Issue 8

The CAPEX explosion

Delivered on 02 November 2018 by Justin Pyvis. About a 4 min read.

I like to keep my eye on happenings that seem out of place, or what we economists call leading indicators. So I watched eagerly when the FAANG stocks (Facebook, Apple, Amazon, Netflix and Google) started to report their third-quarter earnings reports.

A bit of background. Capital expenditure (CAPEX) has exploded in the last few years, especially in Silicon Valley. The chief culprits are the FAANGs, which around 2015-16 really started to ratchet up their spending.

The figure below shows the CAPEX of four of the five FAANGs (2018 is my full-year estimate). I excluded Netflix as although its spending trend is similar - up 248% in the last five years - total CAPEX is just 420 million, well below the other four.

While Google is the biggest spender at an estimated $24 billion, the real outlier is Facebook. Its CAPEX has risen from $1.36 billion in 2013 to an estimated $12.54 billion in 2018, for an increase of about 822% in just five years. It now invests almost as much as Apple and about the same as Amazon, even though it’s a “social media company” (it’s not; see my earlier work to find out why).

Misplaced optimism?

Clearly these companies are optimistic about their future growth prospects; Facebook, Amazon and Apple are spending about the same as Exxon Mobil - a major oil company - and Google is spending more. They’re also spending big on research and development, with Amazon blowing $22.6 billion in the year ended 30 June, up 40% from a year earlier (Google spent $16.2 billion). But given the seemingly constant stream of privacy violations and intense competition in a constantly evolving sector, is that optimism misplaced?

Amazon and Apple are your more traditional, consumer-focused companies. Apple makes phones and other gadgets and sells them directly to you. Amazon is effectively a massive retailer, even if its profits are almost entirely derived from its cloud services. They both need to invest in factories, retail outlets, logistics, and so on.

But Google and Facebook are advertising companies. They really only need office space for their employees (Google spent $2.4 billion on a piece of commercial real estate in New York), along with data centres and computing equipment to power their services. It’s hard to imagine needing to spend nearly $15 billion when your products are essentially a couple of web and mobile applications.

When quizzed on that topic late last year, Facebook CFO David Wehner cited the following reasons for the CAPEX splurge:

  • Sizable security investments in people and technology to strengthen its systems and prevent abuse.
  • Investing aggressively in video content to support the Watch Tab.
  • Continued investment in long-term initiatives around augmented and virtual reality, AI and connectivity.
  • Substantial investments in its infrastructure to support growth and improve its products.

Mark Zuckerberg noted that the company was planning to have 20,000 people working on safety and security in 2018, up from 10,000 in 2017. But even if you paid them all $100,000 a year, that only accounts for 1 of the additional 6 billion in new CAPEX this year. So the rest must be going into infrastructure for video and connectivity, along with possible future ventures such as virtual reality and AI.

Time will tell

Only time will tell whether the new ventures will pay off and reward these companies for their investments. I’m sceptical of AI. I think there is little doubt it’ll improve productivity in numerous sectors (e.g. driverless vehicles), but also that firms are spending far too much on anyone or anything that says it’s an AI expert. It has limitations (which I’ll get into in a future note) and so much of it will turn out to be vapourware, with the capital ultimately wasted. I’m also not sold on virtual reality, but I suppose if you’re an advertising company and you don’t at least explore the technology, it could be your death knell.

But whatever you think of the technologies, it’s a risky strategy to invest so much this late in the business cycle (we’ve now had 111 months of economic expansion, or nearly 10 years of constant growth). But it’s also hard not to. 2018 is shaping up to be the best year since the last recession and financial conditions are the easiest they’ve been since the early 1990s. You’d be crazy not to spend.

Indeed, investors love the FAANGs in part because they spend so much; their lofty valuations are driven by future earnings prospects, which are predicated on today’s large investments paying off sometime down the road.

However as the saying goes, the best laid plans of mice and men often go awry and it won’t take much for those valuations to come crashing back down to Earth. The Federal Reserve is raising interest rates, the fiscal stimulus from Trump’s tax cuts will wear off, and I suspect China is faring worse than many people realise.

Personally I think you’d be brave to buy the FAANGs this late in the cycle, even if you thought the explosion in CAPEX had been perfectly allocated (note that I’m a relatively risk averse investor).

Issue 8: The CAPEX explosion was compiled by Justin Pyvis and delivered on 02 November 2018.