A Thorough Discussion of MCX_Case Study and Capital Theory

June 13, 2018 | Author: John Aldridge Chew | Category:Expense
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Maintenance Capital Expenditures
Our first discussion of Maintenance Capital Expenditures (“MCX”) occurred here: http://wp.me/p1PgpH-6t One method of learning is to EXHAUSTIVELY analyze and read about a subject so we can master the topic and understand the principles and subtleties in applying those principles
Please read the case study on IRDM to learn more about analyzing EBITDA-MCX We are focused on Return on Invested Capital which has been defined one way as Operating Earnings (Earnings before Interest Expense and Taxes, EBIT) or better yet, (Earnings before Interest Expense, Taxes and Depreciation & Amortization, “EBITDA” – MCX) divided by tangible capital or (Net Working Capital + Net Property, Plant and Equipment). We have covered EBITDA thoroughly in a 36 page discussion here: http://www.scribd.com/doc/66843869/Placing-EBITDA-Into-Perspective
Now we review MCX as part of the (EBITDA – MCX) calculation
You goal in valuing a company is simply to discount back to the present value all future cash flows of the business. Easier said than done! But to understand a business you must first know what are owner’s earnings, what cash is available to you after all the necessary expenses/costs have been made to run the business properly. Professor Greenblatt uses a pre-tax method for easier company comparisons (EBITDA –MCX) while Buffett uses an after-tax method (discussed later)
Your specific company and industry knowledge should help you calculate true or normalized maintenance capital expenditures. For example, say you are the operator of an amusement park—one of two—in Phoenix, AZ and you need to plan your future budget. Every year you need to replace certain equipment, repaint the Merry-Go-Round, etc. But what if your competitor is planning a new exhibit with special effects? Do you budget increased expenditures to match your competitor and remain competitive so as not to lose customers? Will you be able to maintain your competitive position? As an analyst you may need to significantly raise your estimate of true, future MCX so as to not underestimate normalized earnings. Imagine if you were a luxury hotel owner and your competitor put in new wide-screen high-definition TV screens in all the hotel’s rooms, would you match that expense/investment or lose customers? Prof. Greenblatt Discusses MXC Prof. Greenblatt would implore his students on EBITDA—don’t show this in your reports. You have to subtract out the maintenance capital expenditures (MCX). Now, if the company is growing and you want to figure out “normalized earnings.” Capital spending is the number to use. Capex is a cash expense but depreciation is a book entry not cash expense
Let us say you are opening 10 new stores in addition the 10 stores you already have, the capex would include keeping up (maintaining their competitive position) the ten stores you already have making capex on those stores and the cost of opening the ten (10) new stores. But you won’t get the benefit of those new stores in that year. What you really want for normalized www.csinvesting.wordpress.com Studying/Teaching/Investing
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Maintenance Capital Expenditures
earnings is maintenance capex. How is this number reported? Ask the management. Breakout growth vs. MCX
Prof. Greenblatt ask for an explanation for MCX and how do they get there. Usually the company understates mcx. When EBITDA, DA = capex, then EBIT = EBITDA – Capex. A quick and dirty when you use EBIT. I try to get at EBITDA – maintenance. capex
Student: Does Ebit = Ebitda – Maintenance Capital Expenditures (MCX) used in the book? Prof. Greenblatt: Right, I put a little note in there for the MBA Students in the book. I assumed MCX = D&A for simplicity purposes. Figuring out MCX for a lot of these companies is pretty hard. On average it (using EBIT) is pretty close to being right for simplistic purposes. If I were doing it myself, I would check to see the true MCX and subtract that number from EBITDA. You might use EBIT as a check to see if you are close
Good companies have high returns on capital (ROIC)   
Defined as operating profit (EBIT or EBITDA – MCX (Maintenance Capital Expenditures)) divided by working capital plus net fixed assets Why do you view EBIT rather than FCF? EV to EBIT. EBITDA – MCX or a pre-tax cash flow? EV to EBIT is a euphemism. Changes in working capital need to be taken into account (if you use Cash Flow from Operations. You have to adjust those metrics to see if they are representative to the company. If there is a difference between earnings and cash, I will use cash
