Is CapEx an Effective Tool to Uncover Value Within Fixed Income?

Is CapEx an Effective Tool to Uncover Value Within Fixed Income?

Rob Costello

Hi and welcome to another episode of Away from the Noise Thornburg Investment Management’s podcast on key investment topics, economics and market developments of the day. I’m Rob Costello, client portfolio manager for Global Fixed Income. Today we are here to discuss the topic of CapEx. Joining me is Arzoo Mulla, fixed income trade associate on the Global Fixed Income Investment Team.

Arzoo has an area of focus within the corporate space and follows CapEx trends very closely. Arzoo is a CFA charter holder, having joined Thornburg last year and has previously been with Voya Investment Management on the agency MBS trading desk and prior to that on the private credit team analyzing middle market and distressed debt situations. Arzoo, thank you for being here.

Arzoo Mulla

Thank you for having me, Rob.

Rob Costello

So, CapEx short for capital expenditures, this is a pretty unique topic, I must say. I know in speaking to clients, I’ll certainly get questions on, say, the Fed, the inflation, the economic trajectory. But as you know, we decided to do a podcast to discuss CapEx. Arzoo, why is this a topic investors should not overlook?

Arzoo Mulla

CapEx is important because it informs is about supply and demand for products and services, which industries are responding to growth, and others which are reacting to cost pressures and supply chain challenges. CapEx is also important because it gives us insight into corporate initiatives. And most importantly, it informs the investor of structural developments that are taking place within various sectors which go beyond the economic cycle.

And just to kind of back up my rationale a little bit. For example, construction companies are actually investing in geographically strategic distribution facilities to keep up with demand and address structural supply chain problems coming from COVID. Another example is shortages of rental equipment in the broader industrial or commercial space creates an opportunistic time for some companies to invest in new and more environmentally friendly fleets to meet sustainability initiatives.

Another example is we can also look at cable and telecom sector, where there’s so much investment in broadband, fiber and high-speed network buildout that’s taking place just to keep up with consumer spending preferences or habits in, you know, this technologically advanced world.

Rob Costello

Walk us briefly through the basics of CapEx if you will. In fact, let’s start with the most basic question. What is CapEx?

Arzoo Mulla

So, my technical definition of CapEx is that it’s a line item on the company’s cash flow statement. And what it basically tells you is a dollar amount of how much the company is investing for long term business growth. This investment can simply be categorized as how much the company has already spent or will be spending on not only fixed assets like computers, manufacturing, plant equipment and any physical asset that the company can use to produce a marketed product or service.

But CapEx also tells you a lot about intangible assets like investments and computers, software licenses, trademarks, patents, et cetera.

Rob Costello

What trends are we seeing within CapEx that gives investors clues into how the 2023 macro picture plays out, especially given most market watchers are calling for a recession in the U.S. this year?

Arzoo Mulla

When thinking about recession just in relation to CapEx, CEO confidence survey is one of the indicators we like to look at just to gauge management sentiment and see if they’re actually going to be investing in their business. What’s interesting is that last I checked, CEO commentaries were still trending on the side of caution in the near-term. But there are some industries which tell a very different story for now and even long-term investment.

Let me talk through some of the CapEx trends in several industries, and I’ll start with machinery and just highlight a few trends there. Cost of doing business has gone from an increase in raw material prices. Which again stemmed from supply chain problems. But some companies are actually able to pass these costs on to their customers because of high demand more volume, more revenue.

So this actually gives companies confidence around sustainability of their revenue stream. And so they start investing more in say, manufacturing plants, convenient distribution facilities and rental fleet. Just speaking plainly for the machinery sector. Note that the sector is exposed to cyclicality, but this time is a little bit different because there seems to be demand visibility from its oil and gas industry clients and the sector particularly Lee.

Second, I will touch on semiconductors. The sector particularly got a boost from the Chips and Signs Act, which is the CHIPS Act of August 2022, which will give about $53 billion to U.S. semiconductor companies for research and development manufacturing capabilities and workforce development in the U.S.. The intent here is to reinforce the U.S. based supply chain and spur technological innovation in this industry, which is so critical now. An interesting nuance in my research was actually precision agriculture, where companies are spending on automation and electrification of farming. So an anecdote there is how precision technology will help farmers position their equipment and accurately plant spray and harvest. So it’s worth pointing out that this may actually be more prevalent in Europe and South America than the U.S.

Lastly, I think it’s also important to highlight that, you know, slowdown in residential growth construction could be offset by a recovery in the infrastructure segment, just given fiscal spending support. Why the Inflation Reduction Act? Again, this dates back to 2022, which encourages offshoring for U.S. companies. So, some sectors to watch out for in terms of spending patterns would be industrials, utilities and auto and especially infrastructure around electric vehicles like charging stations.

