Capital Expenditures: Business spending is bound to increase economic activity.

Capital Expenditures: Business spending is bound to increase economic activity. INVESTMENT STRATEGY GROUP

Introduction One of the key drivers of a country s gross domestic product (GDP) and productivity is the amount it spends on capital stock the machinery, equipment, and buildings used to create goods and services. Since the Great Recession, Corporate America has been under-investing in its capital stock, which has led to significant pent-up demand across many economic sectors. This provides a source of future economic growth and investment opportunities, as capital expenditures (CAPEX) improve over the coming years. In this piece, we look at the industries and stocks that stand to benefit from improving CAPEX. Aging Equipment and Weak Productivity The 5-year growth rate of U.S. capital stock has dropped to the lowest level in the post-wwii era, and the average age of the capital stock is getting close to the previous two peaks indicating that pent-up demand for capital spending exists (Figure 1). This lack of spending now seems to be showing up in U.S. productivity data. Figure 2 shows that productivity s most recent peak occurred around 1999 2000, a time of peak capital spending and new equipment. With the exception of the 2009 2010 timeframe (when only the most productive workers were employed), productivity has been drifting lower toward the current cycle lows. Figure 1: Historically Low Spending on Capital Stock Peak spending corresponded to previous productivity peak. Current spending historically low. (Source: Janney ISG, BCA Research 2014) Figure 2: Waning Productivity Growth 5.0 4.5 4.0 Nonfarm Labor Productivity - Output per Hour Peak productivity corresponded to previous spending peak. 3.5 Labor Productivity - % 3.0 2.5 2.0 1.5 1.0 0.5 Current productivity low. 0.0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 (Source: Janney ISG, U.S. Bureau of Labor Statistics) 2

Corporate America is Well-Positioned to Spend While aging equipment, low spending levels, and waning productivity are indicators of the need for increased CAPEX, Corporate America is also well-positioned to execute CAPEX plans. CEO confidence has dramatically improved since the Great Recession, profitability is at all-time highs, and corporations are flush with cash. Corporate debt financing remains very reasonable, the cost of equity capital has declined, and fiscal (tax and regulation) uncertainty has improved. All of this makes it much easier for managers to give the green light to major corporate expenditures. Healthy Banks are Increasing their Lending The banks are in great shape to provide credit for businesses at favorable financing conditions, and are now doing so. The most recent (July) Federal Reserve quarterly survey of senior loan officers showed a broadly-based increase in the demand for bank credit, while lending standards continued to ease from the very tight conditions that have existed since the 2008 financial crisis. Commercial and Industrial (C&I) business loan demand is rising sharply for large firms as well as small and medium enterprises while loan officers are reporting stronger financing demand related to investment in plant and equipment. Figure 3: Corporate Profitability at Record High $35 Figure 5: Commerical and Industrial Bank Loans at All-Time High $1,800 $30 $1,700 $1,600 Quarterly per Share profits ($) $25 $20 $15 $10 $5 S&P 500 Index Quarterly Profits C&I Loans - $ Billions $1,500 $1,400 $1,300 $1,200 $1,100 $1,000 $900 $800 $0 3/1/2003 6/1/2003 9/1/2003 12/1/2003 3/1/2004 6/1/2004 9/1/2004 12/1/2004 3/1/2005 6/1/2005 9/1/2005 12/1/2005 3/1/2006 6/1/2006 9/1/2006 12/1/2006 3/1/2007 6/1/2007 9/1/2007 12/1/2007 3/1/2008 6/1/2008 9/1/2008 1/1/2003 4/1/2003 7/1/2003 10/1/2003 1/1/2004 4/1/2004 7/1/2004 10/1/2004 1/1/2005 4/1/2005 7/1/2005 10/1/2005 1/1/2006 4/1/2006 7/1/2006 10/1/2006 1/1/2007 4/1/2007 7/1/2007 10/1/2007 1/1/2008 4/1/2008 7/1/2008 10/1/2008 1/1/2009 4/1/2009 7/1/2009 10/1/2009 1/1/2010 4/1/2010 7/1/2010 10/1/2010 1/1/2011 4/1/2011 7/1/2011 10/1/2011 1/1/2012 4/1/2012 7/1/2012 10/1/2012 1/1/2013 4/1/2013 7/1/2013 10/1/2013 1/1/2014 4/1/2014 Figure 4: Corporate Cash (% of Assets) at Record Levels 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 3/1/2003 6/1/2003 9/1/2003 12/1/2003 3/1/2004 6/1/2004 9/1/2004 12/1/2004 3/1/2005 6/1/2005 9/1/2005 12/1/2005 3/1/2006 6/1/2006 9/1/2006 12/1/2006 3/1/2007 6/1/2007 9/1/2007 12/1/2007 3/1/2008 6/1/2008 9/1/2008 12/1/2008 3/1/2009 6/1/2009 9/1/2009 12/1/2009 3/1/2010 6/1/2010 9/1/2010 12/1/2010 3/1/2011 6/1/2011 9/1/2011 12/1/2011 3/1/2012 6/1/2012 9/1/2012 12/1/2012 3/1/2013 6/1/2013 9/1/2013 12/1/2013 3/1/2014 6/1/2014 12/1/2008 3/1/2009 6/1/2009 9/1/2009 12/1/2009 3/1/2010 6/1/2010 9/1/2010 12/1/2010 3/1/2011 6/1/2011 9/1/2011 12/1/2011 3/1/2012 6/1/2012 9/1/2012 12/1/2012 3/1/2013 6/1/2013 9/1/2013 12/1/2013 3/1/2014 6/1/2014 Cash as a % of Assets Cash as a Percentage of Assets for S&P 500 Index All of this makes it much easier for managers to give the green light to major corporate expenditures. 3

