Daniel: The Problem With Capital-Intensity
*Graham and Doddsville Revisited* -- "The Intelligent Investor in the
21st Century" (4/23/98)
*********
"The underlying principles of sound investment should not alter from
decade to decade, but the application of these principles must be
adapted to significant changes in the financial mechanisms and
climate." (Benjamin Graham)
*********
The Problem With Capital-Intensity: Capital Is Expensive To Replace
Daniel Chisolm writes:
<< Why shun capital-intensive industries?
One of the things I have not yet figured out is why so many
successful value investors seem to avoid industries with heavy
capital expenditure requirements. There seems to be something
intrinsically bad about such industries, yet I cannot figure it
out. >>
That wasn't always the case, but see below.
...[L]et's say you are analyzing an industry such as beer or steel.
My understanding is that they are capital intensive commodity
businesses in a mature (or possibly shrinking) market.
(As an aside, if the depreciation schedules mandated by GAAP are
reasonably close to reality, and the company is neither growing
nor shrinking, wouldn't the capital expenditures closely
approximate the D&A charges? (taking into account inflation, etc).
In other words, shouldn't GAAP earnings in fact be a reasonably
close approximation to free cash flow?) >>
Yes, they should be. But, D&A schedules don't consider
inflation. In the 1970s, accrual profits looked fine. But, free cash
flow was being consumed by the inflated replacement cost of capital
equipment.
<< Once you calculate a free cash flow that you believe to be
true, and you are able to buy it at a reasonable multiple, why
should it matter to you whether or not the company that produces
these cash flows is involved in a capital-intensive industry? >>
High capital costs in a slo-/no-growth industry imply slim profit
margins. Thin profit margins, in turn, imply a high level of
competition, which is pushing down revenues to close to the level of
costs. If a high percentage of those costs are in fixed capital, a
lot of red ink will flow onto the income statement during a recession.
Because, unlike salaries and utility bills, fixed costs must be paid in good times and in bad.
<< The only thing I can think of is that being a capital-intensive
industry seems to be closely associated with generating relatively
low ROA, which will limit a company's ability to finance expansion
with internally generated cash. >>
Well, that's a problem.
<< But if the industry is relatively mature, with little
prospects for expansion (i.e., the inability to generate rapid
internal growth doesn't matter, since such opportunities are
unlikely to arise), should this deter your investment? >>
If the firm's capital equipment lasts forever, there's no problem. If it doesn't, then replacing it at a cost, that by the definition of slim profit margins will be a high percentage of future revenues, can be a big problem, particularly if coincident with an economic downturn that reduces those revenues.
Amortization of goodwill and other intangibles, as we wrote in the
4/16/98 GADR, may be totally illusory, depending upon the
circumstances. But, depreciation of tangible assets is very
real. Physical equipment inevitably wears out and/or becomes
technologically obsolete.
Suppose you own common stock in a blue chip company that dominates
a mature industry. "Mature industry" is a nice way of saying that
demand is relatively flat. That doesn't mean that supply is
flat. Somewhere, perhaps 10,000 miles away or perhaps across the
street, a guy or gal with a dream wants to build a spanking new plant
that can increase output per dollar of investment a few percent, i.e.,
the entirety of your company's margin.
When times are good, bankers and their governments, having dreams of
their own, are only too happy to bankroll these entrepreneurial dreams. When business turns down, they run to the IMF for a bailout, the workers are turned out into the streets to riot, and the guy or gal with a dream gets a job waiting on tables at a restaurant where the IMF dines with the bankers and government officials who are being bailed out. (A formerly major Asian conglomerateur has actually done this as an act of contrition.)
But, while the former conglomerateur is engaging in spiritual
atonement, the mature company you have invested in is having problems
of its own. For the past year or two, the upstarts have been dumping
output and slashing prices, just to keep afloat a bit longer. Only
salaries and utilities require cash outlays in the short term. Other
suppliers are put off (making their situation increasingly
precarious), and debt is rolled over, with unpaid interest "capitalized" as added principal.
Eventually the debt can no longer be rolled over, because, with many
businesses selling at below cost, and suppliers not getting paid,
defaults are mounting -- and the banks and bond market are having
their own problems. Their dreams are also turning into
nightmares. Now that they fear not being repaid, they will only lend
at a premium, if at all.
The company you've invested in has been around a long time, has deep
pockets, and is in little danger, if any, of defaulting on its debt.
Nevertheless, market forces have pushed it too into selling at below
the replacement cost of capital to "remain competitive".
