These days, if a business is willing to serially dilute Shareholder Equity by selling additional shares to repay debt (principal), then it is true to say that the only material difference between debt and profit is 4% (the average yield on corporate bonds). If you combine this with the speculative rise of share prices driven solely by the weight of the increased money supply, it is easy to become cynical regarding self-serving monetary policies and what it takes to call something “innovation.”
Cheap debt and increased liquidity are a central bank’s elixir for sustaining GDP growth. The whole world is in on the act. Average real GDP growth in the US from 2009-2015 has crawled along at just 2.2% each year. From 2001-2007, it grew at a rate of 2.8% (Graph: FRED). Without cheap debt, even these anemic growth rates would be unsustainable. Chinese debt has reached 304% of GDP as their ‘miraculous’ GDP growth rates tumble to new lows.
Historically, higher labor productivity has been the tonic for economic recovery. Higher US labor productivity was responsible for 75% of real GDP growth after the ‘dot-com’ bubble collapsed in 2001, yet labor productivity has contributed only 26% of real GDP growth after the sub-prime crisis in 2007 and resulting financial crisis (GFC) of 2009 (Graph: FRED).
While labor productivity grew at 2.1% each year between 2001-2007, it has increased at an abysmal 0.6% per year between 2009-2015 (Graph: FRED). This recovery is weak to say the least.
This time around, Public, Household, and Corporate Debt have been the fuel which has increasingly carried both consumption and asset/commodity prices since 2001.
Household Debt as a percentage of US GDP skyrocketed between 2001-2007 (Graph: FRED), while US Public Debt kicked in to high gear from 2009-2015 and beyond to rescue the beleaguered consumer from the over-gearing of the household balance sheet (Graph: FRED).
Debt will remain historically cheap for the foreseeable future. Except for a belated attempt to cool down real estate speculation by raising interest rates from 2004-2007, the Targeted Federal Funds Rate (FFR) has been on a long-term slide to near zero since 2000 (Graph: FRED). Recent increases in the FFR have done little to dampen appetites for increased debt. Federal Reserve threats to taper the public balance sheet sound like distant threats which may not survive the political imperative to sustain employment and keep the gravy train on its rails.
How does this debt trap affect corporate balance sheets?
Cheap Debt Spawns Excess Production Capacity
Cheap debt reduces the cost of acquiring and holding excess production capacity and mitigates against its removal from the production system. Why bother with the painful extraction of excess capacity or change programs focusing on labor productivity? 4% buys a lot of inertia.
As a result, US Capacity Utilization (CU) has reached long-term lows. The Federal Reserve Bank of St. Louis (FRED) shows Total Industry Capacity Utilization is running at just 76.6% (June 2017). Given this is an average across all industries, many businesses are obviously experiencing capacity utilization levels which are well below 70%. In the worst cases, CU is likely running at well below 50%, especially in a range of commodity related, capital intensive industries. Excess production capacity is everywhere.
A simplistic view of excess capacity suggests it is fully contained within idle production assets. Obviously, this drives higher Fixed Unit Costs. However, Excess Capacity is not only held idle. It is also contained within activated capacity which underperforms production’s Efficiency, Quality, and Reliability Standards.
In addition to underperforming capacity, there are two other insidious forms of excess capacity which are harder to detect. They increase both Fixed and Variable Unit Costs. Inventories which are produced (and look like utilized production capacity) may have their values written off or written down to a negative contribution in subsequent reporting periods. These losses are rarely tracked back into utilization measures. They represent excess production capacity.
Additionally, Demand is conjured through Margin Sacrifice. This involves price discounts and rebates, together with relaxed credit and service standards. It results in producing output which is unprofitable while bloating ‘Receivables’ and upending production scheduling together with supply chain productivity. Margin Sacrifice fully consumes both Fixed and Variable Costs without any economic benefit to the enterprise. Excess production capacity is dressed up as real ‘Demand.’ Again, these losses are rarely tracked back into common utilization measures.
What Does Excess Capacity Look Like in the Financial Statements?
What does excess capacity look like at the level of corporate financial statements? Is it visible? How would you know if a company was suffering from falling CU by looking at its financial statements. Using Caterpillar (NYSE: CAT) financial data as an example, let’s see if anything here suggests falling utilization of productive capacity and how it looks across asset classes (Source: Guru Focus):
Return on Invested Capital (ROIC) obviously deteriorated between 2011-2016. This means the ratio between Net Operating Profit After Tax (NOPAT) and Invested Capital had deteriorated. Like all productivity ratios, this could mean that NOPAT is falling while Invested Capital is held constant, or vice versa. Alternatively, NOPAT may be falling and Invested Capital may be increasing simultaneously.
Looking at the Total Asset Turnover, it is clear that total asset utilization has fallen progressively from a high of .83 turns in 2008 to a low of .5 turns in 2016. However, did this deterioration occur across all asset classes? If we check the major asset classes, we see that utilization has fallen for Total Inventories (high turnover of 6.42 to a low of 4.21). If we look at Net Property Plant & Equipment, we see that utilization has fallen there too, from 4.56 turns to just 2.45 turns.
