Two weeks ago when we presented James Montier's exhaustive analysis [8]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 [9], 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:
[10]
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).
[11]
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:
[12]
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.
[13]
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.
[14]
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 [9]:
Personal Interest Income:
[15]
Personal Dividend Income:
[16]
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.