————–A good author to follow is John Emerson Articles (71) http://www.gurufocus.com/news/137623/understanding-free-cash-flow-series-growth-vsmaintenance-capex Understanding Free Cash Flow Series: Growth vs. Maintenance Capex What is the proper method of separating growth and maintenance capital expenditures (capex)
Why Is It Important to Separate Growth and Maintenance Capex? The answer is simple; in most cases growth capex is an investment, while maintenance capex is a cost. If a business decided to suspend its growth operations, its capex would quickly decline and the result would be increased free cash. The key is to make sure that the reinvested capital is earning a sufficient rate of return to justify the growth expenditures
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Maintenance Capital Expenditures
Allow me to revisit the hypothetical one-man trucking company which I invented in my last article. http://www.gurufocus.com/news/137384/understanding-free-cash-flow-seriesdepreciation-and-accounts-receivable Suppose that instead of selling the business the owner decides he wants to expand by adding additional rigs and hiring drivers
Common sense dictates that buying a new rig is a different type of capital expenditure than installing a replacement set of tires on tractor-trailer. The new rig represents an investment in growth capex, while replacing the tires is a classic example of maintenance capex
Growth capex can be defined as any expenditure which is undertaken in the interest of increasing revenues and profits, while maintenance capex can be defined as any expenditure which is undertaken to sustain current revenues and profits. The lines can become blurred between the two distinctions
Suppose I decide to continue my one-rig operation and after 10 years my rig is no longer suitable for hauling freight. Under those conditions the purchase of the new rig would be considered as maintenance capex spending since it would merely maintain rather than increase my existing profits
How Is Growth and Maintenance Capex Separated? Most companies do not breakout growth vs. maintenance capital expenditures in their annual or quarterly reports. That reality forces investors to do some guess work when attempting to separate the two entities
Two common methods are used to separate capital expenditures; the most simplistic method is to merely deduct depreciation from total capital expenditures. Depreciation is assumed to be maintenance capex, the remaining balance is assumed to be growth capex (Growth Capex = Total Capex less Depreciation)
The effectiveness of that formula is dependent upon the company’s ability to correctly state its depreciation. If the company is understating depreciation in an attempt to manage earnings upward or if they are overly optimistic about the longevity of their fixed assets, growth capex will be materially overstated
Back to the one-rig trucker for a moment; one of his biggest maintenance expenditures is buying new tires. Let’s say that in the past the owner has depreciated them over a threeyear period but since he changed his route to a hotter region, they are only lasting an average of two years
Although he did it inadvertently, he had materially understated his depreciation expense, thus his prior accrual earnings have been inflated. If we had used his old depreciation estimate to approximate maintenance capex, we would have underestimated the “true cost” of maintaining his stream of free cash flow
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An alternative method for calculating maintenance capex has been suggested by Bruce Greenwald and summarized by Jae Jun as follows:    
Calculate the Average Gross Property Plant and Equipment (PPE)/ sales ratio over 7 years Calculate current year’s increase in sales Multiply PPE/Sales ratio by increase in sales to arrive to growth capex Maintenance capital expenditure is the capex figure from the cash flow statement less growth capex calculated above
I believe that for most companies the Greenwald system for calculating maintenance capex is superior than merely substituting depreciation for maintenance capex, however as you will see in the in my upcoming discussion of Casey’s it is far from perfect. The more intimately an investor understands a business, the easier it is to estimate its maintenance capex requirements
Estimating Maintenance Capex for CASY Casey’s owns and operates a string of convenience stores throughout the Midwest which provide gas and sell cigarettes and a limited supply of groceries; they are also one of the country’s largest pizza outlets. They also fry their own donuts and sell them at their outlets
The company generates the majority of its revenues (61%) from gasoline sales however the gross margin of those sales is only about 5%. The groceries generate gross margins of around 30%; the real money-maker is prepared foods items which generate gross margin in excess of 60%. The latter two categories generate 74% of the profits
