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|Subject: Further Thoughts on Cap Ex||Date: 12/11/2000 8:11 PM|
|Author: WTilson||Number: 5675 of 10417|
Let's start with a quick example: a company buys a truck for $100,000 that it expects will last for 10 years. The company will depreciate $10,000 each year over that period -- an expense on the income statement (albeit one that is not usually broken out separately). In the first year, on the cash flow statement $10,000 will be added back in the "Depreciation and amortization" line, and the full $100,000 cash cost will appear under cap ex.
On the balance sheet, as soon as the truck is purchased, cash will decline by $100,000 and "Net property, plant and equipment" will increase by the same amount, and then decline by $10,000 per year as the depreciation is moved to the income statement.
(Incidentally, the failure to account for cap ex is one of the many reasons why EBITDA -- earnings before interest, taxes, depreciation and amortization -- is such a bogus number. EBITDA ignores very real, very necessary, and often very large capital expenditures. Occasionally there is a legitimate reason for a company to use EBITDA as its primary measure of profitability, but in general, be very wary when this is the case.)
Maintenance Cap Ex vs. Growth Cap Ex
Maintenance cap ex is what a company has to spend to maintain its existing operations and market position. In a business with low or modest growth, almost all of cap ex is typically for maintenance. In this case, depreciation will generally be roughly equal to cap ex.
Growth cap ex is what a company spends beyond what is necessary. In this case, a company is taking its free cash flow and, rather than returning it to shareholders (via dividends or stock buybacks), is investing it in the hopes of generating a return above the cost of that capital.
But how can one distinguish between the two types of cap ex, since they are combined in the cash flow statement? Good question. Sometimes a company will give guidance, but you generally just have to use your judgement. If cap ex is significantly higher than depreciation, or had been steady for many years, and suddenly spiked up, it could indicate new growth cap ex. (It could also mean that the company had been spending too little on maintenance cap ex in the past.)
If it's a steady, modest-growth business, with depreciation roughly equal to cap ex, then it's probably safe to assume that all the cap ex is for maintenance. This is also generally true at the opposite end of the spectrum: it is hard to argue that a rapidly growing company with fast-changing technologies could safely cut cap ex and maintain its market position and cash flows. (Keep in mind, however, that current cash flows may not be a good way to value this type of business.) Thus, to be conservative, I generally deduct all cap ex to arrive at free cash flow unless I have a concrete reason to do otherwise.
In Lucent's case, cap ex is somewhat higher than depreciation and amortization, which shows that Lucent is investing increasing amounts in its business (assuming that the line item for depreciation and amortization is mostly depreciation). By itself, this is neither good nor bad -- it depends on how wisely the money is being invested. I'm sure some would argue that a great deal of Lucent's cap ex is for growth, but I don't think Lucent has much choice given that it is in ferociously competitive, fast-moving industries. Thus, I believe it is correct to subtract all cap ex to arrive at free cash flow, but if you want to instead use the lower figures from the depreciation and amortization line, I won't quibble. It doesn't change the results very much.
Deducting Depreciation and Amortization Rather Than Cap Ex
There are two reasons why I sometimes deduct depreciation and amortization (D&A) rather than cap ex in my calculation of free cash flow. First, if I know a company is investing heavily in growth, then the lower figure for D&A is likely to be closer to the cost of maintenance cap ex. Second, sometimes cap ex can vary widely from quarter to quarter, which can give the false impression that free cash flow is erratic. For example, I recently analyzed Blyth (BTH) and over the past 10 quarters, cap ex has ranged from $4.9 million to $24.4 million. However, D&A has risen fairly steadily from $4.6 million to $8.7 million. Thus, when calculating Blyth's free cash flow, I deduct D&A rather than cap ex from operating cash flow.
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