Editor's note: This prescient research note excerpt was originally published by Hedgeye Industrials Sector Head Jay Van Sciver on March 12, 2014.
High Returns (Eventually) May Beget Low Returns
Looking at the recent declines in iron ore and copper prices, we are reminded of how challenging capacity additions can be in capital intensive industries. In the commodity section of our March 2013 Mining & Construction Equipment black book, we reviewed the supply outlook for copper and iron ore. The coming supply increases in these metals, driven by a super-cycle/bubble in mining capital investment, seems likely to keep prices under pressure for years to come. Copper may rally here and there, but the tidal wave of capacity appears to us somewhat inescapable. That seems the case even in a relatively strong “Old China” growth scenario, where the country continues to suffocate itself.
As for iron ore, it seems absurd to dig up rocks in the Amazon, ship them by rail to the east coast of South America, load them on a boat to ship them all the way to ports in China, where they are then taken to some of the dirtiest and least efficient steel mills in the world to be processed into construction materials to building buildings that few people actually use, but are built largely just to goose regional GDP statistics or protect wealthy owners against inflation. If that interpretation is correct, the excess capacity in seaborne iron ore one day might be quite staggering. Looking at Vale’s share price, this is increasingly old news, and we look below at what might be next.
Note: Forecast taken from March 2013 Mining & Construction Equipment slide deck
Of course, iron ore and copper are not alone. In many capital intensive industries, elevated investment impacts capacity on a significant lag. What other basic industries are investing at above “trend” rates?
Below, we present a table of the ratio of Capital Spending to Depreciation & Amortization (Capex/D&A) for the S&P 500 and S&P 400 Industrials, Utilities, Energy and Materials sectors’ sub-industries. In the table, a ratio of 2 would suggest that the index constituents representing that sub-industry are spending twice the level of depreciation and amortization. While we understand that this does not adjust for historic cost accounting in D&A, certain acquisition-related items and myriad other challenges, it does provide a ruler to measure relative investment over time. Another potential flaw is that a lack of investment may indicate a lack of opportunity, such as industries facing secular decline. In mature industries populated by larger capitalization competitors, differentiating these situations is reasonably straightforward.
What Does The Table Imply?
To us, it suggests that caution is warranted when extrapolating the current performance of CAT’s Power Systems division (or Energy & Transportation segment, but we will call it Power Systems until at least the end of 1Q because retitling is not substantive). Nearly all of CAT’s Power Systems key end-markets are investing well above depreciation and amortization. We have previously discussed energy sector capital spending, but it is useful to see the exposure for gas compression, locomotives and power generation, as well. In many ways, Oil & Gas capital spending could look like mining capital spending circa mid-2012. CAT, CMI, DRC and several others may also, eventually, see normalization energy-related capital spending impact results.
The table above also suggests that several construction and building products industries are not over-investing, spending at or below D&A, despite a potential significant rebound in demand. Building products is an industry we like from the long side, not simply from a cyclical perspective, but also because of structural improvements over the past decade.