De-Levered Consumers are Gaining Confidence and have Pent-up Demand A healthy consumer is critical for increased consumption of goods and services produced by Corporate America. Consumers have de-levered, as the housing and financial market recoveries have restored consumer balance sheets to a much better state. Net worth is at an all-time high, and debt service levels are at historically low levels. The recent Fed lending survey also showed that consumer lending demand has picked up sharply across the board, including credit cards and auto loans. Net worth is at an all-time high, and debt service levels are at historically low levels. This supports consumption and provides a solid investment backdrop. Analysis of Historical Capital Spending Points to Opportunities Table 1 shows U.S. capital spending by economic sector over the last decade, and includes the S&P 500 Index s weighting of the sector a measure of the sector s size and importance to the overall stock market and economy. Capital expenditures have been led by Energy (35%), Utilities (21%), and Materials (11%). Table 1: U.S. CAPEX Spending (2003 2013) and Average Age of Private Assets Sector Capex Spending Weight in S&P 500 Equipment Current Age / Average Age since 1980 Energy 35% 10.4% 3.50 / 4.92 Utilities 21% 2.9% 12.30 / 12.55 Materials 11% 3.6% 7.90 / 9.07 Industrials 8% 10.3% 8.20 / 6.86 Consumer Discretionary 7% 12.0% - Telecom 6% 2.4% - Consumer Staples 5% 10.2% - Financials 3% 15.7% - Technology 2% 19.8% 5.50 / 4.26 Healthcare 2% 13.2% 4.50 / 3.85 (Source: BCA Research and BEA) The Energy sector is in the middle of the U.S. Shale Energy Renaissance, and this spending has been very productive. We see additional Energy opportunities, and further discuss this sector below. While the Utility sector is historically CAPEX-intensive, it is finally working through all of the capacity that was built early last decade, and we are mildly bullish on the sector s prospects. The Materials sector added capacity just as China and other emerging markets were seeing their growth rates slow a tough combination that leads us to be cautious on the sector. The table also shows significant under-investment (relative to economic importance) for Technology (2%), Healthcare (2%), and Industrials (8%). We see significant investment opportunities for these sectors. 4

Technology Increased capital spending should benefit many sectors, but the Technology sector stands to benefit disproportionately. Tech investment has fallen close to a 15-year low as a share of overall investment underscoring that the average age of its capital stock is particularly high. The corporate sector s need to address weak productivity growth (an indication that prolonged under-investment may have begun to take a toll on corporate efficiency) is a key catalyst for Technology spending. Governments around the world are now in better fiscal shape. Government spending is a significant contributor to overall demand for Tech goods comprising nearly 20% of total investment. While government outlays on Technology-related goods and services have been extremely weak over the past two years, improvements in federal, state, and local budgets are indicating better times ahead. Personal consumption trends are also a major influence on the Tech sector. Consumer spending growth on Technology products bottomed in 2011, and has crossed into positive territory for the first time in three years. Tech export indicators look healthy and, despite the positive cyclical and secular backdrop, Tech valuations remain reasonable. Industrials Considerable outlays on industrial equipment need to occur to replace aging infrastructure and support the U.S. Energy Renaissance. Significant under-investment has also occurred for electrical equipment, as well as power and communication. CAPEX on structures is just beginning to rebound from the real estate recession. Healthcare Healthcare equipment providers should be major beneficiaries of the last decade s lack of healthcare CAPEX spending and the current favorable healthcare trends. We expect the pace of healthcare expenditure growth to exceed that of the overall economy with an aging population, pent-up demand for healthcare services, lower unemployment levels, and rising commercial insurance membership bolstering the sector. The current trend of increased paid patient hospital visits is providing healthcare facilities with the confidence to continue with their expansion plans, to the benefit of the equipment providers. This is already helping to boost medical equipment new order growth. Energy While U.S. energy investment has been very high over the last decade, we think the U.S. Energy Renaissance has much further to go. We also see global oil markets tightening, as global growth improves and rest-of-world production growth struggles due to geopolitical problems in major oil-producing countries (Iraq, Iran, Libya, and Russia). While the integrated oil companies and the exploration and production (E&P) companies benefit from these trends, the biggest winners of high CAPEX are the oil service companies and the Energy Master Limited Partnerships (MLPs). 5

