Capital Spending: A Cue For Growth

5/21/2012


Executives enjoy a big advantage over shareholders when it comes to knowledge of their company's performance and prospects. Unfortunately, most executives keep such details close to their chests, leaving shareholders to pick through management chatter and financial filings.

Easy-to-spot clues include dividend hikes, which can signal confidence in future cash flow, and share repurchases, which can signal that management sees its stock as undervalued. But capital-spending plans, which can reflect management's belief that demand for its products will remain strong, don't always attract investor attention.

In theory, capital projects lay the foundation for future profits. Through such investments as replacing obsolete equipment, building or upgrading factories, or expanding into alternative product lines, a company expects to reap rewards in coming years.

S&P 500 companies have ramped up spending. Capital spending for the companies in the S&P 500 Index reached $523 billion in 2011, within 2% of the 2008 peak. Expenditures grew 17% last year; the second-highest growth rate since 1994. Capital spending for S&P 500 companies in the December quarter exceeded the 10-year average in nine of the 10 market sectors, according to FactSet Research.

That aggressive spending does not spring out of nowhere, as cash flows have also risen strongly. The proportion of cash flow diverted to expenditures has hovered around 40% in the past two years, the lowest level since 1993, signaling that many companies remain cautious.

Academic studies suggest that markets often react positively to announcements of higher capital spending, especially for companies operating in high-growth industries. But follow-up reporting is limited, hindering investors' ability to evaluate the success of individual projects.

Rather than trying to evaluate each project on its own merits, we use return on investment to help us gauge the effectiveness of a company's spending. For example, both Hewlett-Packard ($22; HPQ) and IBM ($199; IBM) pumped a total of about $12 billion into capital projects in the past three years.

H-P's spending set all-time highs in each of those years, even as return on investment slumped more than six percentage points to 12% in fiscal 2011. Alternatively, IBM's return on investment rose to a record 36% from 28% three years earlier.

Moody's sees capital expenditures rising marketwide in 2012, and several of our recommended stocks have projected higher spending, as shown in the linked table. Three of these stocks are reviewed in the following paragraphs.

AGCO ($41; AGCO) targets a record $350 million in capital expenditures in 2012, up 17% from last year. More than half of the spending will fund manufacturing-related projects such as improving productivity at factories and establishing assembly plants in China. Capital outlays will likely remain elevated for the next couple years as the company pushes further into Asia and Eastern Europe. It will also cut into free cash flow, expected to exceed $200 million in 2012, versus a record $426 million last year.

After AGCO's bullish forecast earlier this month, rising analyst estimates call for 23% higher per-share profits this year on sales growth of 17%. However, the shares haven't yet caught up to the new growth targets, trading at just eight times estimated 2012 earnings, a 43% discount to the median for industrial stocks in the S&P 1500 Index. AGCO is a Focus List Buy.


Bed Bath & Beyond ($71; BBBY) has earmarked $275 million to $325 million for capital expenditures in the fiscal year ending February 2013, up from $243 million last year. The homefurnishings retailer plans to open about 40 stores, roughly in line with the 38 new locations added last year. Management believes the U.S. and Canada can sustain more than 1,300 of its namesake stores; it currently operates nearly 1,000. Addressing the shift toward online shopping, this year the retailer expects to open its third e-commerce distribution center, revamp its website, and build a new data center.

Earlier this month, Bed Bath & Beyond agreed to purchase Cost Plus ($22; CPWM), a discounter that sells homefurnishings, specialty foods, and other exclusive products imported from more than 50 different countries. Valued at roughly $494 million in cash, the acquisition will be the biggest in Bed Bath & Beyond's history. The deal resembles three others made in the past decade, when the company expanded its product mix by purchasing retail chains geared toward baby supplies, beauty products, and even Christmas decorations. At the end of February, Bed Bath & Beyond held $1.76 billion in cash (more than $7 per share) and no debt. Bed Bath & Beyond is a Focus List Buy and a Long-Term Buy.


Macy's ($37; M) delivered 6% sales growth in fiscal 2012 ended January and in fiscal 2011. But while most retailers pursue growth through aggressive expansion, Macy's has notched its gains in large part by making better use of assets already in place. Its store count declined 1% last year and has contracted 3% since fiscal 2006, as the company closes more stores than it opens. By improving product assortment and capitalizing on peers' missteps, Macy's same-store-sales growth has outstripped the average for department stores in 16 consecutive months.

Macy's targets capital expenditures of $850 million in fiscal 2013, the most in five years, funded exclusively through internal cash. The retailer plans to remodel existing stores, upgrade its distribution network, and build a new fulfillment center. Macy's also plans to stick to its conservative growth strategy, opening fewer than 10 stores in the current fiscal year and a similar amount next year. With an Overall score of 93 and sector-specific scores of at least 95, Macy's is a Focus List Buy and a Long-Term Buy.

 

RECOMMENDED COMPANIES REINVESTING IN THEMSELVES
Capital Spending
-- 5-Year Annualized Chg. --
Est. Current-
Year Change
Return On
-- Investment --
------ Quadrix Scores ------
Company (Price; Ticker)
Last
Fiscal Yr.
($Mil.)
Estimated
Growth,
Curr. Yr.
(%()
Capital
Spending
(%)
Sales
(%)
Cash
Provided
By Operations
(%)
Earnings
Per Share
(%)
Sales
(%)
Current
(%)
3-Yr.
Avg.
(%)
Momen-
tum
Quality
Overall
Advance Auto Parts
($81; AAP)
268
8
1
6
20
17
5
30
22
88
90
95
AGCO ($41; AGCO)
300
17
18
10
10
13
15
16
10
68
90
94
Apache ($83; APA)
7,078
38
5
16
18
6
9
12
5
64
78
91
Apple ($553; AAPL)
4,260
88
45
41
76
71
50
49
38
99
100
100
Bed Bath & Beyond
($71; BBBY)
243
24
(5)
7
15
14
8
25
19
85
94
95
CF Industries
($164; CF)
247
62
33
26
59
5
(4)
24
20
89
100
100
Chevron ($101; CVX)
26,500
23
14
4
11
0
10
21
18
59
80
95
DirecTV ($47; DTV)
3,170
4
10
13
10
26
10
23
16
81
96
98
Dover ($57; DOV)
272
19
7
4
4
16
11
12
10
55
77
83
Exxon Mobil
($82; XOM)
30,975
19
15
5
2
(1)
3
23
22
59
75
93
Intel ($27; INTC)
10,764
16
13
9
15
3
6
24
19
45
95
95
Macy's ($37; M)
555
53
(16)
0
(11)
17
5
11
NM
84
61
93
Microsoft
($30; MSFT)
2,355
6
8
10
13
1
6
32
38
63
92
96
Notes: Quadrix scores are percentile ranks, with 100 the best. Some capital-spending projections represent midpoints of growth-estimate ranges.     NM Not Meaningful.

 


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