Focus on US Fixed Investments:

Prospects for 2018-19

Mark Killion, CFADirector, US Industries

mkillion@oxfordeconomics.com

January 2018

Business investments accelerating

Growth rates of US

business investment

disappointed after the

initial rebound from GFC

Weakness in oil and

commodity prices led a

further decline in 2015-16

Recovery in 2017 with

renewed momentum at

the start of 2018

Further boost from

changes in taxes and

regulation

Return on investment

framework highlights the

key factors shaping each

industry’s performance

1

Investment patterns driven by industry profits, technology

Technology shocks, cost cutting & automation

• Oil and gas supply up, so price falls

• Chemicals and plastics enjoy lower feedstock costs

• Peak auto, electric vehicles, driverless & ride-sharing

• Automation via robotic assembly and machine learning

Cycles in global trade, currency & commodities

• Agriculture, energy and metals

• Machinery, transportation and electronics

ROI and expectations of future profitability

• Greater spending on intellectual property & technology

• Faster depreciation & higher capital intensity clash with low rates of asset turnover and capacity utilization

• Competition for use of cash from stock buybacks, M&A, dividends, marketing campaigns, employee hire

2

Which industries are largest in US fixed investments?

3

Shares Growth Rate Capital Intensity ROICSector / Industry: % of total 5 yr. CAGR US$ CapEx / Sales (%) Profits / Capital (%)

2016 2012-2016 2016 2016

All private sectors (excludes gov't) 100 6.5 10.6 10.6

Agriculture 2.1 4.4 14.6 9.7

Mining 3.2 -9.2 27.2 -0.1

Oil & Gas mining 2.5 -8.6 35.0 -0.9

Utilities 4.4 4.8 33.9 2.3

Construction 1.6 11.5 3.3 85.1

Manufacturing: durables 8.8 2.8 9.0 12.6

Computers & electronics 3.1 -0.6 23.3 7.8

Motor Vehicles & parts 1.5 7.5 6.6 22.9

Manufacturing: non-durables 7.8 6.9 8.4 21.9

Refineries 0.6 6.9 4.5 40.3

Chemicals & Plastics 5.0 6.7 14.4 17.8

Wholesale, retail, accommodation & restaurants 7.8 6.2 5.4 23.1

Transportation services 4.0 8.9 11.4 7.6

Information 9.7 5.4 18.0 14.8

Internet & data processing 2.7 16.6 33.4 1.5

Broadcasting & communications 4.5 2.9 15.2 13.2

Finance, banks & insurance 6.7 9.4 33.4 29.7

Real Estate 28.7 12.9 8.3 7.2

Business & professional services 7.3 4.1 6.0 25.3

Others incl. education, health care, entertainment 8.0 4.0 6.6 3.7

US Private Fixed Investment by Industry

Cost of capital higher in manufacturing & construction;

lower in finance and utilities

4

95 Financial Svs. (Non-bank & Insurance)

94 Utility (General)

92 Bank (Money Center)

91 Power

89 Real Estate (Development)

85 Insurance (General)

83 Broadcasting

81 Telecom. Services

79 Total Market

76 Restaurant/Dining

72 Recreation

66 Hotel/Gaming

57 Information Services

50 Retail (General)

45 Total Market (without financials)

35 Chemical (Specialty)

34 Aerospace/Defense

31 Software (System & Application)

30 Machinery

27 Engineering/Construction

19 Semiconductor

18 Retail (Online)

16 Drugs (Pharmaceutical)

5 Software (Internet)

4 Oil/Gas (Integrated)

2 Drugs (Biotechnology)

1 Steel

Business spending measured against profits and assets

Balance

Sheet:

• Equity

• Liabilities

• Assets

Income

Statement:

• Revenues

• Costs

• Profits

Cash Flow

Statement:

• Operating CF

• Financing CF

• Investing CF

Free Cash Flow (FCF)

demonstrates the inter-action

between profits, dividends and

investment spending

Net operating surplus subtracts

depreciation from the total of

corporate profits, proprietor's

income, earnings from rental,

interest and business transfers

Retained earnings = Corporate

Profits minus Dividends Paid

5

Return on Invested Capital (ROIC) Framework

6

Return on Invested Capital = Profits (Net income) / Capital StockROIC = NI / K

Ratio Analysis:

ROIC = (NI / Sales) x (Sales / CapEx) x (CapEx / Depreciation) x (Depreciation / Sales) x (Sales / K)

Ratio Reflects

(+) Profit Margin (NI / Sales) Operating efficiency & pricing power

(-) Capital Intensity Inverse (CapEx / Sales) CapEx requirement for operations

(-) Replacement Ratio Inverse (Depreciation / CapEx) Replacement of consumed capital

(+) Depreciation Cost of Sales (Depreciation / Sales) Degree of operating leverage

(+) Asset Turnover (Sales / Capital Stock) Capital utilization & sales generation

ROIC and related ratios help evaluate investment performances

One ratio is not enough, need several to fully understand conditions

Variability in the inputs over time, and across industries, also affects

their interpretation

What is being purchased by industry CapEx in the US?

7

Graph shows shares of private

sector investment that are

spent on structures vs.

equipment vs. intellectual

property products

Shares are shown over the

long term, along with the latest

history and short-term forecast

Shares on structures have

been stable over the long- &

short-run, with intellectual

property products shares rising

CapEx on machinery and

equipment have seen shares

fall, but 2018 should shows a

small reversal from the trend

Which industries are using CapEx for Intellectual Property?

8

Shares of CapEx on IP

have been rising in

technology, information,

finance & business svs.

Sectors with a legacy of

high shares of IP, such

as in Motor Vehicles,

Chemicals and

Internet/data processing,

have seen IP shares

stabilize and fall back

Transportation and

distribution have seen

rising shares, but from a

low base. Along with the

utilities sector, these

have significant room for

further increase in

coming years.

IP Share of CapEx Δ in Share

Sector / Industry: 2016 2016-2005

Total private non-residential investment 25.1 5.8

Agriculture 0.5 -0.1

Mining 3.9 2.1

Oil & Gas mining 3.5 1.8

Utilities 3.6 -0.7

Construction 4.0 -1.5

Manufacturing: durables 61.7 4.2

Computers & electronics 87.4 14.1

Motor Vehicles & parts 51.8 -2.7

Manufacturing: non-durables 49.8 0.6

Refineries 16.6 0.6

Chemicals & Plastics 64.8 -3.1

Wholesale, retail, accommodation & restaurants 21.3 3.7

Transportation services 4.9 0.5

Information 58.2 4.7

Internet & data processing 65.9 -2.4

Broadcasting & communications 36.6 6.0

Finance & banks 30.9 4.2

Real Estate 0.4 0.2

Business & professional services 59.8 6.5

Others incl. education, health care, entertainments 18.3 3.6

Intellectual Property (IP) shares of Industry

What Intellectual Property is being purchased by CapEx?

9

The 3 categories of

Intellectual Property

Products are software,

R&D and entertainment

& artistic originals

Software includes

purchases “off the shelf”

vs. made on a custom

basis by another

company vs. made ‘in-

house’

R&D is classified by the

funding industry

Fast growth seen in

spending on software, as

well as R&D from

Pharma, Electronics,

Chemicals and Finance

What is the average age of items purchased with CapEx?

10

The productive lives of intellectual property

& electronics are much shorter than

structures & other equipment

Software and R&D for electronics have

dramatically shorter productive lives

Spending on these raises depreciation

charges to income, and more quickly leads

to the need for replacement spending (via

capital consumption)

Faster capital consumption (economic depreciation) reflected in high replacement ratios & capital intensity

11

Greater spend on software, electronics and

automation carries faster capital consumption and

thus higher replacement ratios. The slowdown in

CapEx over 2014-16 will help stabilize these by

2018, but then they should rise again thereafter.

Competitive and market pressures will continue to

direct new spend toward technology, cost cutting

and automation, which, along with increased

need for replacement of used capital, pushes up

rates of capital intensity in several industries.

