32. Does the business have high or low capital-expenditure requirements?
Determining the capital-expenditure requirements of a business will help you understand how much free-cash flow the business is able to generate. If the capital-expenditure requirements are high, then the cash flows of the business need to be continually reinvested in the business just to maintain existing assets. High capital expenditures reduce cash flow, which is what the value of a business is based on.
For example, a paper manufacturer often loses money due to the cyclical nature of the business. When the paper manufacturer finally generates excess cash flow, management must spend the excess cash flow upgrading its manufacturing plants. Therefore, the cash flows are continually recycled into the business, which causes the value of the business to be stagnant. On the other hand, a business with low capital-expenditure requirements (one that requires less capital to maintain its assets) carries less risk, especially in inflationary environments. Because a business does not need to continually recycle its excess cash flow to maintain its assets, this allows it to reinvest excess cash flow to create more value or distribute these excess cash flows to shareholders.
A capital-intensive business is a business that requires a large amount of capital or assets for every dollar of sales. Here are some examples of capital-intensive businesses:
Semiconductors
Telecom
Retail
Chemicals
Cement
Steel
Pulp and paper
Materials
Mining
Oil and gas
Theme parks
Airlines
Traditional manufacturing companies
Distribution companies
The ratio of capital expenditures to sales of most of these businesses is more than $0.20 of capital for every $1 in revenue. Telecom businesses are some of the most capital-intensive businesses because they require, on average, $1 of capital for every $1 in revenue.
In contrast, businesses that are not capital intensive include:
Franchisors
Intermediaries that earn commissions for connecting buyers and sellers
Software businesses
These businesses are not capital intensive because they do not require major investments in new facilities to grow or maintain their business. These types of businesses add employees, instead of physical plants, to grow the business.
Calculate Maintenance Capital Expenditures
It is important for you to calculate the amount of maintenance capital expenditures a company needs to maintain its business in order to calculate the distributable free-cash flows of a business. Maintenance capital expenditures are the amount of investment necessary to keep the company in a steady state: For example, replacing or upgrading administrative or support facilities such as buildings or parking lots. These expenditures typically do not earn an excess return on the capital expended. They generally help maintain current cash flows, but they do not increase cash flows.
Many businesses require large amounts of maintenance capital expenditures to keep their equipment operational. For example, an oil refinery must constantly reinvest capital to maintain its business. These types of businesses need to spend a lot of their capital updating their plants to meet government regulations or environmental standards, such as Occupational Safety and Health Administration (OSHA) or U.S. Environmental Protection Agency (EPA) regulatory standards. This capital does not earn a return, although in a few instances, it can make a facility more productive. You need to determine what percentage of capital needs to be reinvested to meet these regulatory standards or other non-discretionary required investments. By doing this, you will understand the amount of excess cash flows a business generates, which will help you value the business.
Some businesses continually defer capital expenditures to maintain property and equipment, but that can increase risk because those assets may lose value or require extremely heavy expenditures at a later point in time. For example, if a refinery does not maintain its assets, then the refinery will suffer prolonged periods of downtime when the assets need to be repaired or replaced. This will result in lower cash flows from the business because the refinery will have to shut down parts of its plant to fix the assets that were neglected.
You can find the capital expenditures of a business by reading the company’s cash-flow statement, and you can find further explanation of the breakdown in the MD&A section. Some businesses will differentiate between capital expenditures needed for growth and capital expenditures needed to maintain a business.
For example, Whole Foods Market reported in its 10-K that for fiscal year 2010 (which ended on September 26, 2010) that its capital expenditures amounted to $256.8 million, of which approximately $171.4 million was used for new store development and approximately $85.4 million was spent on remodels and other property and equipment expenditures. However, this is unusual: Most businesses do not separate out the amount of capital expenditures used for growth and those to maintain the business.
Whenever you are unable to calculate the maintenance capital expenditures, you can use depreciation as a rough approximation. It is easier to use depreciation if the business has a low or well-defined growth pattern or steady state. In other cases you will have to adjust the depreciation upward or downward depending on the types of assets a business must maintain.
For example, at book retailer Barnes & Noble, the depreciation of the shelves in the bookstore is higher than the reinvestment needed to maintain them, therefore using depreciation to calculate maintenance capital expenditures would not be appropriate. In contrast, the children’s entertainment restaurant Chuck E. Cheese constantly has to invest more than its depreciation charges to refresh its store base. Those high maintenance expenses decrease the distributable free-cash flows of the business.