The business model for CASY involves setting up stores in smaller rural communities where less competition exists; over 60% of their stores reside in communities with populations of 5000 or less. More recently they have been purchasing stores in larger communities and rebranding them under the Casey’s logo
The strategy involves constructing new stores as well as buying competing stores at reasonable prices, rebranding them and building a kitchen which allows them to prepare pizza, donuts and other food items. The construction of new stores and the rebranding and remodeling to facilitate their restaurant sales in recently purchased stores, is a perfect example of growth capex
Clearly that type of activity needs to be separated from capex which is necessary to maintain existing stores if one hopes to ascertain the true profitability of the enterprise
If CASY was to stop constructing new stores as well as buying and remodeling new stores, the result would be a quick reduction of capital expenditures (as soon as the remodeling was completed); the effect would be an immediate increase in free cash. In essence, the company would be sacrificing future growth in favor of increasing its near term production of free cash
This is a decision that almost every business faces at some point in time after it matures www.csinvesting.wordpress.com Studying/Teaching/Investing
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sufficiently and runs out of opportunities to expand without changing it business model in some material form
In regard to CASY, I believe that Greenwald’s model of estimating maintenance capex is inappropriate since gas sales represent over 60% of revenues. For most businesses, the ratio between plant, property, and equipment (PP&E) and revenues represents a pretty stable figure
No such stability exists at CASY due to the volatility of gas prices. Higher gas prices result in increased revenues but not necessarily in higher profits
Greenwald’s formula would have to be reformed to factor out fluctuating gas prices; figuring revenues for groceries and prepared foods as a percentage of PP&E might work, but for practical purposes, equating maintenance capex with depreciation is the best solution for this company
CASY breaks down its capital expenditures by separately listing its purchases of property and equipment, from its payments for acquisitions of businesses, before adding back its property and equipment sales
Cash flows from investing activities )
Purchase of property and equipment
(129,233 )
(136,351 )
Payments for acquisition of businesses
(45,688 )
(11,813 )
(8,858 )
Proceeds from sales of property and equipment
Net cash used in investing activities
(173,152 )
(144,964 )
(88,133 )
That provides little information as to the cost of remodeling a store although past CASY annuals have disclosed the average construction cost for building a new store. Theoretically, one could multiply the new store constructions by the average cost and whittle away at the figure but in the end it is unlikely that a figure more accurate than the companies stated depreciation could be attained
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So what is CASY’s adjusted FCF average for the past three years when growth capex is factored out? Net cash provided by operating activities Depreciation and amortization
$214,068 $73,546
$170,624 $69,451
$177,422 $67,893
The company has averaged just under 117 million per year in FCF in the past three years. That puts the multiple at around 14.3X its market cap or about 19.6x its enterprise value. That sounds expensive but one does need to consider the fact that the company owns virtually all the land on which its stores reside, and many of its stores are located in areas which provide the company with a significant moat
Conclusion 1) It is impossible to estimate the intrinsic value of a business in terms of free cash flow if one does not separate growth vs maintenance capital expenditures
2) If growth capital expenditures were discontinued, the free cash would almost certainly increase for most businesses
3) Growth Capex should be viewed as an investment; maintenance capex should be viewed as an expense
4) Two methods are commonly used to estimate maintenance capex: the simple method assumes maintenance capex = listed depreciation, the second uses a formula which involves using PP&E as a percentage of revenues
5) Calculating maintenance capex is an estimation, having an intimate understanding of a companies’ business model is important in deciding which method to use
I hold no position in CASY About the author: I have been of student of value investing since the mid-1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett’s early investment career when he was able to purchase shares of tiny companies
Whitney Tilson (www.tilsonfunds.com) Discusses Capex 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 www.csinvesting.wordpress.com Studying/Teaching/Investing
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