Taxes Fall, Capex Rises

National (and often international) attention was focused on the unveiling of the White House’s revamped tax plan for much of 2017. Regardless of your political leaning, the impact of the bill on US companies was undeniable; the CBO has predicted a $300B+ benefit to US corporations within a decade of the bill’s passage. This impact raised a major question: what will these firms do with their newfound capital? While this question remains largely unanswered, new data from Q1 earnings season suggests some of this cash is headed toward the long term.

The seismic shift in US tax policy, and the resulting payout, may have given companies a necessary push toward re-evaluating their capital allocation strategy.  Of the companies in the S&P 500 that have reported results thus far, capital expenditure (capex), or funds used to acquire and maintain assets such like property or equipment, increased by 39% to levels not seen since 2011. Conversely, the rise in reported buybacks post tax cut from the same companies is less than 20%, albeit off a significantly higher prior year level.

FactSet capex growth chart

This flies in the face of fears that buybacks would skyrocket in the wake of the Tax Cuts and Jobs Act of 2017, the plan’s formal name. It’s an understandable fear when you consider the influence  of short-term pressures and a lull in thoughtful long-term capital investment within the past several years; 101% of S&P500 earnings was spent on buybacks and dividends in 2016. A hypothetical surge coupled with the already high rate of corporate buybacks would likely have contributed to an unsustainable business environment. Buybacks are not necessarily a harbinger of short-term behavior, but a pattern of forgoing reinvestment in the company in favor of more immediate returns does not, on its own, support future growth. A nearly 40% bump in capex off the back of the tax plan would indicate a more widespread long-term intention for these newfound resources, and the return to a more balanced approach to capital allocation decisions on the part of US business.

As McKinsey demonstrated in the Corporate Horizon Index, long-term firms often invest more than their shorter-term peers, especially when it comes to R&D and capex spending. Cumulatively, long-term companies spent nearly 50 percent more on R&D than other firms, continuously seeding future growth. This thoughtful reallocation of capital drives superior returns over time. Companies that maintain allocation priorities year over year, or what McKinsey calls “resource-allocation inertia”, often fail to adapt to new realities or meet new goals, whereas companies with higher levels of capital reallocation experienced higher average shareholder returns.

While many observers were wary of how the recent US corporate investment stagnation trend could manifest itself when injected with billions in tax savings, the data coming out of the first quarter paints a more hopeful picture. Based on the numbers, it appears that US firms are making long-term oriented choices and reevaluating existing allocations when deciding what to do with their new money. 

Is this rise in capex just a flash in the pan? It’s too soon to be certain, but the data are pointing in an encouraging direction.