capital equipment and structures is reaching record highs and has limited productivity growth. A confluence of sentiment and necessity may finally drive higher spending this year. Investments in companies that provide industrial goods could surprise on the upside with higher revenue and strong cash flow.
A trade-off to those dividends you’ve been receiving
Five years into the recovery and most economic data has come back close to where we were at before the recession. The market indices are making fresh highs and household wealth has more than recovered. Even the jobs picture, though slow to recover, has passed several milestones.
One piece of the economy continues to lag in this cycle, capital spending. Like those increasing dividend payments and historic buyback programs? It’s because businesses have not been investing in long-lived equipment or projects. Cash has been building up on the balance sheet but no one wants to spend it.
Businesses spent just 13% of GDP on non-residential fixed investment last year, well under spending over most of the last decade. Normally this business investment in long-lived equipment and structures drives a strong rebound in the economy and improves productivity. Over the last five years, spending has failed to keep up with depreciation. Productivity has gradually fallen and capital stock of equipment and structures has reached record ages.
The average age of equipment is now 7.4 years, the oldest since 1995, with both transportation and communications equipment reaching record highs. The average age of non-residential structures is now at 22.2 years, the highest since 1964. Within structures; manufacturing facilities, lodging structures and communications structures have all reached record ages.
While higher dividends and buybacks are great, the lack of spending could eventually hit profitability. Old equipment and structures are not as productive as new structures and lower depreciation will not reduce taxes as much. Productivity growth on an annual basis has been constrained to under 2% since 2011, well under the growth seen in previous cycles.
Liz Ann Sonders of Charles Schwab thinks this year could be the turnaround. A perfect storm of rising CEO confidence, stable balance sheets and strong trends in commercial lending could combine to drive a recovery in investment. Management will need to act quickly, the chorus of activist investors demanding companies use cash or return it to shareholders is growing louder every year.
Industrials with diversified products
While a wide range of industries may benefit from higher corporate spending on equipment and structures, those selling industrial products may do especially well. Many of these companies, the large conglomerates in particular, have lagged by a wide margin as sales stagnated over the last several years. Sentiment is low on the shares and a boost in capital spending could drive significantly higher prices in addition to higher cash flow.
3M Company (MMM) provides products and services to nearly every sector with industrial products accounting for 34% of 2012 sales. Beyond industrials, the company reports in four other segments; Safety & Graphics (18%), healthcare (17%), electronics & energy (17%) and consumer (14%).
Sales have increased at an annualized pace of 4.1% over the last five years though growth was just 0.6% last year. Expenses have grown by slightly less, an annualized pace of 4.0% over the last five years, so earnings have increased over the period. The company had $3.3 billion in cash against $4.3 billion in debt as of the last quarter.
3M is an impressive cash flow machine with $4.1 billion in free cash flow last year without a decrease in its own capital spending program. The total dividend payout was increased by 1.1% last year, well below the 4.3% annual pace over the last five years, but the company expanded its buyback program significantly. Total cash returned to shareholders totaled more than $6.9 billion last year, nearly 8% of the company’s market capitalization.
Shares trade relatively expensively at a price of 5.1 times book value against an industry average of 2.8 times. Management will probably continue to return cash to shareholders in the form of a buyback so this should help drive the stock higher along with the 2.5% dividend yield.
General Electric (GE) is a $263 billion behemoth providing industrial goods to every region and nearly every sector of the economy. Power & water is the largest segment at 19% of 2012 sales, followed by aviation (14%), healthcare (12%), oil & gas (10%), energy management (5%), home & business solutions (5%) and transportation (4%). The company also runs its own financing segment that provides lending to the other segments and accounted for 31% of 2012 sales.
The company recently filed a registration statement for an IPO of its retail finance business. The company may not divest of the entire business immediately in the IPO but the partial spin-off means a more focused and less volatile company.
Sales have decreased at a pace of 4.4% over the last five years though the loss stabilized to a drop of just 1% last year. Expenses have declined by similar percentages over the same periods and earnings have managed to increase on higher margins and lower taxes. The company had $132.5 billion in cash against $221.7 billion in debt at the end of the last quarter. While cash flow is not quite as impressive as 3M, the company did manage to generate $15.1 billion in free cash flow last year on only slightly lower spending.
The total dividend payout last year increased by just 1.7% to $7.8 billion though the company did pay off $16 billion in debt. The shares pay an attractive 3.4% yield and could return more cash to shareholders on a more certain business environment. The potential for total return on shares is very attractive with the stock trading for just 2.0 times book value against an industry average of 2.8 times. Any improvement in sentiment could send the share price significantly higher.
Most companies think well ahead when they are setting their dividend payout policy and those quarterly checks will continue to come regardless of higher capital spending. Share buybacks for some companies may be reduced but the large pile of cash on corporate balance sheets should keep total cash return fairly high. Lagging capital spending has failed to rebound for so many years that analysts are not expecting a change. If it does rebound this year, companies that make industrial products could see a strong jump in sentiment and cash flow.
Thanks for the post Zach. This business cycle is a crazy one. Capital spending has been rotten for years as businesses are unwilling to buy all but their most essential goods. With so much fear in the market i would say that it’s a great time to invest, but at 5 years old…….history suggests this bull market in stocks is on borrowed time. That being said, historically, large cap industrial companies are the last ones to rally…..
-Bryan
I’d love to see capital spending pick up and I’d take that as a sign that management’s across the board are expecting an improved economic climate. The recovery has been painfully slow and it’s a bit of a double edged sword that managements are wielding. They are building up cash reserves to give them cleaner balance sheets and also out of fear of a lackluster recovery/potential new recession in the works but the economy struggles because companies aren’t loosening their purse strings to spur on economic growth. I own GE and recently added to my position there as well and would love to get my hands on some 3M but it’s a bit richly valued for me personally.