Table 2: Stocks Benefitting From CAPEX Company Name August 13, 2014 Ticker Forward P/E Earnings Growth Dividend Yield Credit Rating Notes Coverage Technology Tech investment has fallen to a 15-year low as a share of overall investment. Technology firms are enabling advanced infrastructure development and playing a key role in improving productivity. They are also developing the advanced wireless and wireline communications networks for businesses and consumers across the world. APPLE INC AAPL 14.18 11.31 1.84 AA+ MICROSOFT CORP MSFT 15.69 8.16 2.56 AAA Providing leading edge wireless productivity solutions for consumers and business. New product releases are just in time to help increase productivity. /J ORACLE CORP ORCL 12.67 10.16 1.20 A+ Enterprise technology solutions are at center of corporate productivity enhancements. QUALCOMM INC QCOM 13.76 13.57 1.97 NR Leading provider of wireless broadband technology. EMC CORP/MA EMC 14.26 11.38 1.43 A Storage is always at the top of the IT budget list. /J VANGUARD INFO TECH ETF VGT Cap-weighted basket of 410 info tech stocks. ISHARES NORTH AMERICAN TECH-SOFTWARE IGV ISHARES NORTH AMERICAN TECH- MULTIMEDIA NETWORKING Industrials IGN Cap-weighted basket of 59 U.S.-traded software companies. Cap-weighted basket of 32 U.S.-traded multimedia networking companies. Considerable outlays on industrial equipment need to occur to replace aging infrastructure and support the energy renaissance. Machinery firms manufacture construction and mining equipment, engines, and turbines for industrial and transportation use. Railroads are playing a key role in increasing infrastructure productivity. GENERAL ELECTRIC CO GE 15.03 9.15 3.30 AA+ CATERPILLAR INC CAT 16.22 9.76 1.81 A Leader in Power & Water, Oil & Gas, Aviation, Transportation, and Energy Management. Enables much of the heavy infrastructure lifting across the globe. INGERSOLL-RAND PLC IR 17.14 12.50 1.52 BBB QUANTA SERVICES INC PWR 16.58 11.75 NR UNION PACIFIC CORP UNP 16.96 12.62 1.70 A Energy Company is participating in the residential and commercial construction recovery. Designs, installs, and maintains electric, gas and telecom infrastructure. Largest U.S. railroad. Rails are playing major role in many aspects of infrastructure. The U.S. Energy Renaissance has a long way to go, and Energy Service & Equipment companies and MLPs are well-positioned. HALLIBURTON CO HAL 14.27 12.00 0.83 A SCHLUMBERGER LTD SLB 17.30 13.00 1.69 AA- NATIONAL OILWELL VARCO INC NOV 12.98 10.51 1.51 A+ ENTERPRISE PRODUCTS PARTNERS EPD 23.38 8.94 3.78 BBB+ ISHARES U.S. OIL EQUIPMENT & SERVICES IEZ Leading Oil Service firm at the center of U.S. Energy Renaissance. Bellwether of oil services group, and hence, premium valuation. Major provider of energy infrastructure equipment and services. Large, well capitalized MLP operating in virtually all shale basins. Cap-weighted basket of 47 oil & gas equipment and services companies. ETRACS ALERIAN INFRASTRUCTURE MLPI Health Care Provides broad exposure to energy infrastructure MLPs. Health Care Equipment companies are major beneficiaries of an aging population and future high levels of healthcare spending. MEDTRONIC INC MDT 15.62 7.64 1.78 AA- CERNER CORP CERN 31.47 17.33 ISHARES U.S. MEDICAL DEVICES IHI Very diverse product line, strong cash flow, valuation and dividend support. Leading health information technology firm is helping to transform healthcare. Cap-weighted basket of 40 equipment manufacturers and distributors. Definitions: Forward P/E - Current stock price divided by EPS consensus estimate for the next four quarters. Earnings Growth Estimate - Mean broker estimate of the compounded annual growth rate of the operating eps over the company s next full business cycle (typically 3-5 years). Dividend Yield - Trailing 12-month dividend per share divided by share price. Credit Rating - Rating assigned by Standard & Poor s to the long-term obligations of the issuer if repaid in the local currency of the issuer. 6

JANNEY MONTGOMERY SCOTT LLC www.janney.com The Highest Standard of Success in Financial Relationships 2014, Janney Montgomery Scott LLC Member: NYSE, FINRA, SIPC This report is provided for informational purposes only and shall in no event be construed as an offer to sell or a solicitation of an offer to buy any securities. The information described herein is taken from sources which we believe to be reliable, but the accuracy and completeness of such information is not guaranteed by us. The opinions expressed herein may be given only such weight as opinions warrant. This Firm, its officers, directors, employees, or members of their families may have positions in the securities mentioned and may make purchases or sales of such securities from time to time in the open market or otherwise and may sell to or buy from customers such securities on a principal basis.