High capex companies are usually bad investments as they rarely produce enough free cash flow

Supermarket companies, in general have consistently spent more on capex than depreciation and produced very low free cash flow per share compared with EPS for many years.

For example:  Sainsbury's 

Sainsbury's has regularly spent more on capex than its depreciation expense for the period 2006 to 2015.  At the same time, it has reported no meaningful growth in profits as measured by EPS.

Its capex to depreciation ratio for 2006-2015 ranged from 120% to 240%.   

Despite all this investments (capex), EPS has not grown (In 2010 EPS was 30 p  and in 2016 EPS was 22.5p.) and its FCFps has been negative for every one of these ten years,   

Question to ponder

How much of the money spent on capex was to grow the business and how much was needed to maintain its existing assets and sales?

If most of this capex was actually needed for maintenance, then Sainsbury's depreciation expense may have been too low and its profits too high.   

Take home point

Regardless of what the reason is for the high capex, these kind of companies are usually bad investments as they rarely produce enough free cash flow.

The above situation probably explains why Sainsbury's share price went nowhere over a 10-year period from 2005 and 2015 and why Sainsbury's had to cut its dividend payment to shareholders.

If free cash flow per share is consistently a lot lower than EPS, this is a warning sign.

 The 2 main reasons for FCF being lower than a company's EPS are:

1.  Poor operating cash conversion

2.  High levels of investment in new assets.

Poor operating cash conversion

This tends to occur when a company is growing quickly and sells a lot of its goods and services on credit.

The profits on these sales get booked in the income statement but there are no cash flows until the customer pays.

Companies may also build up stocks or inventories in anticipation of selling more.  This is fine as long as the reason is genuine.

But building up stocks is also a good way for companies to shift overhead costs such as labour away from the income statement in order to boost profits.  This can happen when companies include the overhead costs of producing stock in the balance sheet value.  If the stock is unsold at the year-end that overhead cost has not been expensed through the income statement and can therefore boost profits.  

Selling products on credit can be a sign of overtrading, or even fictitious sales.  This sort of thing never turns out well for shareholders, so you need to watch out for this.

2.  High level of investment in new assets

This is when capex is much higher than depreciation.

Depreciation reduces profits, but money spent on capex reduces free cash flow.

In this case, free cash flow per share will be a lot less than EPS.

• Capex that is consistently higher than depreciation with improvement in ROCE

It is not necessarily a problem for a company to spend heavily on capex, as long as the capex is earnings a decent ROCE.  

[Example:   Easyjet in 2015.  Its FCF per share was less than its EPS due to capex being significantly more than depreciation.  However, this is not a cause for worrying too much, as the company's ROCE had been increasing at the same time.]

• Capex that is consistently higher than depreciation with NO improvement in ROCE

However, capex that is consistently much higher than depreciation with no improvement in ROCE is rarely the hallmark of a great company.  

It can be a sign of dodgy accounting as companies can and do shift expenses into capex to boost profit.

When FCF per share is a lot less than EPS it may also be a sign that a company is manipulating its profits to make them look bigger than they really are.  

In these cases, capex is often much higher than depreciation but the company might be spending this cash just to maintain its existing assets, rather than using the expenditure to enhance it s income-producing assets.

• In a nutshell, the cash spent should be expensed against revenues and so it should reduce profits.  
• Unless it does, this, the depreciation charge reported by the company is probably too low and profits too high.   

CAPEX: Look for companies where the capex ratio is consistently below 30%

Quality companies produce high ROCE (at least 15%) and lots of free cash flow because they don't need to spend much money on new assets in order to grow.

Capex Ratio

                              Capex ratio = capex / operating cash flow

This ratio compares the amount of cash a company ploughs back into tits business through capex to the amount of cash coming into the business - its operating cash flow.

It is very easy to calculate a capex ratio for a company, using its cash flow statement.

Low capex ratio (< 30%).

