The stock market presents investors with a paradox, for while it can be hard to put it all into practice, the basic principles are mostly pretty straightforward. One of the most important of these is "be very wary of capital-intensive businesses".
A capital-intensive business earns a relatively small return on the assets its owns – and has to spend a large portion of that profit on maintaining and enhancing those assets.
Before a bread manufacturer can make a loaf, for example, it will need to buy dough-mixers and an oven – and it will need to spend money each year to maintain the existing mixers and ovens and to buy new ones if it wants to grow. This is known as capital expenditure, or ‘capex’ if you find seven syllables exhausting.
- Understand why companies are spending on capex
- Get to grips with the cash flow statement
- Favour companies that gush free cash flow
It's dead easy to see how much a company is spending on capex. All you need to do is head to its cash flow statement. We'll use ResMed’s 2013 annual report as an example (jump to page F6). Table 1 is an extract if you’d like to keep it simple.
|Net cash provided by operating activities||402.8||383.2|
|Purchases of property, plant and equipment (capex)||63.6||47.1|
|Free cash flow||339.2||336.1|
The line you’re looking for is ‘Purchases of property, plant and equipment’ (sometimes called ‘payments’ and found under ‘Cash flows from investing activities’). This is the money the company has spent on capital expenditure. In ResMed’s case it will include spending on the machinery needed to manufacture its range of masks and flow generators.
You can see from Table 1 that ResMed spent $63.6m on capex in 2013. To determine whether that’s significant, you need to compare it to something else. Usually, the appropriate number is ‘net cash provided by operating activities’ (also known as operating cash flow).
Not capital intensive
Table 1 shows that ResMed isn’t a capital-intensive business. In 2013 it spent only 16% of its operating cash flow on capital expenditure (up from 12% in 2012). ResMed produces copious quantities of free cash flow – the cash flow that remains after the capex – and that, as a shareholder, is just what you’re looking for. (For more on free cash flow – and capital expenditure – see Why cash flow yield beats PER from 26 Apr 12.)
|Net cash provided by operating activities||161.0||267.4|
|Purchases of property, plant and equipment (capex)||293.2||215.5|
|Free cash flow||-132.2||51.9|
BlueScope spent almost double its operating cash flow on capital expenditure in 2013 and, over the past two years, its operating cash flow has been entirely consumed by its ongoing investment in plant and equipment. It is the very definition of a capital-intensive business.
So what’s the problem?
It’s true that capital-intensive businesses can thrive, at least for a while. Boom conditions will swell operating cash flow and help fund the necessary capex. Management will usually spend even more on shiny new equipment while the good times roll. Who wants ageing machinery when your markets are going gangbusters?
Banks are only too happy to lend companies money for expansion during booms. Up go a company’s sales, up goes its capex, and up goes its debt.
Cash flow crunched
The problem arises when a downturn hits. Cash flow gets crunched but capital-intensive businesses still need to spend money maintaining and replacing equipment. Dividends are slashed and capital raisings launched.
In fact, this describes BlueScope’s situation exactly over the past five years.
If you’d like to follow the story of a capital intensive business, Intelligent Investor Share Advisor’s reviews of BlueScope Steel between 2002 and 2013 make for interesting reading. Today’s share price of $6.56 is the equivalent of $1.09 thanks to a 6-for-1 share consolidation in 2012, which is a decline of more than 90% from its peak. The series of articles illustrate how a capital intensive market darling came unstuck after the boom ended in 2008.
So here’s the problem with capital-intensive businesses: the significant amounts of money required to fund capital expenditure have to come from somewhere. Operating cash flow and banks might fund it for a while, but shareholders usually end up paying eventually.
But this isn’t the only issue with capital expenditure. The value of plant and equipment depreciates over time, which is how the accounting term ‘depreciation’ originates. Depreciation represents an allocation of the cost of plant and equipment over its useful life.
Like a car that depreciates by 20% as soon as you drive it out of the showroom, plant and equipment declines in value quickly. Unlike your car, it’s difficult to know whether these items are worth the value ascribed to them on a company’s balance sheet. And capital-intensive companies have more plant and equipment on the balance sheet than most.
Maintenance vs growth capex
It's important to recognise, however, that – like the assets themselves – capital expenditure comes in different shapes and sizes and not all of it is bad. Probably the first distinction to make is between what is often called maintenance (or ‘stay-in-business’) capex and growth (or 'expansion') capex.
Maintenance capex is spending that’s required to upgrade existing assets to remain competitive and keep profits at existing levels; growth capex is the spending that companies undertake to expand operations and increase profit. Theoretically it’s maintenance capex that you should deduct to determine free cash flow, but in practice few companies separate it out and it’s safest to deduct all capex, while recognising that this should be a conservative figure.
Some companies do, however, split capex into different categories. Woolworths, for example, splits its capex between property-related and other spending. Property capex is higher quality because it’s likely to increase in value rather than depreciate, and land and buildings are easily saleable. Woolworths’ other capex – shop fitout, distribution centre machinery and the like – is lower quality because it declines in value and will eventually require replacement.
As you can see, it's vital for investors to get to grips with a company's cash flow statement. And, after operating cash flow, the next most important item to consider is a company’s spending on property, plant and equipment.
It’s your money after all; any cash spent on capital expenditure is money that won’t end up in your pocket, at least for the time being. Companies that are profligate here rarely deserve your investment capital. Make sure you prefer the cash generators over the cash consumers.