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Uncertainty Breeds
Conservative Capital Spending

Machinery manufacturer Caterpillar set a cautious tone on its first-quarter earnings call, saying that trade tensions called for more conservatism in its plans for capital expenditures, or capex. The company lowered spending to $547 million in the first quarter from $757 million in the same period a year earlier. With trade policy still unsettled, corporations in many different areas of the economy are keeping a watchful eye on how they deploy capital, says Scott Gates, Chief Investment Officer, Friess Associates.

According to The Wall Street Journal, five of the 10 firms that spent the most money in capital outlays last year already lowered their spending forecasts by March 2019. Uncertainty regarding trade and the global economy are commonly cited factors.

Shares of FedEx Corp. fell in September after the worldwide shipper fell short of the consensus earnings estimate and cut its guidance for 2020. “Our performance continues to be negatively impacted by a weakening global macro environment driven by increasing trade tensions and policy uncertainty,” Chief Executive Frederick Smith said at the time.

Capital expenditures are investments by a company to acquire, upgrade and maintain physical assets such as property, buildings, technology or equipment. They can include everything from repairing a roof to building a new manufacturing plant. The investments are made to create a future benefit and can typically be depreciated on the balance sheet, making them very different from the ongoing day-to-day expenses required to run a business.

It’s the type of financial outlay that requires some planning, making it an indicator as to how a company or industry feels about demand in the months or years ahead. For example, the communications industry continues to aggressively build out datacenters as more workflow from enterprise moves off traditional servers and onto cloud-based platforms. While the trend remains strong, should demand for cloud-services from large businesses fade, we would expect to see some of these investments slow. In another industry, a large ocean shipper benefits as new regulations associated with low-sulfur shipping fuel exacerbates an already tight market for tankers that move oil-related products.

The new International Maritime Organization, or IMO, 2020 regulation is effectively disrupting supply and demand dynamics for product tankers, creating inefficiencies likely to further strain tanker availability at a time when the order book for new product tankers is at a two-decade low. The ocean shipper spent roughly $800 million to add new product tankers ahead of the regulations going into effect at the end of this year.

Capex is set to grow 3.5 percent this year, down from the 4.2 percent anticipated just four months ago. The downward revisions compiled by Citigroup reflect the spending plans of 714 public U.S. companies.

Capex is often used as a rough gauge of future profits. Expenditures surged 11 percent in 2018 as companies capitalized on savings from that year’s corporate tax cuts. Spending is set to expand, but the lower growth levels and recent downward revisions are beginning to worry investors that businesses could become overly cautious amid signs of slower economic trends.

The spending slowdown is most pronounced in the communication-services and consumer-discretionary sectors, where capital spending fell from a year earlier. Spending growth also softened for some technology companies caught in the U.S.-China trade drama because they rely on Chinese demand and trade flows to drive revenue. One of the world’s largest semiconductor manufacturers slowed its spending growth in the first quarter and lowered its estimate for the current fiscal year as inventories of memory chips grew.

Additionally, in recent months the year-over-year growth rate for inventories-to-sales has increased sharply. Similar to lower capex, rising inventory levels could point to a softer economic backdrop. Historically, rising inventories relative to sales can be interpreted as a sign that demand is weakening, potentially signaling the need for companies to reduce production and, likely, curtail capex.

There’s a flip side to the story, as lower capital spending by a particular company or even an entire industry boosts cash flows, setting the stage for future growth. It’s also part of the cycle in which companies with the strongest fundamentals should stand out.

In the end, the approach that individual companies take to capex as well as the overall strength of spending plans across the economy is something we watch closely. When, why and how investments are made in future growth will help shape the economic landscape going forward.

Source: Friess Associates, a growth-oriented investment manager driven by individual-company research. For more than 40 years, Friess Associates has employed its bottom-up, company-by-company approach on behalf of institutions, corporations, high net worth individuals and retail investors.

Friess Associates LLC serves as advisor to the Friess Small Cap Growth Fund and is subadvisor to certain mutual funds advised by AMG Funds.

For more information on Fries Small Cap Growth Fund visit www.friess.com and AMG Managers Brandywine Fund, visit www.amgfunds.com.

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