The lower this ratio, the less capital intensive a company is and the better chance it has of producing lots of free cash flow and a high ROCE. 

Look for a capex ratio of lower than 30%.

Non-financial companies with low capex ratios, generally also have very high ROCE figures as well.

High capex ratio (>30%).

Companies with high capex ratios tend to have a very low ROCE.  Generally, companies with capex ratios of 30% or more tend not to produce very high ROCE.

A high capex ratio is sometimes necessary in order to give a company the scope to grow.  This is not usually a problem, as capex will tend to fall back afterwards.  However, when the capex ratio is consistently high year after year, this is a warning sign for investors.

Shell (High capex ratio) versus Domino's (Low capex ratio) for 2006 to 2015

Company Shell consistently ploughed more than half its operating cash flow back into its business with capex for 2006 to 2015.  This consistently high capex ratio - along with volatile oil prices - meant that its free cash flow moved around all over the place in this period.

Domino's capex ratio from 2006 - 2015 were mainly below 30%, except in 2008 and 2009 when it was 45% and 60% respectively.  Domino's capex ratio has declined significantly since 2008 and 2009 (when the company was investing in new distribution centers to help grow the business).  Company Domino's capex ratio is now less than 10% and in 2015 was 8.45%.  

In the ten years to June 2016, Domino's trounced Shell as an investment.  Domino's returned nearly 660%, compared with just 63% for Shell.   The divergent share price performance of the two companies was not  a surprise given what we now know about the importance of free cash flow in quality companies.

Which is Better: Dollars in the Hand or "in the Bush"?

Professional investment managers strongly favour corporations which can plow back a high percentage of earnings into growing their business.

Does this always pay?

Or should the investor prefer his dividends?

For every example of a company that has compounded its growth by wise investment of its cash there are several that would have done better to pass their surplus on to their stockholders.

Very rarely, one finds a management that can do both.

• For example:  Company XYZ paid out almost 70% of its earnings in dividends.  It has invested its cash flow internally to maximum advantage.  Its shareholders have had their cake and eaten it too.

Expected Profits

The normal way for management to look upon proposed investments is to estimate the expected amount of profit.

This varies from industry to industry.

In any case,it would be unreasonable to invest company funds unless the expected return was substantial.

One finds far too much reinvestment that fails to pay off.

It is difficult for management to understand that in some cases stockholders are paid off better with their company dead than alive.




Examine the past record.

Correct judgement of management policy can only come from a full understanding of the problems involved.

It will pay the investor well to look beyond the superficialities of figures showing totals put back into business by management.  

Consideration should be given to the past record.

How have plow-back expenditures actually turned out?




There is no hard-and-fast rule.

Some stockholders profited enormously by management spending.

Other stockholders suffered through management hoarding.

Many unwise investments were made by corporate management at the wrong time.

Some very wise one were made at the right time.

This is an often overlooked factor which you should include in your analysis of stocks to buy.

CAPITAL EXPENDITURES: not having them is one of the secrets to getting rich

CAPITAL EXPENDITURES: NOT HAVING THEM IS ONE OF THE SECRETS TO GETTING RICH

Cash Flow Statement
($ in millions)
-> Capital Expenditures	($1,648)
Other Investing Cash Flow Items	(5,071)
Total Cash from Investing Activities	($6,719)

Capital expenditures are outlays of cash or the equivalent in assets that are more permanent in nature---held longer than a year---such as property, plant, and equipment. They also include expenditures for such intangibles as patents. Basically they are assets that are expensed over a period of time greater than a year through depreciation or amortization. Capital expenditures are recorded on the cash flow statement under investment operations.

Buying a new truck for your company is a capital expenditure, the value of the truck will be expensed through depreciation over its life---let's say six years. But the gasoline used in the truck is a current expense, with the full price deducted from income during the current year.

