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How The Fed's Visible Hand Is Forcing Corporate Cash Mismanagement

Tyler Durden's picture




 

Two weeks ago when we presented James Montier's exhaustive analysis on corporate profitability and specifically its relationship to the Kalecki equation, we highlighted something peculiar, namely the fact that despite record fiscal deficits, Japan's corporate profitability has been flatlining at best, and gradually sinking at worst depending on one's perspective. The reason for this fundamental deterioration in corporate profitability? Not accounting for accumulating and rising depreciation, or as we said, "we get back to what we have dubbed the primary cause of all of modern capitalism's problems: a dilapidated, aging, increasingly less cash flow generating asset base! Because absent massive Capital Expenditure reinvestment, the existing asset base has been amortized to the point of no return, and beyond. The problem is that as David Rosenberg pointed out earlier, companies are now forced to spend the bulk of their cash on dividend payouts, courtesy of ZIRP which has collapsed interest income.

Which means far less cash left for SG&A, i.e., hiring workers, as temp workers is the best that the current "recovering" economy apparently can do. It also means far, far less cash for CapEx spending. Which ultimately means a plunging profit margin due to decrepit assets no longer performing at their peak levels, and in many cases far worse." And while we have touched on Europe's record aged asset base, we now get confirmation that, as expected, the same issues affect the US and Asia too, where Japan, not surprisingly, has the oldest average asset age. But there is more: as we suggested, courtesy of Fed intervention, which in turn shifts capital allocation equations, ever less cash is going into replenishing asset bases. The implications are that following the recent surge, corporate profits are set to plunge (no more terminations possible as most companies are already cutting into the bone) once the depreciation and amortization cliff comes, and the threshold of useful asset life is crossed.

Here is what average asset age looks like:

Now investing in CapEx is a traditional strategy for growing companies. This can be seen in the chart below, showing cash usage in Asia, es-Japan (which is much more like the US than any of its peers).

Asia is doing the right thing: it is investing proportionally the same amount of cash in CapEx as it has in the past. Alas, one can not say the same about the US:

When it comes to deploying excess cash, traditionally, the decision for CFOs and Treasurers has been to either put the money into Capex or into M&A. Here is how Goldman summarizes that decision three:

Organic growth (capex)...

  • Greater control
  • Keep corporate culture on place
  • Grow from lean base
  • Prevents overpayment or bidding war
  • Allows entry where others aren't playing
  • Successful capex leads to greater outperformance vs sector (>30% outperformance, vs c.18% for successful acquirors)

...vs acquisitive growth (M&A)

  • Timely/ immediate access to growth
  • Early-mover advantage in new markets
  • Allows for a step-change in industry positioning
  • Less execution risk (but more integration risk?)
  • Ready-made brands
  • Acquire local knowledge, infrastructure and distribution networks
  • Opportunity to extract synergies

What is quite curious is that companies that grow via CapEx vs M&A, typically have far greater returns in future years, as can be seen on the chart below.

However, with debt financing effectively at zero cost these days, companies can prefund M&A using debt market access, thus making the IRR calculation skewed to prefer M&A. Unfortunately, none of the underlying problems go away, and the returns are still far lower for M&A compared to the now largely ignored CapEx growth.

And here we get to the second point of Fed pushing capital misallocation, namely dividends. The chart below shows the cash manager framework in its simplest format: in norm al times dividend payments are the last of management's concerns, when there are little to no growth opportunities at the company's growth hurdle rate available (remember this Apple in 1 year). In other words, it signals the end of the growth and the start of the stagnation phase.

Instead, what the Fed has done by crushing returns on interest-bearing instruments, is to force companies to pay ever greater dividends (hence push equity investors into the dividend bubble), because companies too realize that for US baby boomer investors/consumers to make up lost purchasing power shortfall, they need to get the cash from somewhere. And since the fascination with capital appreciation is now gone, the only option is dividend return. Recall these two charts from a recent report by David Rosenberg:

Personal Interest Income:

Personal Dividend Income:

All this simply shows merely the most insidious way in which the Fed's ZIRP policy is now bleeding not only the middle class dry, but is forcing companies to reallocate cash in ways that benefit corporate shareholders at the present, at the expense of investing prudently for growth 2 or 3 years down the road.

Then again, with the US debt/GDP expected to hit 120% in 3 years, does anyone even care anymore. The name of the game is right here, right now. Especially with everything now being high frequency this and that.

Anything that happens even in the medium-term future is no longer anyone's concern. And why should it be: the Fed itself is telegraphing to go and enjoy yourself today, because very soon, everything is becoming unglued.

 

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Mon, 04/02/2012 - 12:24 | 2309811 Colombian Gringo
Colombian Gringo's picture

Feds visible hand is only good for stroking the banksters. No Happy Ending for the rest of us.

