Monday, January 7, 2008

Maintenance & Growth Capex

In my last post about rejigging Greenblatt ROIC someone asked about maintenance capex and growth capex in calculating free cash flow.

Maintenance capex is the spending a firm makes in its plant and equipment to maintain current output while growth capex is the spending in plant and equipment made to ramp up production. Free Cash Flow attempts to differentiate between the two and but as many companies do not issue a division between expansion & maintenance capex figuring it out is often necessary, and this requires making judgement calls.

Often it is easiest to identify maintenance capex.
1. Typically for mature businesses most capex will be maintenance capex; depreciation should generally be about equal to capex.

2. Continuously high or stable capex over a number of years that does not lead to increased revenues is also probably all maintenance capex.

3. For rapidly growing firms in fast-changing industries (i.e. tech) most capex will actually be maintenance as is it is unlikely such companies could safely cut capex and maintain market position and cash flows. (Cash flow though may not be a good way to value these businesses though, especially start ups.)

1. You can read the management discussion and analysis and see if the firm is embarking on new business lines. If capex has been steady for many years, and suddenly spiked up this difference probably indicates new growth capex.

It is important to read what management is doing though as some companies scrimp on capex for a no. of years and then suddenly end up having to rush to make a load of new capex to keep the business humming along. Calculating the average age of equipment and depreciation policies of the firm and benchmark to industry norms is another way to confirm this.

2. If cap ex is significantly higher than depreciation it could indicate new growth cap ex. (Again caveats about management that has been less than generous on capex in the previous years applies to this).

Still, some people - like Whitney Tilson on this post - ignore the difference between the two types of capex completely and deduct the whole lot. The argument being this is generally a conservative way of arriving at FCF.

However, even if you do this there is still the question of how one treats acquisitions. Acquisitions fuel the growth of some companies and should be considered capex.

In particular, if a company is a serial acquirer acquisitions will be part of its strategic business operations... therefore, for these firms acquisitions are capex. How do you figure this out? Read the company literature and make your call.

Deducting Depreciation and Amortization Rather Than Cap Ex
If companies are investing heavily in growth, then the lower D&A figure should be closer maintenance capex costs than the full blown capex numbers. So you may want to go for the D&A number to get normalized FCF, especially, if you foresee the expansion phase ending soon.

D&A can also be useful to approximate FCF when capex is highly lumpy and erratic as the D&A figures tend to be smoother. Alternatively, you can create a normalized capex figure over a period of time to calculate FCF.