When it comes to making capital expenditures, not all companies are created equal. Many companies must make huge capital expenditures just to stay in business. If capital expenditures remain high over a number of years, they can start to have deep impact on earnings. Warren has said that this is the reason that he never invested in telephone companies---the tremendous capital outlays in building out communication networks greatly hamper their long-term economics.

As a rule, a company with a durable competitive advantage uses a smaller portion of its earnings for capital expenditures for continuing operations than do those without a competitive advantage. Let's look at a couple of examples.

Coca-Cola, a long-time Warren favorite, over the last ten years earned a total $20.21 per share while only using $4.01 per share, or 19% of its total earnings, for capital expenditures for the same time period. Moody's, a company Warren has identified as having a durable competitive advantage, earned $14.24 a share over the last ten years while using a minuscule $0.84 a share, or 5% of its total earnings, for capital expenditures.

Compare Coke and Moody's with GM, which over the last ten years earned a total $31.64 a share after subtracting losses, while burning through a whopping $140.42 a share in capital expenditures. Or tire-maker Goodyear, which over the last ten years earned a total of $3.67 a share after subtracting losses and had total capital expenditures of $34.88 a share.

If GM used 444% more for capital expenditures than it earned, and Goodyear used 950%, where did all that extra money come from? It came from bank loans and from selling tons of new debt to the public. Such actions add more debt to these companies' balance sheets, which increases the amount of money they spend on interest payments, which is never a good thing.

Both Coke and Moody's, however, have enough excess income to have stock buyback programs that reduce the number of shares outstanding, while at the same time either reducing long-term debt or keeping it low. Both actions are big positives to Warren, and both helped him identify Coca-Cola and Moody's as businesses with a durable competitive advantage working in their favor.

When we look at capital expenditures in relation to net earnings we simply add up a company's total capital expenditures for a ten-year period and compare the figure with the company's total net earnings for the same ten-year period. The reason we look at a ten-year period is that it gives us a really good long-term perspective as to what is going on with the business.

Historically, durable competitive advantage companies used a far smaller percentage of their net income for capital expenditures. For instance, Wrigley annually uses approximately 49% of its net earnings for capital expenditures. Altria uses approximately 20%; Procter & Gamble, 28%; PepsiCo, 36%; American Express, 23%; Coca-Cola, 19%; and Moody's, 5%.

Warren has discovered that if a company is historically using 50% or less of its annual net earnings for capital expenditures, it is a good place to look for a durable competitive advantage. If it is consistently using less than 25% of its net earnings for capital expenditures, that scenario occurs more than likely because the company has a durable competitive advantage working in its favor.

And having a durable competitive advantage working in our favor is what it is all about.

Comparing average capex spending with depreciation and amortization.

1.   Where depreciation and amortization <<< capex

In some cases, the annual depreciation and amortization expense is a lot less than the average five- or  ten-year capex.#

This is the case in asset intensive companies.

When you see this, you have two good reasons against investing in them.  It should not be surprising that these companies

• have very poor free cash flow track records and 
• modest ROCE performances.

Avoid these companies, unless they have been able to produce a good ROCE whilst investing heavily.


2.  Where depreciation and amortization >>> capex.

Normally, you should be suspicious of companies with this kind of behaviour.

Is this a company that has been under-investing?

If yes, this could hurt its ability to make more money in the future.

However, you need to study the company's history on this issue to make sure that it is not under-investing.

Some companies have to spread the cost of things over their useful lives, (for example the costs of a TV channel such as licences, customer contracts, software and programme libraries), which don't need to be matched by outflows of cash every year.   



# As a rough rule of thumb, if the five-year capex figure is higher than the ten-year average, you should use the higher figure.

Calculating Owner Earnings of Buffett or the Company's Cash Profits

Buffett in his 1986 letter to shareholders described how he worked out what he called the "owner earnings".   

This is also referred to as the cash profits of a business.

Buffett believed the reported profits of a business were not a conservative estimate of the amount of money that really belonged to the shareholders of a business.



How to calculate owner earnings or cash profits of a business?