For any business you’re considering investing in, you will need to determine how long the assets will last before they need to be replaced. Read the notes to the financial statements in the section where management discloses the breakdown of property, plant, and equipment into categories such as information technology, property, machinery, equipment, buildings, or land. You can then focus on those assets that need to be maintained or replaced (such as machinery) and exclude those that don’t (such as land) when estimating depreciation.
Suppose you’re considering investing in an airline, you should know that planes are replaced every 10 to 20 years. The time to replace an asset depends on the asset and the age of that asset: For example, a plane that is utilized more than another will have to be replaced sooner. As assets age, maintenance capital expenditures typically increase. In order to get a rough estimate of the average age of assets, calculate the ratio of net property, plant, and equipment (PP&E) to gross property, plant, and equipment (note: If a business uses accelerated depreciation, adjust it to straight-line depreciation).
For instance, in 2009, the ratio of net assets to gross assets at cement maker CEMEX was 61 percent, which means that the assets are getting close to their half life. This means that CEMEX potentially faces higher maintenance capital expenditures in the future to upgrade many of its older plants. You would therefore adjust your estimate of future cash flows downward to account for these potential future capital outlays. The closer the ratio of net assets to gross assets is to one, the more this means that a business will not face higher maintenance capital-expenditure requirements to replace its existing assets in the future.
Key Points to Keep in Mind
What You Need to Know about Earnings
The range or distribution of future earnings (cash flow) is a key factor in determining how much investors should be willing to pay for that business.
The wider the potential distribution of future earnings is, the more difficult the business is to value.
For Businesses that Use Conservative Accounting Methods:
The difference between current taxes (taxes paid to IRS) and
the income-tax provision is less than 10 percent.
Cash flows from operations closely approximate net income.
Revenue is recognized when it is earned instead of front-loaded.
Items are expensed quickly rather than capitalized.
Discretionary costs are not manipulated by cutting advertising, research and development (R&D), or maintenance expenses in order to smooth earnings.
Depreciation expenses are not artificially reduced by extending the useful life of assets.
Restructuring charges are not inflated to lower future expenses.
Reserve accounts are neither overstated nor understated.
Provisions for doubtful accounts are correctly matched to charge-offs.
For Businesses that Use Liberal Accounting Methods:
Revenue may be overstated and expenses understated.
Deteriorating fundamentals may be masked.
Low-quality earnings may be derived from unsustainable sources such as:
Gains and losses from debt retirement
Asset writeoffs from corporate restructurings
Temporary reductions in discretionary expenditures for advertising, R&D, or maintenance expenses
Evaluate a Business’s Recurring Revenues
It is easier to forecast the future revenues for a business with recurring revenues because the starting base is a certain percentage of last year’s level of sales, rather than zero.
A business with recurring revenue does not have to continually come up with new products or services to replace the prior year’s revenues, and management is able to more easily budget its expenses.
Identify Whether a Business Is Cyclical, Countercyclical, or Recession Resistant
Earnings that display greater stability over the business cycle are easier to forecast. These businesses are also easier to value.
If customers can defer purchases for a long time, the business will be more cyclical than if customers can only defer purchases for a short time.
The degree to which an industry or business is affected by recessions depends on the amount of recurring revenues a business generates, the percentage of the customer’s budget that is spent on that business’s product or service, and the percentage of the business’s customers that are exposed to the economic cycle.
When a business is labeled as recession resistant, make sure it did not benefit from supply/demand imbalances in previous recessions.
Assess a Business’s Operating Leverage
The more operating leverage a business possesses, the more difficult it is to forecast the earnings of the business because small changes in revenue will cause large swings in earnings.
Those businesses that have high operating leverage typically have a high labor component, high capital-expenditure requirements, high material and production costs, or are required to invest a lot of money in inventory.
Businesses that have high operating leverage and large amounts of debt have a higher probability of going bankrupt.
Identify How Much Working Capital the Business Has
The amount of working capital a business needs depends on the capital intensity and the speed at which a business can turn its inventory into cash.
Businesses that manage working capital inefficiently have less cash flow to put to work.
If improvements in working capital are sustainable, then every dollar of freed-up working capital will boost cash flows.
Know How the Business Handles Its Maintenance Capital Expenditures
A business with high maintenance capital expenditures has to continually reinvest cash flow just to maintain existing assets, typically without making an excess return on that investment.
Whenever you are unable to calculate the maintenance capital expenditures, use depreciation as a rough approximation.
1. Taub, Stephen. “SEC Charges Six with Inflating Revenues.” CFO.com, October 16, 2006. http://www.cfo.com/article.cfm/8047493.
