Capital Expenditures

Over a year ago we wrote "How The Fed's Visible Hand Is Forcing Corporate Cash Mismanagement" in which we explained that due to ZIRP, management teams are left with just two (very shareholder-friendly) capital allocation choices: stock buybacks and dividends, to the detriment of such much more long-term critical uses of funds as capital expenditures, and to a lesser extent M&A. So far, this observation has proven spot on with buybacks (most of which using leverage to arb the record low cost of debt, notably in the case of Apple) dominating cash allocation decisions. However, there is a key drawback to this strategy: corporate assets whose age has hit all time highs across the globe.  Naturally, this is a critical issue in a world in which the return on assets is now rapidly declining as seen in two years of deteriorating profit margins, and in which as much utility has been extracted as possible from an asset base which in many cases is well beyond its functional age. Logically, more and more companies will have no choice but to reasses capital deployment and in the coming months formerly very shareholder friendly companies will have no choice but to redeploy cash from dividends and buyback and to long-ignored capex once more. We bring this up because moments ago Dole Food just provided the missing piece to this capital allocation puzzle.

A week later and everyone is a bit more nervous, with the speculation that US sovereign debt purchases by the Federal Reserve will wind down and with the Bank of Japan completely cornered. In anticipation to the debate on the Fed’s bond purchase tapering, on April 28th (see here) we wrote why the Federal Reserve cannot exit Quantitative Easing: Any tightening must be preceded by a change in policy that addresses fiscal deficits. It has absolutely nothing to do with unemployment or activity levels. Furthermore, it will require international coordination. This is also not possible. In light of this, we are now beginning to see research that incorporates the problem of future higher inflation to the valuation of different asset classes. Why is this relevant? The gap between current valuations in the capital markets (both debt and credit) and the weak activity data releases could mistakenly be interpreted as a reflection of the collective expectation of an imminent recovery. The question therefore is: Can inflation bring a recovery? Can inflation positively affect valuations? The answer, as explained below, is that the inflationary policies carried out globally today, if successful will have a considerably negative impact on economic growth.

In the past months and right after implementing Quantitative Easing Unlimited Edition, the Fed began surfacing the idea that an exit strategy is at the door. With the latest releases of weak activity data worldwide, the idea was put back in the closet. However, a few analysts have already discussed the implications of the smoothest of all exit strategies: An exit without asset sales; a buy & hold exit. We have no doubt that as soon as allowed, the idea will resurface again. Underlying all official discussions is the notion that an exit strategy is a “stock”, rather than a flow problem, that the Fed can make decisions independently of the fiscal situation of the US and that international coordination can be ignored. This is logically inconsistent as we address below...

Caterpillar just can't catch a break. First, in January the firm was punk'd by a Chinese acquisition fraud, forcing the company to write off half of its Q4 earnings. This, of course, in the aftermath of the miss in both Q3 and Q4 earnings. And now we get the latest disappointing news from the firm as Q1 numbers are reported lower across the board.

• Q1 EPS $1.31, Exp $1.38; this includes a tax benefit of $87 million
• Q1 revenue: $13.2 billion, Exp. $13.8 billion
• Guides much lower, with revenue now seen at $57-61 billion, compared to $60-68 billion previously
• CAT forecasts profit per share of $7.00, compared to $7.00-9.00 previously.
• Operating cash flow of $900MM, but all of it generated from net working capital, i.e., inventory liquidation
• And when you can't spend on capex, you spend on buybacks: CAT to extend buyback through 2015

So much for that.

By now regular readers should be aware that one of our favorite metrics on the state of not only the economy, but corporate viability in the New Normal centrally planned age, are not fudged, manipulated earnings which always find a way to "beat" downward revised expectations, not even free cash flow (which in far too many cases has ceased to exist), but capital expenditures for two reasons: i) it number can not be fudged, adjusted, recasted or in any other way modified, and ii) it represents the managements' own view of what the growth prospects of the company are. The logic is simple: if management itself is not confident on growth prospects, it will not replenish its asset base (already at a record old age across the world) and will not invest in projects that have a high hurdle rate but only after several years of gestation. Instead, management will merely opt to use the company as a cash cow in the here and now, extracting as much shareholder value is possible with dividends and buybacks while the future viability of the company... well, that can be some other management team's concern.