Weak asset turnover hurts the ROIC of key industries

12

Higher capital intensity raised

the asset stock, relative to the

sales it generates, for several

big-spending industries

Falling asset turnover counters

some of the benefit to ROIC

from secular increases in profit

margins and operating leverage

The few exceptions have been

in motor vehicles and finance,

with steady asset turnover, and

health care, with rising asset

turnover due to fast sales

Manufacturing saw asset

turnover reach a bottom in

2016, due to slow CapEx in

previous years, and turnover is

now expected to rise into 2018

Late cycle rise in margins extended by lower tax burdens

13

Profit Margin = Net income (after tax) / SalesPM = NI / Sales; PM = (NI / EBT) x (EBT / EBIT) x (EBIT / Sales)

Ratio Reflects

(-) Tax Burden Inverse (NI / EBT) Taxes on Income

(+) Interest Earnings (EBT / EBIT) Net interest earned

(+) Operating Margin (EBIT / Sales) Operating efficiency

2017 recovery in margins

boosted by better pricing and

high operating leverage

Further gains in 2018-19 from

lower tax rates and

expensing of investments

Will faster wages put a cap

on margins by 2019-20?

Sector impacts from Tax Cuts & Jobs Act of 2017

4 key changes in TCJA:

1. Changes to tax rates

2. Cap on interest deduction

3. Full expensing of CapEx

(5yr.-10yr. window)

4. Overseas earnings treatment

Using the first 3 as a trifecta ---

Sector winners are those with:

Past high effective tax rates

High CapEx intensity

Low debt, interest due

Transportation, Metals, Mining,

Machinery, Retail, Real estate

Relatively lower impact due to:

Previous low effective tax

rates, low CapEx, high debt

Hospitality, Hotel & Gaming, Diversified

Services, Computer Services, Utilities

14

3 tech-related sectors account for 45% of “trapped cash”

? How much of the overseas profits will be

recognized in 2018?

8 years to recognize the past

overseas profits at special rates

Some may opt to wait until their

taxable income is be lower

A portion of the taxed profits may

be deployed overseas

? What are the uses of the money that is

directed to the US?

Pay taxes, keep liquidity, pay

down debt, buybacks & dividends,

hiring, marketing, OpEx or CapEx

? How fast will the CapEx be put to work?

Apple recently designated $30

billion to be deployed over 5 years

3 scenarios for use of the overseas profits in the US

1. Slow walking

50% recognized in 2018

Lower shares for CapEx

5 year deployment

2. Apple’s plan

90% recognized in 2018

Higher shares for CapEx

3.5 year deployment

3. All in, and right now

98% recognized in 2018

Highest CapEx shares

2.5 year deployment

Scenario allocations of recognized foreign profits(shares allocated to different uses of funds)

Scenario impacts range between 1.5% to 6% of 2017 CapEx

Forecast change in leadership of sector investments

18

Sector / Industry: 2016 2017e 2018f 2019f 2020fAll private sectors (excludes residential investment) 1.9 6.6 8.8 5.9 4.0

Agriculture -2.7 -8.3 4.6 3.3 2.4

Mining -38.4 41.4 13.4 10.0 7.4

Oil & Gas mining -41.7 47.5 14.6 10.8 7.9

Utilities 0.0 0.4 6.2 6.0 4.0

Construction -5.0 3.9 7.5 6.0 5.3

Manufacturing: durables 4.1 4.6 7.0 5.6 3.8

Computers & electronics 4.9 5.1 7.4 5.9 3.2

Motor Vehicles & parts 5.6 4.4 8.0 5.5 3.8

Manufacturing: non-durables 4.2 4.5 7.7 5.9 4.8

Refineries -0.5 1.6 5.4 4.3 5.2

Chemicals & Plastics 5.8 5.2 8.3 6.3 5.3

Wholesale, retail, accommodation & restaurants 7.2 7.0 8.9 6.1 5.1

Transportation services -10.0 1.7 6.8 3.4 3.0

Information 4.4 5.9 8.4 4.9 4.1

Internet & data processing 6.0 9.2 9.1 5.2 4.1

Broadcasting & communications 3.7 2.9 8.8 6.3 5.5

Finance & banks 2.3 4.8 7.3 6.1 3.0

Real Estate 8.0 7.2 10.6 6.6 3.4

Business & professional services 3.8 6.2 8.2 4.6 3.7

Others incl. education, health care, entertainments 4.3 7.1 8.9 5.7 3.8

Annual growth of US Industry Investment (Nominal US$)

Thank you !

Questions ?