Finally, it is always worth looking at Intangibles and Goodwill (plus other Long-Term Assets) to see if perhaps the issue is contained significantly within the impact of acquisitions. Keeping in mind that Caterpillar acquired Bucyrus in July 2011 using cash and debt, it is worth asking whether this acquisition was a driving factor for lower asset utilization. Was the excess capacity imported?
There had been a significant reduction in asset utilization by the end of 2016, and it was clearly evident in ratios between the value of various asset categories and revenue over time.
In addition to lower capacity utilization, Operating Profit deteriorated significantly from 2012. This means that the collapse of ROIC was due to a deterioration at both ends of the ROIC ratio, NOPAT, and Excess Invested Capital.
The Gross Margin did deteriorate from a high of 28.7% in 2010 to 26.54% in 2016. However, this deterioration was not the driving cause of the collapsing Net Margin. It also does not appear to line up with the Bucyrus acquisition in 2011, as the Gross Margin was sitting at or above 28% in both 2014 and 2015. It appears that the Gross Margin was not the overarching problem. That suggests that productivity declines and margin sacrifice were at most only marginal drivers of deterioration in profit.
The phenomenal loss of revenue between 2014-2016 ($16.6B) left only difficult decisions at the Operating Margin. Research and Development expense for autonomous technology and improving product productivity was not brought in line with falling revenue rising from 3.87% to 5.06% of revenue between 2014-2016.
Restructuring Costs and Other Expenses burgeoned in 2015 and 2016 as $1.5B of expenses were targeted (including SG&A). They doubled from 4% of revenue to 8% in 2016. Restructuring Expenses combined with SG&A and R&D pulled the Operating Margin down to 1.69% in 2016. SG&A needed to be ruthlessly reduced, but here, management were trying to catch a falling knife. It is easy to be ‘ham fisted’ in an account of these outcomes. However, the the best starting point for an action plan is to start with the answer and ask, ‘What had been Caterpillar’s best utilization of assets and margins over the last ten years?’ Surely, those asset and profit performance ratios should be the starting point.
Start with the Answer
If we go back and simply ask what value of assets would have been required to meet the customer demand implicit in 2016 revenues ($38.537B), having realized the best asset turnover performances from the last 10 years, the answer is sobering.
If Caterpillar has maintained its best Total Average Asset Turnover from 2008 (.83), it would have required a total of only $46.521B in Total Assets in 2016 instead of the $74.704B it had parked on its balance sheet at the end of 2016. That is a phenomenal amount of excess invested capital. In turn, it represents an incredible amount of excess inventory, property plant and equipment, as well as $18B of Intangible and Long-Term Assets that it would not have required in 2007. If the balance sheet was as well utilized in 2016 as it was in 2007, Caterpillar would have needed $28.103B less than it had on its balance sheet at the end of 2016.
This would go a long way to returning Caterpillar’s ROIC to a positive economic spread rather than its present situation where NOPAT is not sufficient to cover its Weighted Average Cost of Capital (WACC).
Caterpillar management would no doubt cite the unreasonableness of expecting them to shed these assets in current circumstances ‘on a dime.’ They would probably argue that most of the damage accrued from falling demand from 2014-2016. However, the best performance turnover of .83 was reached in both 2008 and 2011. It deteriorated over a period of nine (9) years rather than just two (2). In fact. it recovered in 2011 only to decline again to its present level. Caterpillar’s asset utilization did not deteriorate ‘on a dime’ and nor did its Asset Turnover ratios.
The point of this paper is not to propose a path forward for Caterpillar or to second guess management’s decisions on any single issue in the past. It is to make the point that managing Capacity Utilization is not some operational slideshow that deals solely with the task of utilizing idle plant and machinery within the production function. Nor is it something that should be controlled by subjecting it to periodic ‘big bang’ rationalization events. Managing Capacity Utilization is a sophisticated problem that must be subjected to persistent cross functional scrutiny and review disciplines, as well as clear goals. It must be managed on both a financial and operational plane.
Disclaimer: This article is meant to facilitate an open discussion of management methods and programs. It is for discussion purposes only. It is not intended to rate risks associated with investment or to recommend any form of investment activity. There are risks involved with investing including loss of principal and income and the author does not profess to have any knowledge or expertise related to investment performance. The author makes no explicit or implicit guarantee with respect to the accuracy of the data presented herein, or any related calculations or projections. As always, conduct your own research. I wrote this article myself, and it expresses my own opinions.
Productivity Step Change (PSC) is a global Management Consulting Group based in the US dedicated to maximizing Capacity Utilization, improving Return on Invested Capital (ROIC), and increasing productivity for its clients across industry. Our enterprise-level, data-led, cross-functional business analysis typically requires 4-6 calendar weeks and is designed to provide evidence of your opportunities for overall growth. Please contact us if you would like to schedule time for a discussion and presentation.