Mon, 04/02/2012 - 12:31 | 2309870 Zero Govt
Zero Govt's picture

The Fed will kick the can in 2012, 2013, 2014, 2015 and maybe even further than that

they are chained to Big Banks and Big Govt, they'll ruin the economy and trash the money (monopoly) system to prop up their 2 masters and drag 300 million down the toilet with them 

that's 'Democracy'

Tue, 08/14/2012 - 15:33 | 2704783 diogeneslaertius
diogeneslaertius's picture

me love you long time

Mon, 04/02/2012 - 12:15 | 2309819 Cognitive Dissonance
Cognitive Dissonance's picture

The Fed is a huge gravity well distorting the fiscal/financial (corporate/private/public) space time continuum.

http://en.wikipedia.org/wiki/Gravity_well

Mon, 04/02/2012 - 12:15 | 2309823 kito
kito's picture

china smells blood....................

linked from chris martenson's site:

 

http://www.nytimes.com/2012/04/03/world/asia/chinese-insider-offers-rare-glimpse-of-us-china-frictions.html

Mon, 04/02/2012 - 12:16 | 2309825 SDRII
SDRII's picture
  • Nonfinancial corporate debt has grown from 7.26T in 2008 to 7.8T presently - +600B

  • The 419 current nonfinancial members of the S&P 500 index held $776 billion in cash on their most recent quarterly balance sheets, which is up 72% compared with five years ago


Mon, 04/02/2012 - 12:20 | 2309837 Cognitive Dissonance
Cognitive Dissonance's picture

That pretty much offsets the negative ($4 Trillion) "real" cash on hand if you consider the S&P 500 financial sector......give or take a few Trillion$.

This new math is VERY confusing to me.

Mon, 04/02/2012 - 12:17 | 2309827 centerline
centerline's picture

The process of pulling forward future productivity for present gains is reaching a point of diminishing returns - with college debt being one of the the final acts in this tragic comedy.

Households are not any different... only mission critical maintenance is being done.  Now it is just a matter of time before something big breaks... or enough little stuff breaks.  Most folks are now squarely in the live-for-today mode of operation.

Mon, 04/02/2012 - 13:44 | 2310079 smb12321
smb12321's picture

Thank you.  This is what happened to Japa. They cut, honed, cut, realligned, cut, changed, cut...but at some point the end was reached.  It's what we all face -  individuals, families, cities, business and states - everyone except the Federal government.

Notice that savings are again declining as folks spend what should be kept.   Alas, as you said, there is an end point - something seen in many businesses that have cut all fat.

Mon, 04/02/2012 - 12:20 | 2309830 SheepDog-One
SheepDog-One's picture

'The FED is telegraphing to go ahead and enjoy yourself today, because very soon everything will become unglued again.'

Well I never really believed in the strength of their QE glue to begin with, just cheap library paste at best, but yea it seems now theyre just churning in place, greatly dimishing returns here, so somethings going to have to give.

Mon, 04/02/2012 - 12:35 | 2309864 centerline
centerline's picture

If I didn't know any better, I would think that they are trying to manufacture wage inflation. One of the big rubs here is that entitlements will be get kicked in the nuts - there are so many people now at the margins.

Mon, 04/02/2012 - 12:29 | 2309865 DavidC
DavidC's picture

"...the Fed itself is telegraphing to go and enjoy yourself today, because very soon, everything is becoming unglued."

Not today though...

DavidC

Mon, 04/02/2012 - 12:49 | 2309924 riphowardkatz
riphowardkatz's picture

the old double/triple whammy. less capex equals less productivity, less competition through mergers equals less pricing pressure, more money chasing less goods equals more money to buy inventory. And of all of it equals higher and higher and higher prices. It is like watching a slow motion train wreck and to think some people see deflation coming, amazing.

Mon, 04/02/2012 - 12:51 | 2309936 slewie the pi-rat
slewie the pi-rat's picture

 

note to self: 

  • slewie!  get yer asset bases shovel-ready!
Mon, 04/02/2012 - 13:13 | 2309982 q99x2
q99x2's picture

Schumer and a whole slew of politicians are getting paid off with FB shares so the market will likely be fantastic until at least May. Long term the Banksters and politicians will lose the most.

Mon, 04/02/2012 - 13:18 | 2309994 Jason T
Jason T's picture

It's like trying to work today on a computer that is from 2002.. can you imagine how slow and unproductive it would be??

The disintigration will continue.... 

Mon, 04/02/2012 - 13:23 | 2310008 I should be working
I should be working's picture

S&P pays too much in dividends?  Really, the dividend yield is under 2% and payout ratios are considerably below average.  They are spending the money on share buybacks.

Problem is companies are notoriously bad at buying low when it comes to buybacks.  Because their cash flow is a big part of the pricing of their stock, buybacks are a Catch-22.  Companies can only afford to do them when their stocks are highly valued and lack the cashflow to buyback when their stocks are cheap.

Mon, 04/02/2012 - 15:55 | 2310487 Carl Spackler
Carl Spackler's picture

BINGO.

CAPEX for growth and future productivity has been replaced by share buybacks not dividend payments.

Fundamentally, the result is the same.  Monetary resources leave the ripest opportunity for productivity gains and then go through a decision of spend or re-invest into an asset bubble.

So myopic.

 

Mon, 04/02/2012 - 13:57 | 2310111 Fuh Querada
Fuh Querada's picture

"...Instead, what the Fed has done by crushing returns on interest-bearing instruments, is to force companies to pay ever greater dividends...."

huh ? non sequitur.

Mon, 04/02/2012 - 15:36 | 2310402 silverserfer
silverserfer's picture

Even if putting your money into PM's doesnt give you the return that eqities used to in a functioning economy, it is a vote of no confidence to the banks, FED, and the rest of the peanut gallery that has become a plump oversized parasite weighing on all of us.

Saving in PM's is investing in truth and honesty and hard work. It is something you can pass down tyo your children and teach them about those values and how PM's represent those values and they are immunt to the ills of the failes system we live in and will withstand their fleeting corruption or something.

Fri, 07/20/2012 - 16:09 | 2637600 Cranios
Cranios's picture

the real issue isn't ZIRP, it's a lack of profit margins due to too much capacity and too little market growth. IOW, too much competition and therefore, low return on invested capital. Throw in foreign competition and lots of regulation here in the USA, and companies can hardly cover their expenses, let alone fund new capital investments!

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