Just four days ago we noted the 'endgame' scenario that JCP appears to be heading in as they looked to raise new capital. It would appear things have escalated a little more quickly than hoped. Amid chatter of vendor concerns and what appears to be a slower process than they hoped for raising capital, the firm announced today, that "the Company has drawn $850 million out of its  $1.85 billion committed  revolving credit facility.  Proceeds will be  used to fund working capital  requirements and capital expenditures, including the  replenishment of inventory levels  in anticipation of the completion  of its newly  renovated home departments  next month." More worrisome is the fact that the firm managed to extract only $850 million on $2.3 billion in Inventory: while not completely worthless as we first suspected, it appears JPM is only willing to give JPM credit for about a third of its inventory at liquidation value. Remember that the revolver it is the cheapest financing JCP has in palce which raises the question - why not draw more? Ask JPM.

There is no hope whatsoever of so-called U.S. "energy indepedence" unless three things happen. First, environmental rules have to be wound back to 1970 standards -- in other words, disband the EPA and make civil plaintiffs show actual harm, not just hypothetical harm because someone goofed on a sheaf of mandated paperwork. Second, stop wasting taxpayer money on nonsense like $25 per gallon biofuel. Third and most urgently, stop subsidizing Wall Street. Let the market decide what interest rates make sense, rewarding companies who can find and produce oil, instead of gorging themselves sick on artificially cheap junk bonds that money-losing shale swindlers will never pay off.

For those claiming there is something called a "recovery" underway, perhaps they can point out just where on this chart of Real Disposable Income per capita one can find said recovery. Because we are confused: with the average Real Disposable Income of $32,663 per person, or lower than where it was in December 2006 ($32,729), one may be excused for scratching their head.

After the January Empire Manufacturing data came at the worst level in years, it was only logical that the February print would post a massive surge of some 18 point, from -7.78 to 10.04, the highest since May 2012, the first positive print since August, and above the highest expectations whose consensus saw a rise to -2.00. The driver: a surge in the New Orders number which soared from -7.18 to 13.31, indicating that the recent northeast snowfall did little to impact manufacturing unlike various other series, whose miss was blamed on snow in the winter. And while there were increases in all subindices, the divergence between prices received, which dropped, and prices paid, which rose, implies corporate margins will continue to suffer. But in this new dot com/housing/credit bubble, who cares about such trivial things as profitability.

The ongoing message from the mainstream media, analysts and most economists is that the economy has turned the corner and we are set for substantially stronger growth in the coming year.  While that sounds great on the surface the economic data has yet to hint at such a robust recovery.  What is worrisome is that CNBC has started using the term "Goldilocks economy" again which is what we were hearing as we approached the peak of the market in early 2008.  As David Rosenberg pointed out in his morning missive: "Maybe, it's just this:  so long as there is a positive sign in front of any economic metric, no matter how microscopic, all is good.  After all, you can't be 'sort of in recession' - it's like being pregnant... either you are or you are not." The bottom line is that ex-artificial stimulus, and other fiscal supports, there is little in the way of an economic recovery currently going on.  In order for the economy to reach "escape velocity" it will be on the back of sharply rising employment and wages which are needed to prime consumer spending.  This is not happening as the the gap between wages and rising cost of living continues to drive the consumer to shore up that shortfall with more debt.  

Sometimes, it feels good to hope. But since last September, nothing has really changed. At least not fundamentally. The zero-interest rate policies were going to encourage share buybacks, dividend payments and any method to allow the extraction of whatever real value is still available to extract from corporations/businesses by their owners. This meant leverage was going to increase, unemployment would remain high, capital expenditures were going to decrease and the risk of defaults was to going to rise. A year later, all these symptoms are starting to surface. One more reason to avoid stocks and be long gold. But in my view, it will take longer than many believe, for these imbalances to burst "...As long as the people of the EU put up with this situation and the EU Council (…) effectively kills democracy at the national level AND as long as the Fed continues to extend US dollar swaps, this status quo will remain… Whenever the political sustainability of the EU is challenged, we will see a run for liquidity... The trend is for asset inflation, and will last as long as the people of the EU and the US do not challenge the political status quo..." Unemployment and the tolerance of those unemployed will tell us when the time has come.

