Mysteriously Shrinking Cap-Ex

5/29/2017


During expansionary periods, business investment spending tends to climb at twice the rate of gross domestic product, say analysts at Goldman Sachs ($224; GS). In the current environment, that implies about 4% annual growth in capital spending. Yet capital expenditures — investments in long-term assets such as equipment and facilities — fell 8% in 2015 and 4% last year for companies in the S&P 500 Index.

Over the past 20 years, annual capital expenditures have contracted just five times. Lower spending in 2015 and 2016 stands out because the declines didn't occur in the aftermath of a recession.

A popular theory among investors is that dividends and stock buybacks have crowded out capital investment in the years since the Great Recession. That may be true to an extent.

Since 2011, dividends climbed at an annualized rate of 9%, while stock buybacks rose 8%. Capital expenditures declined at an annualized rate of 0.4%, well below the 20-year growth rate of 2.5%. Yet 2016 was notably weak for spending on dividends, up 4%, and share repurchases, down 6% — suggesting other factors may have contributed to the lower capital spending.

Executives' confidence in the economy may be one factor. Another is volatility in oil prices.

In both 2015 and 2016, capital expenditures plunged more than 30% for the energy sector but rose for eight of the other nine sectors. Stripping out energy, S&P 500 capital spending increased both years.

Improving operating momentum and business confidence could set the stage for a rebound in corporate investment. S&P 500 per-share profits are projected to surge 11% in 2017. Energy companies are showing signs of increased investment, as the U.S. rig count has more than doubled from an all-time low set in May 2016, according to Baker Hughes.


STOCK BUYBACKS EASE UP

Stock repurchases by S&P 500 companies totaled $536 billion in 2016, down 6% from 2015 but above the five-year average of $507 billion and the 10-year average of $431 billion. Buybacks rose for the financial and health-care sectors but dropped sharply in the energy, materials, telecom, and utilities sectors.

--- Buyback Spending (In Millions) ---
S&P 500 Sector
2016 *
($)
2015
($)
5-Yr. Avg.
($)
Consumer discretionary
89,528
92,039
79,723
Consumer staples
43,440
44,890
44,273
Energy
5,762
15,250
27,722
Financials
104,357
94,557
77,039
Health care
87,588
70,320
69,903
Industrials
76,166
80,113
61,798
Technology
119,457
150,327
124,524
Materials
8,397
15,521
13,366
Real estate
759
NA
NA
Telecom services
529
6,222
7,343
Utilities
399
2,920
1,419
Total
536,382
572,159
507,262
* Preliminary data.     Source: Standard & Poor's.

In the first quarter of 2017, the median S&P 500 company boosted capital spending 3%, based on the 95% of index constituents that have posted results. Energy companies reported a median 2% decline.

Below, we review four stocks with a track record of growing capital investment and dividends, while also using buybacks to shrink their share counts.

Applied Materials' ($45; AMAT) business centers on the capital investments of semiconductor makers — currently a highly attractive space. S&P 1500 semiconductor companies grew capital expenditures a median of 7% over the past 12 months, versus a median of 2% for the technology sector and 1% for the broad index. The company says industrywide spending on wafer-fabrication equipment could climb 15% in 2017, up from its prior target of 5% growth. Applied Materials expects to keep taking market share and seems upbeat about 2018.

The stock rallied to a 17-year high after Applied Materials delivered strong April-quarter results and offered encouraging guidance. Per-share profits of $0.79 excluding special items topped the $0.34 earned in the year-ago quarter and the consensus estimate of $0.76. Revenue surged 45% to $3.55 billion, roughly in line with analysts' estimates.

Operating cash flow and free cash flow more than doubled, marking the seventh straight quarter of growth for both metrics. Management said it could ramp dividends and stock buybacks once it gains more clarity on U.S. tax-reform efforts. For the July quarter, Applied Materials expects per-share profits to jump 58% to 74% on revenue growth of 28% to 33%; the consensus had anticipated growth of 38% for profits and 21% for sales at the time of the announcement. Applied Materials, which yields 0.9%, is a Buy and a Long-Term Buy.


With more than 100 ships scattered around the globe, Carnival ($62; CCL) served 48% of the people who took leisure cruises last year. Carnival estimates that operating cash flow will reach $5 billion and capital spending about $3 billion in fiscal 2017 ending November, roughly flat from fiscal 2016 levels. The company introduced three new cruise ships to its fleet last year and plans to add the same number of ships in both 2017 and 2018. In all, it plans to take delivery on 17 new ships from 2017 to 2022. Management expects net capacity to grow about 4.5% over the next five years, slower than the cruise-line industry's estimated 5.5% pace. That growth will be concentrated in China, which is seeing booming demand from its growing middle class and the government's support of the cruise industry.

