Good morning. Yields on 10-year Treasuries rose to a nine-month high of 4.7 per cent yesterday, after a strong ISM services survey and a Jolts report that showed higher job openings. Inflation break-evens and the dollar both rose. Looks to us like the market is pricing in a hot economy. Send us cooling thoughts: [email protected] and [email protected].

Accounting is boring but important. Particularly important: the difference between a capital expense and an operating expense. A capital expense (buying a big piece of equipment, say) does not count directly against earnings on the income statement, as an operating expense (paying a salary, say) does. Instead, a capital expense appears on the income statement over time, in theory matching the drag on profits to the life of the capital asset. This spread-out expense shows up in a line called “depreciation”.

I see you sleeping at the back. But I drag you through this tiresome point because the most important companies in the world, the Magnificent 7 Big Techs, are running up a huge amount of capital expenditure, mostly on data centres for artificial intelligence. This is cash out the door today, but the expense will only appear in earnings per share over time. The AI arms race has not fully hit profits yet. The question is whether the market has digested the fact that it must do so before long.

Here is capex at the five of the seven that are, to greater or lesser extents, going bananas on capex (at Apple, capex is steady; at Nvidia, the capex money is coming in, not going out):

These are staggering numbers, and they are still growing.

Amazon looks like an outlier, but that is not quite true. One needs to scale the spending to the rest of the company’s financials. For example, one can look at capex as a percentage of revenue:

At Meta and Microsoft, one of every five dollars that comes in the door goes out as capex; at Alphabet, it is one in seven. And the trend is up (wondering about that big mountain of spending in 2022 at Meta? Remember the Metaverse?).

Now we have a sense of the scale of the spending. But what is important for our topic is the scale of the capital spending compared to what is currently being charged against profits. That is, what is capex relative to depreciation expense? As of the past 12 months, here is what that looks like:

Take Meta for example: depreciation expense is 9 per cent of revenue, capex 20 per cent. That means depreciation expense has to go up significantly in the coming years. That does not mean the group’s operating margins have to eventually fall by the difference (11 per cent); data centre capital expenditures will be spread over four to five years. But if the current level of spending keeps up, the drag on margins will be significant.

So, how much margin compression do Wall Street analysts’ estimates price in for these five companies in the next few years, as AI capex comes home to roost? None whatsoever. At all five companies, in fact, operating margins are expected to expand a bit in the next few years. This is possible, of course. Except for Tesla, all of these companies are increasing revenues quickly, and there is plenty of operating leverage in their models. But it won’t be easy. The optimism about Big Tech profits momentum overcomes all.

Our colleague Will Schmitt pointed out yesterday that corporate bankruptcies in the US hit a 14-year high in 2024. At least 686 companies filed for bankruptcy last year, 8 per cent above 2023’s filings and the biggest load of bankruptcies since 2010:

Is this evidence that higher rates have, at long last, come for over-indebted corporations? Or has the US economy slowed more than we have appreciated?

Of the top 10 largest bankruptcies in 2024, five were private. One, Red River Talc, is Johnson and Johnson’s holding company for baby powder liabilities. We took a look at the remaining four, and threw in two other high-profile names: home goods store Big Lots, container maker Tupperware, fabric seller Jo-Ann Stores, tinsel emporium Party City, discount air carrier Spirit Airlines, and Franchise Group, owner of retail chains such as The Vitamin Shoppe and Pet Supplies Plus.

Just a glance betrays a theme: all are discount stores, or franchises pitched to lower-income consumers. Just like the dollar stores and other discounters, many suffered as low-income Americans cut back on spending amid high inflation. One of them, Big Lots, directly blamed its downfall on this issue. Together they are an acute example of the US’s “K-shaped” recovery.

But these companies, and by extension 2024’s bankruptcy numbers, are not clear evidence of a slowdown. Many were dinosaurs; perhaps surprising they held on for this long. Brick-and-mortar Jo-Ann, Party City, Franchise, and Big Lots have not been able to keep up with Amazon, or bigger box stores such as Walmart and Costco. Same goes for Tupperware and its anachronistic peer-to-peer sales model. Spirit Airlines is a more unique case: while all airlines struggled in the early days of the pandemic, it failed to stay competitive afterward, had issues with its planes, and wound up in a failed merger with JetBlue.

Were Fed rate increases the culprit? The financials paint a mixed picture. All of the companies were saddled with floating rate debt, and many took on more debt in the aftermath of the pandemic (particularly Big Lots, Spirit and Franchise). But not all of them saw their interest expenses balloon: Spirit was able to shrink its payments over time after a big jump in 2019, Jo-Ann and Party City kept interest payments in check, and Tupperware even shrunk them.

The problem for most of them was weak earnings, not rising debt. Here is a chart of their net debts to ebitda ratios. All but Tupperware jumped above six, the ratio that generally sends lenders running for the hills:

Judging by the biggest of the 2024 bankruptcies, we have a lopsided economy, not a weakening one.

(Reiter)