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A new study shows which companies are getting the most bang for their capital-investment buck.
Ronald Fink, CFO Magazine
December 1, 2004
See the capital-spending scorecard
It's no secret that the economy's anemic recovery from the recent recession reflects weak spending on the part of corporations. While the Federal Reserve Board has kept interest rates low to keep borrowing costs down, the confidence of consumers — whose spending represents some two-thirds of gross domestic product — has been dampened by weak job growth. And the lackluster trend in employment reflects companies' reluctance to open their wallets.
Instead of making new investments, most companies seem content to allow cash to pile up on their balance sheets (see "Too Much Cash," August).
When will capital spending pick up again? Some observers say it will be sooner rather than later. After all, the Fed reported a rebound in corporate spending for the second quarter, ending June 30. Capital expenditures of nonfarm, nonfinancial corporations rose to an annualized rate of $892 billion, up 21 percent from a post-2000 low of $737 billion in 2002. The latest figures are only 4 percent below the $929 billion that those companies spent in 2000.
Monthly durable-goods orders, a leading indicator of capital spending, rose for the third month in four last September (after taking out orders for both defense and transportation equipment). And in some industries — including energy and utilities, health care, food and beverages, and aerospace and defense — capital spending increased by an average annual rate of 6 percent or more from 2000 through 2003, according to a new study by Pittiglio Rabin Todd & McGrath (PRTM), a Waltham, Massachusetts-based management-consulting firm.
But other observers question whether such data presages a broad-based revival of capital spending, given the economy's weak fundamentals. "The rate of growth of profits, industrial production, and job creation is slowing," notes Philip Arestis of the Cambridge Centre for Economic and Public Policy at the University of Cambridge, in England. While consumers' spending continues to grow, their incomes are rising less rapidly, calling into question the sustainability of their purchasing power.
Meanwhile, PRTM's new study of spending at 300 companies — presented here as CFO's first capital-spending scorecard — shows just how deep, and wide, the capital-spending trough has been. During the past four years, the 20 largest U.S. and foreign companies in 15 capital-intensive industries reduced their expenditures by 17.9 percent. The total for the companies in the study came to $533 billion in 2003, compared with $649 billion in 2000. And the decline in spending came despite a 9 percent increase in revenue for the group during the same period. Unless these companies are about to abruptly reverse course — and there's little evidence beyond the latest durable-goods report to suggest they will — it seems clear that the U.S. and global economies will continue to be held back in the near term by weak expenditures.
Yet the study also gives reason for optimism. By tracking the top performers in capital spending as measured by return on gross fixed assets (see "Measuring Capex," at the end of this article), our scorecard shows that companies can spend more on capex without hurting their bottom lines.
Spending on Innovation
Of course, some industries, including chemicals and heavy manufacturing, are particularly cyclical and therefore face troughs and peaks in capital spending. Others, including pharmaceuticals and technology, have to keep spending to maintain technological progress. Yet Amram Shapiro, director of PRTM, insists that capital spending that supports innovation is critical to both types.
"In long-product-life-cycle, capital-intensive industries, where plant capacity is often added at a large scale, whether best-in-class process technology is developed and piloted and ready to scale up determines the economics of the company for many years," explains Shapiro. "In short-product-life-cycle, R&D-intensive industries, the ability to execute quickly and ramp up to the levels needed is often the secret to success."
Corning Inc., which has spent the past several years writing down huge investments in fiber-optic technology, now plans to spend $900 million to $1 billion in 2005, mostly on new plants that make liquid crystal display (LCD) screens for flat-panel computer monitors. That figure is two-and-a-half times what it spent in 2004. "We are ramping up our capital spending quite significantly," says Jim Flaws, CFO of the Corning, New York-based diversified technology company. Flaws points out that Corning isn't betting on a broad economic recovery to justify its new spending, but rather is seeking to exploit a specific growth opportunity.
Besides Corning, four other companies — biotech firm Amgen, computer hardware manufacturer Dell, automotive and transport parts maker Johnson Controls, and aerospace communications manufacturer L-3 Communications — are spending much more on capex than the average for their industries. Yet those four companies also achieved the highest returns on their expenditures in their respective industries. That suggests that under the right circumstances, companies can increase their capital spending without sacrificing their bottom lines.
Amgen, for example, not only increased its spending during the past four years at an average rate of 46 percent — some 20 times the industry average — but also tops the pharmaceutical industry with a return on gross fixed assets of 80 percent, more than twice the industry's average. Shapiro says Amgen isn't the only R&D-oriented company that has been increasing its capital spending. "There are many cases of companies spending large sums in both [R&D and capex]," he says, noting that the challenge is to integrate them. In practice, Shapiro says, that means turning future technology into present technology as efficiently as possible.