Owner earnings are calculated as follows:

Owner earnings =   net income
                               + depreciation & amortisation
                               + other non cash item
                               - maintainance capital expenditure.


Buffett's view was that the amount of money a company needed to spend to maintain its competitive position (known as maintainance, or stay in business, capex) often exceeded the depreciation and amortisation expense, and therefore profits were overstated.

Also, if a business needed extra working capital (more stocks, or more generous credit terms to customers), this should be added to the maintainance capex figure.



The difference between Owner Earning of Buffett and FCF

Generally speaking, in the owner earnings of Buffett or cash profits of a business, the calculation ignores changes in working capital that are included in free cash flow.



Hardest part of calculating owner earnings is estimating maintainance or stay in capex

The hardest part of this calculation is trying to estimate what maintainance or stay in business capex is.

As a company outsider without intimate knowledge of its assets and their condition it is virtually impossible for you to be exactly right on this.

But the good thing is, you don't need to.

The whole purpose is to get a figure for the amount of cash needed to keep fixed assets in good working order so that you can then have a conservative estimate of cash profits to value a company

Basing your valuation on a conservative figure is more prudent and lowers your changes of paying too much for a share, which in turn lowers your investment risk.

(Additional notes below)



What to do when the owner earnings or cash profits of a business are negative?

If you come across a company that looks as if it is losing money when estimating its cash profits you need to either

• do some more research to see if you have missed something - such as the company investing in lots of new assets rather than replacing them - or 
• look for another share to buy.

Summary:

In summary, here is what you need to do in calculating owner earnings or company's cash profits:

1.  Take the company's most recent annual underlying or normalised net income/profit.

2.  Add back depreciation and amortization.

3.  Take away an estimate of stay in business capex.

4.  Divide by the weighted average number of shares in issue for the latest financial year to get an estimate of cash profit per share.


Knowing a company's cash profits, we can use these to value shares.  




Additional Notes:

How do you get an estimate of stay in or maintainance business capex?

There are 3 reasonable methods:

1.  The company tells you.

Some companies are very good at simply stating what the figure is.  They give this figure in their annual reports.

2.  Use a multiple of the current depreciation or amortization expense.

Use a figure that is bigger than this, such as 120%.  This can be a reasonable estimate, sometimes.

For some companies, it can be way off if the cost of replacing assets is falling.

3.  Use a five or ten-year average of capital expenditure or capex.

This is likely to include money spent to grow a business but these assets will need to be replaced in the future and so this could provide a good proxy for cash needed to stay in business.

This is a good approach to use if the company does not state the figure outright.

The Capital Expenditure Budget

This is extremely significant in some companies, less so in others.

It will list all the planned capital expenditure showing the date when the expenditure will be made, and the date that the expenditure will be completed and the asset introduced to the business.

Major contracts may be payable in installments and the timing is important to the cash budget.

A sum for miscellaneous items is usually necessary.  For example, major projects might be listed separately and then $15,000 per month added for all projects individually less than $5,000.

Within the capital expenditure budget, timing is very important.

Expenditure affects cash and interest straight away.

Depreciation usually starts only on completion.

Evaluating a Company - 10 Simple Rules

Having identified the company of interest and assembled the financial information, do the following analysis.

1.  Does the company have any identifiable consumer monopolies or brand-name products, or do they sell a commodity-type product?

2.  Do you understand how the company works?  Do you have intimate knowledge of, and experience with using the product or services of the company?

3.  Is the company conservatively financed?

4.  Are the earnings of the company strong and do they show an upward trend?

5.  Does the company allocate capital only to those businesses within its realm of expertise?

6.  Does the company buy back its own shares?  This is a sign that management utilizes capital to increase shareholder value when it is possible.

7.  Does the management spent the retained earnings of the company to increase the per share earnings, and, therefore, shareholders' value? That is, the management generates a good return on retained equities.

