Estimating growth capex is sometimes easy because one knows that the company is expanding capacity from x units to y units and its capex plans are known. Even when we don’t know exact capex plans, sometimes to we know how much money is needed in an industry to expand capacity from x to y.
Sometimes we know that almost all the capex is maintenance capex because of competitive pressure. For example what happened in the “Shutdown of textile industry” example, or in the petrol pump example i gave in class. The functional equivalent of these examples are very very common in the business world so one must not take the accountants’ definition of capex as sacrosanct. Accountants don’t like to make estimates. They would rather have something precise even if its wrong. You don’t have to be like them.
When you look at capex numbers you must ask the following questions:
1. Is this expenditure likely to result in a sustainable rise in economic earnings in the future? This is not the same as asking if margins will improve or not – they may improve temporarily but the nature of the business may be such that such gains would be temporary and the cost savings will flow through to the customers instead of the owners. So what may look nice on DCF analysis in an excel model, will not translate into sustainable economic earnings jump. You really need to do this “second step analysis” by asking how much of the benefits of the capex will go to the owners and how much to customers. If the benefits will go to customers, then its NOT Capex for US. For US its and EXPENSE. something we reduce from operating cash flow to arrive at owner earnings.
2. How competitive is this industry? If its extremely competitive or has a lot of foolish competition, then its very likely that capex won’t result in improvement in long-term sustainable earning power. In some businesses, you just can’t be a lot smarter than your dumbest competition. And there is plenty of DUMB competition in some industry. Witness for example, what’s happening in the airline industry in India right now…
3. Is there a lot of inflation? Historical cost accounting and inflation result in under provision of depreciation in accounting books.
4. Are there substantial productivity improvements? Inflationary effects are sometimes offset by productivity improvements. This was discussed in class in detail.
5. Is the plant really old and dilapidated and probably needs replacement? Sometimes there are very old plants chugging along for a long time but ultimately they have to be replaced. The plant may have almost zero value in books because they have already been written off. But they need to be replaced and replacement cost could be a bomb. When you spent that money, should you record it as Capex? Well the accountants will ALWAYS record it as capex. But they key question you have to ask is this: will this money spent improve long term earning power, or only help the company maintain current earning power. If the consequence of the money spent is going to be mere maintenance of earning power, then its NOT CAPEX FOR US. Rather its an EXPENSE.
6. Whats the rate of Obsolescence in this industry? Industries with very high obsolescence rates require frequent capex just to keep up with the competition which keeps on inventing new applications of technology making old technology obsolete. We talked about what happened to Moser Baer and Samtel Color. Well the unfortunate people who invested in those companies learnt the hard way that essentially these companies made NO REAL PROFITS because when you CORRECTLY TREAT the money spent on frequent capex programs of such companies not as CAPEX but and MAINTENANCE CAPEX, you would have figured out that essentially there were NO OWNER EARNINGS. And when there are no owner earnings there is NO VALUE. This is true even though interim value in the market may end up being BILLIONS OF DOLLARS!