2. Plunkett, Linda M., and Robert W. Rouse. “Revenue Recognition and the Bausch and Lomb Case.” CPA Journal, September 1998; Standard & Poor’s Capital IQ.
3. Badawi, Ibrahim M. “Global Corporate Accounting Frauds and Action for Reforms.” Review of Business, 26, no. 2 (2005).
4. Lahart, Justin. “Corner Office Thinks Short-Term.” Wall Street Journal, April 14, 2004.
5. “Waste Management Ex-CEO Says SECs Suit Against Execs Is Biased.” Corporate Officers and Directors Liability Reporter 17, no. 17 (2002).
6. Byrne, John A. “Chainsaw Al Dunlap Cuts His Last Deal.” BusinessWeekOnline, September 6, 2002; Sunbeam 1996 and 1997 10-K.
7. Sysco 2010 10-K.
8. “Break-even Occupancy Declining.” Hotel & Motel Management, June 16, 2003.
9. Standard & Poor’s Capital IQ.
10. Standard & Poor’s Capital IQ.
CHAPTER 7
Assessing the Quality of Management—Background and Classification: Who Are They?
Most investors overlook the human aspect of operating a business, yet, in most cases, the future success of a business is directly tied to the quality of its people. Instead of focusing on management, many investors spend their time determining whether a business has a competitive advantage or if it is trading at a low valuation, because they believe that products or operational strengths are what set the most successful organizations apart, such as Microsoft’s ubiquitous Windows operating system. The truth is that, over time, these advantages can be imitated, and if the talented managers who created these advantages leave the business, then the business will struggle to continue to innovate and create value.
In fact, Microsoft did lose many talented people who either called in rich or joined new businesses, such as Google. This is one reason that Microsoft has created fewer innovative products. Microsoft’s stock price peaked during the tech boom at $60 per share on December 29, 1999, dropping to $22 per share only a year later. Since then, it has appreciated to $28 per share as of December 31, 2010—not exactly a great rate of return over a 10-year period.
As an outside investor, you cannot know every detail of what’s going on inside a business. There are too many variables that impact the future valuation of a business. You must trust management to make the right decisions. More important, you must know that management can recover quickly from setbacks. In order to trust managers, you need to gain insight into their character and their ability to execute. This will help you improve your forecasts for the business going forward.
Think about how many great businesses of the past have faced ruin due to mismanagement—for example, energy business Enron. Early on, Enron held many high-quality assets, including pipelines. Over time, management transitioned the business into a trading firm, and Enron spun off or sold these high-quality assets. While Enron went bankrupt, many of these spin-offs, such as pipeline business Kinder Morgan Energy Partners (operated by highly capable chief executive officer Richard Kinder), went on to become extremely successful.
To appreciate how essential sound management is to the long-term success of a business, consider that top managers typically:
Are responsible for designing the business.
Determine the future growth rate of a business.
Are in charge of choosing the right people and providing the right environment for these people to perform at their highest potential.
Determine how to allocate the firm’s capital.
Knowing the type of management team you are partnering with will help you forecast the future of the business, because the most logical predictor for the future success of a business is its management. A business does not need to have every manager be an allstar, but at the very least, the managers in key positions need to be allstars. Give yourself plenty of time to understand the quality of the management team running a business. This topic is so important that I’ve devoted three chapters to it: Chapters 7, 8, and 9.
It is best to evaluate a management team over time. By not rushing into investment decisions
and by taking the time to understand a management team, you can reduce your risk of misjudging them. Most errors in assessing managers are made when you try to judge their character quickly or when you see only what you want to see and ignore flaws or warning signs. The more familiar you are with how managers act under different types of circumstances, the better you are able to predict their future actions. Ideally, you want to understand how managers have operated in both difficult and favorable business environments.
Your overall strategy should be to develop a working picture of a manager and the management team. You can start learning about management by gathering all of the historical and current articles written about each manager. These articles serve as a trail of evidence as to the past accomplishments of the management team, the type of people they are, and how they have dealt with different types of situations. You can answer a great number of questions in this book just by reading articles. You can use aggregated news archives, such as Dow Jones Factiva or LexisNexis, which archive historical articles as far back as the 1980s from publications including the Wall Street Journal, the Financial Times, the New York Times, and various trade journals. Look for articles that reveal how the top managers run the business and the type of people they are. Interviews are especially useful, because managers tell you a great deal about their business philosophy or how they operate the business. Use interview sources such as the Wall Street Transcript or the Charlie Rose show, which often feature roundtable discussion or lengthy interviews. Pay particular attention to what motivates the managers and why they are where they are professionally.
The Investment Checklist Page 21