8.  Is the company's return on equity (ROE) above average?

9.  Is the company free to adjust prices to inflation?  The ability to adjust its prices to inflation without running the risk of losing sales, indicates pricing power.

10.  Do operations require large capital expenditures to constantly update the company's plant and equipment?   The company with low capital expenditures means that when it makes money, it doesn't have to go out and spend it on research and development or major costs for upgrading plant and equipment.


Once you have identified a company as one of the kinds of businesses you wish to be in, you still have to calculate if the market price for the stock will allow you a return equal to or better than your target return or your other options.  Let the market price determine the buy decision.  

Dividends and Total Returns

During the bull market, the pursuit of rapidly growing businesses
obscured the real nature of equity returns. But growth isn't all there
is to successful investing; it's just one piece of a larger puzzle.
Total return includes not only price appreciation, but income as well.


And what causes price appreciation? In strictly theoretical terms,
there's only one answer: anticipated dividends. Earnings are just a
proxy for dividend-paying power. And dividend potential is not solely
driven by growth of the underlying business--in fact, rapid growth in
certain capital-intensive businesses can actually be a drag on
dividend prospects.

Investors who focus only on sales or earnings growth--or even just
the appreciation of the stock price--stand to miss the big picture. In
fact, a company that isn't paying a healthy dividend may be setting
its shareholders up for an unfortunate fate.

In Jeremy Siegel's The Future for Investors, the market's top
professor analyzed the returns of the original S&P 500 companies
from the formation of the index in 1957 through the end of 2003.

What was the best-performing stock? Was it in color televisions
(remember Zenith)? Telecommunications (AT&T T)? Groundbreaking
pharmaceuticals (Syntex/Roche)? Surely, it must have been a
computer stock (IBM IBM)?

None of the above. The best of the best hails not from a hot, rapidly
growing industry, but instead from a field that was actually
surrendering customers the entire time: cigarette maker Philip
Morris, now known as Altria Group MO. Over Siegel's 46-year time
frame, Philip Morris posted total returns of an incredible 19.75% per
year.

What was the secret? Credit a one-two punch of high dividends and
profitable, moat-protected growth. Philip Morris made some
acquisitions over the years, which were generally successful--but the
overwhelming majority of its free cash flow was paid out as
dividends or used to repurchase shares. As Marlboro gained market
share and raised prices, Philip Morris grew the core business at a
decent (if uninspiring) rate over the years. But what if the company-
-listening to the fans of growth and the foes of taxes--attempted to
grow the entire business at 19.75% per year? At that rate it would
have subsumed the entire U.S. economy by now.

The lesson is that no business can grow faster than the economy
indefinitely, but that lack of growth doesn't cap investor returns.
Amazingly, by maximizing boring old dividends and share buybacks, a
low-growth business can turn out to be the highest total return
investment of all time. As Siegel makes abundantly clear, "growth
does not equal return." Only profitable growth--in businesses
protected by an economic moat--can do that.


http://news.morningstar.com/classroom2/course.asp?docId=145248&page=3&CN=COM

A great company with a Durable Competitive Advantage will have a ratio of Capital Expenditures to Net Income of less than 25%. Less is better.

Capital Expenditures are expenses on:

• fixed assets such as equipment, property, or industrial buildings
• fixing problems with an asset
• preparing an asset to be used in business
• restoring property
• starting new businesses

A good company will have a ratio of Capital Expenditures to Net Income of less than 50%. 

A great company with a Durable Competitive Advantage will have a ratio of less than 25%. 

Less is better.


http://equitybondtheory.com/cash-flow/capital-expenditures

Graphic representation of Cash Flows

Strong Cash Flows




Competitive Dividends


http://www.faqs.org/sec-filings/091210/NORTHWESTERN-CORP_8-K/ex99-1_westcoastpres.htm

Buffett (1986): The concept of Owners Earnings and Maintainance Capex

We got to know the master's views on his textile business. Let us go a year further and try to discuss what the guru has to say in his 1986 letter to shareholders.