One of the first axioms of analysis is: "Garbage In, Garbage Out"! If your data is flawed, everything you do with it and the decisions stemming from it are flawed and dangerous to your financial health. Experienced analysts will often be found relentlessly checking, rechecking and validating their inputs and assumptions. If only our economists and the sell side analyst community were this diligent. But then it isn't their money. Only a year-end bonus for the 'extras' in their life is at risk. If economic practitioners were held to higher standards of accountability, they simply wouldn't accept the raft of fundamental data points that are the pillars of most economic assessment. Markets have become so dysfunctional with so much cheap money chasing so few real opportunities, that collateral values within the rehypothecation process are now in jeopardy and exposed to collateral contagion. The question is - what would things look like if the Fed wasn't engaged in Monetary Malpractice?

The platinum group of metals (PGMs) have received some perhaps unwarranted attention in recent weeks as the 'coin' idiocy came and went; but, it is noteworthy, as Eric Sprott points out that with demand rising and supply under pressure, the outlook for investment in physical platinum and palladium is increasingly compelling. The following infographic (and various supply and demand dynamics) provides a succinct picture of what these metals are used for, where they are produced, and the supply/demand imbalances.

Updated for the summary of MSFT, SBUX and T earnings.

Amid the deafening screams of hundreds of hedge fund managers looking for any hedging port in an AAPL storm, stock indices (expect the Nasdaq) surged to new highs from the moment the US day-session began until POMO was complete and European markets closed. Volume and block size was large as we took out S&P 500 highs up to 1500 and it appeared we ran out of the short-term proverbial great fool. In general, risk-assets and stocks were well correlated though the big disconnect today was a rising VIX. HY Credit did not play along with the exuberance early on either - as it seemed relatively clear that any and every trick in the book was being used to enable more out of the AAPL boat as we ramped up to VWAP. Once Europe had closed, AAPL slid, stocks slid (with S&P 500 dropping its most of 2013 so far), and risk-assets in general slid lower. JPY weakness and EUR strength helped support risk but Treasury yields falling back and a drop in commodities overall (Gold -0.9% on the week) had the opposite effect. The typical late-day ramp failed despite the best efforts of vol compression as stocks closed almost unch, at VWAP, in line with risk-assets (ahead of tomorrow's LTRO news). AAPL at lows as ramp failed...

Good news, bad news on the economic front this morning. The good news: December advance retail sales rising 0.5% on expectations of a 0.2% increase, up from a 0.4% revised November print. Excluding the volatile auto sales, the number was up 0.3% on expectations of a 0.2% increase, and up from a 0.1% decline. Excluding autos and gas, the print was 0.6%, on expectations of a 0.4% increase. The biggest increase in December retail sales by category was in food services and drinking places which rose 1.2% in December, the same as November. Strong numbers were posted at clothing and accesory stores (+1.0%) and health and personal care (+1.4%) - all very low margin sales. Yet where the report was undisputedly weak, and where many were hoping for a boost but did not get it, was in the higher margin electronics and appliance stores, which dropped -0.6% in December, down big from the 2.3% increase in November, and further weakness for those hoping that December saw a surge in spending over gadgets and gizmos.As for the bad news: it was all in the Empires State Manfuacturing Index which missed expectations big, and in fact posted a decline from the abysmal November miss, revised to -7.30, and now down to -7.78, the sixth negative print in a row, on expectations of an unchanged print. This was the 5th miss in the series in the last 6 reports, the worst miss in 4 months, and the lowest number in 4 months. Alas there was no hurricane in December to blame this major miss on.  Oh yes, we remember, "the fiscal cliff."