Rob Costello

Let’s hone in on a specific industry in particular, and that is energy. We all know there’s a lot going on in energy where particularly at this point where we’ve seen the rise in now moderate falling oil prices, the geopolitics and the outright war in Russia and Ukraine. CapEx obviously seems to matter a lot in this sector because it matters really how much energy is going to be produced going forward. So, I’d love to hear your thoughts on CapEx trends specifically in the energy sector.

Arzoo Mulla

Good question, Rob. I would categorize the as the most talked about sector. So, let me touch a little bit upon just the geopolitical backdrop. I think the Russia/Ukraine war was a turning point for the energy sector, which, by the way, is now expected to grow 60% by 2025 to about one and a half trillion. And you know, just for a context this industry it was just 900 billion in 2021.

And this energy cycle appears to be different because it follows seven years of hydrocarbon underinvestment between the years 2015 and 2021 and now an ongoing focus and priority when it comes to decarbonizing and from various companies. Companies are also factoring in this seasonal component that is not talked about a whole lot. So, what I mean by that is that when they’re building out infrastructure, they have to take into consideration what demand is going to look like in summer versus winter for example. Winter gas demand is typically greater than two times than what it is in the summer and that will actually require companies to have liquefied natural gas imports and hydrogen along with renewable power growth. The global LNG pipeline is expected to have about 150 billion of new projects over the next five years. And the average CapEx needs of low intensity carbon energy build out is a little bit expensive. So, it’s two times than that of hydrocarbons again, which is roughly about one and a half trillion.

Rob Costello

Needless to say, as fixed income investors the Thunderbird Global Fixed Income Team is very active in the corporate bond market. Our surveillance is across industries, up and down the credit spectrum. Based on the CapEx trends you’ve highlighted thus far, how are we taking advantage of these themes in our fixed income portfolios today?

Arzoo Mulla

On the fixed income desk, we like to research companies based on cyclicality and seasonality within that business and industry in line to invest in those which actually grow through economic cycles. If there is a credit we really like. But it’s also cyclical, we make sure that we are getting paid to take on that cyclical risk by comparing it to relative value within industry and also across different fixed income asset classes.

We try and be cognizant of what is leading that CapEx growth. Is it really growth maintenance or is it just plain inflationary pressures where the company has to succumb to customers and suppliers who have more pricing power and therefore end up spending more in CapEx. And especially for growth driven CapEx, I think it’s important to highlight that if they have the balance sheet to weather this kind of investment, meaning what will this do to existing capital structure, how EBITDA accretive is this company going to be upon CapEx spend and will the company still be free cash flow positive? And what does this do to leverage and interest coverage metric? So, we also like to look at companies and compare its metrics to other companies in that sector and understand better their risk return profile. We like companies that can pass on their production costs to their customers because of high demand, so they can charge higher prices. And we also think through cost management of a company and operating leverage which comes from owning and controlling your manufacturing plans.

And I’ll say that it’s best to study companies who are positioned to invest in sector specific tailwinds and be able to capture their total addressable market over the years. And CapEx can actually point us to a lot of these emerging macro trends in different industries.

Rob Costello

Arzoo, perhaps share a couple of anecdotes in the portfolio where CapEx was an impactful factor in the decision to buy or even the decision not to buy. Can you share some perspective?

Arzoo Mulla

Absolutely. So, I’ll take this opportunity to touch on both growth CapEx and maintenance CapEx. I’d like to start with cyclicality again here, and I think it’s important for us to pick out a company that performs through its debt obligations and in worst case scenarios, a company which has collateral value, which will hold up in stressed situations. And what I mean by that is we recently passed on an aerospace financing and leasing company. And, you know, even though the company was very well positioned to benefit from growth in the increasing airline traffic and the spread levels offered on this bond actually looked attractive, to but we just didn’t want to take the credit risk because debt levels were really high, 13 times leverage. CapEx spend was material enough where the company was actually free cash flow negative.

The industry has been very cyclical in the past and the company’s interest coverage was well below our comfort level. And, you know, in an event of a restructuring, we just wouldn’t know what to do with a bunch of airplanes, bondholders.

Now, CapEx stories that we do like you know, there is an energy pipeline and storage company that we invested in and this company is currently investing in expansionary CapEx like tanks and temperature controlled storage in its existing pipeline infrastructure even.

And, you know, we found good balance sheet strength and credit metrics. What this company had was debt holder, friendly financial policies, stronger customer contracts, good secular tailwinds, from energy demand, and had significant backlog in natural gas demand, which gives us some comfort around some of the key credit risks that may still persist in the name.

Rob Costello

Thank you, Arzoo, for a very educational and informative discussion today. Also, I want to thank you all for listening. You can find this and other episodes of Away from the Noise at Thornburg.com/insights as well as on Apple Podcasts, Spotify or wherever you prefer to listen to podcasts. Please subscribe and review us and I’d invite everyone to go to visit Thornburg.com

We have a variety of great content about interesting topics that are going on in the market today. Thank you all again and have a great day.

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