The letter, as usual, though did contain quite a bit of commentary on the company's major businesses, it also had general investment related wisdom. This time around the master chose to speak on himself and his partner's role. This is what he had to say:

"Charlie Munger, our Vice Chairman, and I really have only two jobs. One is to attract and keep outstanding managers to run our various operations. This hasn't been all that difficult. Usually the managers came with the companies we bought, having demonstrated their talents throughout careers that spanned a wide variety of business circumstances. They were managerial stars long before they knew us, and our main contribution has been to not get in their way. This approach seems elementary - if my job were to manage a golf team - and if Jack Nicklaus or Arnold Palmer were willing to play for me - neither would get a lot of directives from me about how to swing."

"The second job Charlie and I must handle is the allocation of capital, which at Berkshire is a considerably more important challenge than at most companies. Three factors make that so - 

• we earn more money than average; 
• we retain all that we earn; and, 
• we are fortunate to have operations that, for the most part, require little incremental capital to remain competitive and to grow. 

Obviously, the future results of a business earning 23% annually and retaining it all are far more affected by today's capital allocations than are the results of a business earning 10% and distributing half of that to shareholders. If our retained earnings - and those of our major investees, GEICO and Capital Cities/ABC Inc. - are employed in an unproductive manner, the economics of Berkshire will deteriorate very quickly. In a company adding only, say 5% to net worth annually, capital-allocation decisions, though still important, will change the company's economics far more slowly."

The master's non-interference in the management of the businesses he owned is now almost legendary. But just like the companies he invested in, he made sure that the people he put in charge had outstanding track records. Once that was done, he would completely move out of their way and let them manage the business. Indeed, when a business with favorable economics is run by an exceptional manager, the last thing one would want to do is upset the applecart. Yet again, while the line of thinking is simple yet extremely effective, it must have stemmed from the master's own experience of managing the operations of the textile business of Berkshire Hathaway. Having been at the wheels for years, he must have realised how difficult it is to successfully run a business and deliver knock out performances year after year.

Berkshire Hathaway, from the time Buffett has been at the helm, has never paid dividends to shareholders. This is because the master has always felt that he would be able to find a better use of capital than paying out dividends. And find he did! The returns that the company has generated for its shareholders have vastly exceeded returns by any other American company. A very difficult task indeed, especially over a very long period of time. He is also very right in saying that a company that earns above average returns and retains all earnings is likely to see its economics deteriorate much faster than a company retaining only 5% if the retained capital is not put to good use. In the end, the honours should definitely go to the company that makes the most effective use of capital.

The master rounded off the 1986 letter by introducing a concept of owner earnings, the one he frequently uses to evaluate companies. It is nothing but

(a) reported earnings plus 

(b) depreciation, depletion, amortization, and certain other non-cash charges minus

(c) the average annual amount of capitalised expenditures for plant and equipment that the business needs to fully maintain its long-term competitive position and current volumes.

While owner earnings looks similar to cash flow after capex and working capital needs, it does not take into account capex and working capital investment required for generating more volumes but instead takes into account capex that is required to maintain just the steady state operations. In other words, what we call as the maintenance capex. Since inflationary pressures can make maintenance capex look very large, analysts who do not consider it are bound to overestimate the worth of the company. In fact, this is what he has to say on those who do not consider the all-important (c) item in their evaluations.

"All of this points up the absurdity of the 'cash flow' numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) - but do not subtract (c). Most sales brochures of investment bankers also feature deceptive presentations of this kind. These imply that the business being offered is the commercial counterpart of the Pyramids - forever state-of-the-art, never needing to be replaced, improved or refurbished. Indeed, if all US corporations were to be offered simultaneously for sale through our leading investment bankers - and if the sales brochures describing them were to be believed - governmental projections of national plant and equipment spending would have to be slashed by 90%."

http://www.equitymaster.com/detail.asp?date=8/30/2007&story=3