Management seeks to return all 2017 free cash flow to shareholders through opportunistic stock buybacks and dividends. The company shrank its share count 5% in the 12 months ended February, paying an average price of $47 per share.

Carnival has grown its quarterly dividend at an annualized rate of 6% over the past five years, though dividend hikes in 2016 and 2017 exceeded 15%. The dividend represents 46% of earnings, in line with Carnival's payout-ratio target of 40% to 50%. Carnival, yielding 2.6%, is a Focus List Buy and a Long-Term Buy.


Lear ($145; LEA) shares are up 9% this year, even as cracks begin to form in the automobile market. European vehicle registrations, a proxy for car sales, slumped 7% in April, the steepest decline since March 2013. Yet some analysts expect auto sales in Europe to climb this year, building on the nine-year high set in 2016.

The U.S. auto industry has delivered seven straight years of higher sales, culminating in a record 17.55 million vehicles in 2016. But U.S. car sales fell 2% in the first four months of 2017, according to industry researcher Autodata. With sales softening, automakers plan to pause production at some plants this summer to keep inventory from ballooning.

About 41% of Lear's sales come from North America, 38% from Europe and Africa. The company continues to benefit from consumers' shift toward larger cars, which tend to require more of Lear's components. Encouragingly, management maintained its 2017 guidance in late April. Capital spending is projected to rise 4% to a record $550 million in 2017, leaving about $1 billion in free cash flow for acquisitions, stock repurchases, and dividends. The stock trades at just 10 times estimated 2017 profits, ranking among the cheapest 10% of stocks in our research universe. Lear, yielding 1.4%, is a Focus List Buy and a Long-Term Buy.


In the past month, Southwest Airlines ($60; LUV) has begun to roll out its new technology platform, a $500 million upgrade that should bring the airline up to speed with rivals. Management blamed its 30-year-old reservations system for an embarrassing computer glitch that canceled thousands of Southwest flights last summer. There is always execution risk when a large company upgrades its systems, and airlines have a mixed track record for updating their reservations platforms in recent years. However, Southwest is emulating a successful strategy used by American Airlines Group ($47; AAL) two years ago. Management sees the upgrade boosting operating profit by at least $500 million by 2020.

Rising wage and fuel expenses cut into Southwest's March-quarter profits, but management expects upward pressure on costs to ease in the second half of the year. Shares dipped on the results but have since rebounded to an all-time high in late May. Although capacity rose 5.0% though the first five months of 2017, Southwest continues to expect capacity growth of 3.5% for the full year. Southwest is a Focus List Buy and a Long-Term Buy.

INVESTING INTHEIR FUTURE
We screened for recommended stocks that have consistently boosted capital expenditures, while at the same time reducing their share counts and growing their dividends.
--- Capital Expenditures ---
-- Share Count --
--- Dividend ---
Oper. Cash Flow
Free Cash Flow
Company (Price; Ticker)
12-Mo.
Total
($Mil.)
12-Mo.
Change
(%)
Annual.
5-Year
Change
(%)
1-Year
Change
(%)
5-Year
Change
(%)
Yield
(%)
Annual.
5-Year
Change
(%)
12-Mo.
Total
($Mil.)
12-Mo.
Change
(%)
12-Mo.
Total
($Mil.)
12-Mo.
Change
(%)
Quadrix
Overall
Score
Alaska Air ($85; ALK)
775
15
17
(1)
(14)
1.4
51
1,331
(17)
417
(49)
89
Amgen ($155; AMGN)
750
19
4
(3)
(7)
3.0
35
10,824
12
6,981
8
91
Apple ($153; AAPL)
13,095
13
20
(5)
(20)
1.6
9
66,339
(2)
40,831
(7)
78
Applied Materials
($45; AMAT)
279
29
6
(3)
(16)
0.9
5
3,322
123
2,611
224
96
Carnival ($62; CCL)
3,144
87
2
(5)
(6)
2.6
6
5,268
15
1,125
(45)
97
Comcast
($40; CMCSa)
9,746
9
13
(2)
(12)
1.6
20
19,786
6
7,393
2
92
Foot Locker ($60; FL)
665
14
12
(4)
(14)
2.1
11
604
(19)
293
(21)
90
Lear ($145; LEA)
561
18
11
(7)
(31)
1.4
22
1,610
(1)
948
(11)
99
Southwest Airlines
($60; LUV)
2,014
6
14
(5)
(20)
0.8
86
4,302
26
2,039
57
95
Notes: Dividend growth for Apple and Alaska Air is for three years because neither company has five years of data. Quadrix scores are percentile ranks, with 100 the best.

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