Though revenues are down, and profits even more so, shareholders are
still expecting the rich dividends that induced them to buy shares of a slo-/no-growth company in the first place.
So, borrowing may be necessary, not only to replace worn out capital,
but also to maintain the dividend. Though paying the dividend is not a legal obligation like paying interest on debt, the economic incentive is the same: continued access to the financial markets when it is needed most.
Here's how Warren Buffett put the problem in the Chairman's Letter to
Berkshire Hathaway shareholders, for fiscal year 1978:
" .... Textile plant and equipment are on the books for a very small
fraction of what it would cost to replace such equipment today.
And, despite the age of the equipment, much of it is functionally
similar to new equipment being installed by the industry. But despite
this "bargain cost" of fixed assets, capital turnover is relatively low, reflecting required high investment levels in receivables and inventory compared to sales. Slow capital turnover, coupled with low profit margins on sales, inevitably produces inadequate returns on capital. Obvious approaches to improved profit margins involve differentiation of product, lowered manufacturing costs through more efficient equipment or better utilization of people, redirection toward fabrics enjoying stronger market trends, etc. Our management is diligent in pursuing such objectives. The problem, of course, is that our competitors are just as diligently doing the same thing. [emphasis added.]
"The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. [emphasis added.] As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed. Such a supply-excess condition appears likely to prevail most of the time in the textile industry, and our expectations are for profits of relatively modest amounts in relation to capital.
"We hope we don't get into too many more businesses with such
tough economic characteristics...."
(See: berkshirehathaway.com
In his investments, Buffett has attempted to be a steward responsible
to all "stakeholders", as they would be called today. But, investors
in Berkshire are stakeholders too. As much as Buffett regretted the
effect it would have on the hard working employees of the mills, and
their community, he eventually drew the line at using Berkshire's
other assets to indefinitely subsidize a business that could pay its
own way only in the best of times.
Thin Margins Reduce Margin of safety
Let's look at some of the arithmetic. Say the profit margin is 2%
(not that unusual in, for example, food retailing). This means that
for every dollar of revenues, the company has 98 cents of costs. If
revenues drop 2% (2 cents on the dollar), all other things being
equal, revenues and costs both become 98 cents, and the profit drops
100%, to zero.
Whereas, if a service company's profit margin is 20%, its costs are 80
cents on the dollar. Therefore, the same 2% drop in revenues, all
things again being equal, will cause only a 10% in profits.
Of course, certain variable costs usually drop when revenues drop.
But, for example, in the fiscal quarter just past, Advanced Micro
Devices' revenues dropped just 2% from the previous year, but its net
income dropped to a loss of $56 million, from a gain of $13 million in
the prior year.
Dow Value Portfolio: The Movie Plays In Reverse
Conversely, if a company with thin margins can widen those margins,
even by a bit, profits will rise much more rapidly than revenues. One
way to widen margins is to reduce costs. "Mature companies", like
certain of us mature people, often carry much more weight than is
necessary <g>. When a new CEO takes over, particularly one drawn
from outside the company's ranks, the first order of the day is usually to cut costs.
This has already had salutary affects on earnings, in spite of anemic
revenue growth, at AT&T, GM, and IBM. The fact that cost cutting
at these firms is now a permanent part of their "culture", rather than
merely an ad hoc response to a temporary emergency, is, in
our view, still not fully reflected in the price of their common shares.
This process of cutting costs, thereby widening margins, is already
under way at the new Boeing-McDonnell Douglas combine. We
predict that it too will bear fruit to a degree not yet reflected in the share price, though perhaps not until next year.
*********
Graham and Doddsville Revisited
Editor: Reynolds Russell, Registered Investment Advisor
web.idirect.com
Web Site Development/Design: ariana <brla@earthlink.net>
Consultants: Axel Gunderson, Wayne Crimi, Bernard F. O'Rourke,
Allen Wolovsky
In addition to editing *GADR*, Reynolds Russell offers investment
advisory services. His goal is to provide total returns in excess of
those produced by the S&P 500.
His investment strategy applies the principles of Value Investing
established by Benjamin Graham to the circumstances of today's economy
and securities markets.
For further information, reply via e-mail to: gadr@nyct.net
*********
For a free e-mail subscription to GADR, reply to: gadr@nyct.net
In the subject header, type: SUBSCRIBE.
*********
"There are no sure and easy paths to riches in Wall Street
or anywhere else." (Benjamin Graham)
(C) Reynolds Russell 1998. |