Meanwhile, some companies that have cut spending acknowledge that they will have to reverse course soon. Lafarge, for instance, has seen its capital expenditures decline by an average of 13 percent a year since 2000, compared with only 8 percent for others in the construction-materials industry. Part of that reflects a natural downturn after heavier-than-normal spending by the French company in the late 1990s, when its U.S.-based subsidiary began laying out roughly $700 million to build or refurbish several plants in North America, the company's single biggest market. And Lafarge N.A.'s annual maintenance capital budget requires anywhere from $200 million to $250 million a year in capital spending, about equal to one- half cash flow from operations. Last year, however, the U.S. subsidiary's capital spending fell below $200 million, which Lafarge N.A. CFO Larry Waisanen says "is probably not sustainable." The good news, he says, is that the subsidiary expects demand for its products — and its operating cash flow as a consequence — to improve soon, enabling it to boost spending without having to borrow.
Still, Waisanen expects the company to grow as much by dint of acquisitions (it has been buying an average of two companies a year since the mid-1990s) as by new capital investment. He notes that because Lafarge's aftertax cost of capital is 9 percent, its internal rate of return on new investments is in the midteens, posing a big challenge for a capital-intensive company that must nevertheless meet quarterly earnings expectations. "That's a significant hurdle for a company like ours," he says.
For some companies, higher costs will force bigger expenditures. The sharp spike in the price of crude oil, for example, is helping oil companies' cash flow and earnings, but it has also raised the price of the exploration services they purchase to find oil. Meanwhile, higher steel prices have raised the cost of rig construction and thus extraction costs. As a result, BP Ltd., for one, expects that its spending could rise to $1.5 billion next year. According to PRTM's analysis, that would represent a 10 percent increase over what it spent last year, and almost two-and-a-half times the annual rate of increase in its capital expenditures since 2000. That would at last bring BP's rate of spending growth in line with that shown so far this decade by the rest of the energy and utility industry.
Yet BP may find it challenging to get a superior return on those expenditures, as its 2003 return on gross fixed assets was only 16 percent, roughly average for the industry but 5 to 10 percentage points less than that of the top four companies in its group — Statoil, PetroChina, Conoco-Phillips, and Ente Nazionale Idrocarburi. In fact, BP's share price slid on the day it disclosed the need for higher expenditures next year, despite a big increase in its most recent quarterly earnings.
Other companies are boosting spending to exploit new market opportunities, but even they are more cautious about capital outlays than they were during the 1990s. Corning, for instance, was burned badly by the telecom industry's implosion around the end of the decade after the company ramped up fiber-optic capacity based exclusively on service providers' orders. This time, as it hikes spending for LCD screens, the company is placing more weight on third-party research. What's more, it is requiring upfront deposits on particularly big orders from certain customers, even though LCD panels give Corning more time to adjust to changes in demand, since the production capacity can be up and running within six months, whereas its fiber-optic plants typically required two years to build.
Of course, generating sufficient profits from new capital spending is no sure thing for any company, particularly in a recovery as weak as the current one. But without such spending, and the job growth that accompanies it, a stronger recovery will surely remain elusive. At this point, most companies and consumers still seem to be waiting for the other to open their wallets first.
Ronald Fink is a deputy editor of CFO.
To find out how the 300 companies in its sample fared in terms of return on capital spending, Pittiglio Rabin Todd & McGrath (PRTM) ranked the 20 largest companies (by sales) in each of 15 industries according to their 2003 earnings before interest, taxes, depreciation, and amortization (EBITDA) divided by the book value of their fixed assets. The resulting ratio — return on gross fixed assets (ROGFA) — reflects how much a company earns on its property, plant, and equipment. But since that number can be boosted by a decline in asset value, the Waltham, Massachusetts-based consulting firm's scorecard also shows how much those companies spent in 2003 and how that amount has changed since 2000. To complete the picture, the analysis also shows a company's degree of capital intensiveness (capital expenditures divided by revenue) and its revenue growth and shareholder returns.
Granted, ROGFA may not be the most appropriate measure to determine whether to, say, build a new plant or outsource manufacturing. For that type of decision, a metric that takes into account a company's cost of capital is generally more appropriate. But such measures provide too broad a perspective for assessing capex productivity. For one thing, they assume that assets fully depreciated for tax and accounting purposes have no value, when in fact most companies spend money to maintain tangible assets even after they have been fully written off. They also include working capital. As a result, ROGFA can be more useful in helping companies understand how efficiently they are deploying capital on those assets. ROGFA is most useful, says PRTM director Amram Shapiro, "in assessing the overall productivity of a company's capex investment." — R.F.
See the capital-spending scorecard