Capital Markets

Putting a Cap on Capex

Even companies that spend big are working harder to make sure they spend smarter.
Randy MyersJanuary 4, 2007

If consumers spent like companies, credit-card debt would vanish. When it comes to capital spending, recent data suggests that CFOs on the whole are scaling back their expectations (see By the Numbers). And while those employed in the 15 most capital-intensive U.S. industries have relaxed their grips on their checkbooks, caution remains the watchword. (See the 2006 Capital Spending Scorecard.)

For the three-year period from 2002–2005, reports management consulting firm PRTM, all but one of those industries increased capital spending, up from only 6 of 15 in the period 2001–2004. Not surprisingly, the energy and petrochemicals industry, riding what until recently had been a remarkable run-up in energy prices, has been the biggest spender by sheer dollar volume. The 20 largest companies in that sector shelled out an average $3.5 billion each in capital expenditure (capex) in 2005, equal to 12 percent of their revenues. Only the communication-services industry was more capital intensive, channeling 15 percent of revenue to capex, or an average of $2.4 billion per company among the industry’s 20 biggest players. Metals and chemicals companies couldn’t match those raw dollar figures, but they did ramp up their spending faster than anybody else over the latest three-year period, with compound annual capex growth rates of 28 percent and 20 percent, respectively.

While there were strong differences by industry, one common theme emerged: increases to capex spending lagged increases in revenue among North America’s 300 largest companies virtually across the board. Revenue grew at a 12.8 percent compound annual rate from 2002 to 2005, while capex grew only 5.1 percent. That suggests both a healthy capex outlook and, according to PRTM’s director of operational strategy practice, Roger Wery, room for further increases. “The picture today is not completely perfect,” Wery concedes, citing the slumping housing market and volatile energy prices, “and certainly every industry has a different pulse and cycle. But when you look at all the curves together, it’s a sustained and smooth trend that we would expect to continue for at least two years.”

As for why capex has not moved in lockstep with revenue growth, Wery suggests that the reasons vary by company. “Assuming the revenue growth correlates with increased profits,” he says, “companies may favor other uses for their increased cash flow: to buy back shares, pay dividends, add to their cash reserves, or pull whatever other operational lever suits their needs at the time.” In short, he says, although there is a long-term relationship between revenue growth and increased capex spending, many other factors explain annual variances.

In Search of Bigger Payoffs

What matters to most companies, however, isn’t how much they spend but how well they spend. To identify those that are most adroit at balancing capital spending with customer demand, PRTM ranks the 20 largest companies in 15 capital-intensive industries by a measure it calls adjusted return on gross fixed assets, or ROGFA, which roughly equates to the ratio of operating profits to capital spending. (For more on the methodology, see “Measuring Capex” at the end of this article.) In many industries, a high ROGFA correlates with strong performance in other key areas, such as sales growth and shareholder return.

Case in point: $2.3 billion SanDisk Corp., a Milpitas, California-based producer of flash memory cards and related products used in digital cameras, mobile phones, MP3 music players, networking equipment, and other electronic devices. Demand for such gear is soaring, and SanDisk, whose revenues have more than doubled in the past three years, has been investing furiously to keep pace. For the most-recent three-year period tracked by PRTM, it increased capex at a compound annual rate of 101 percent, shelling out $134 million in 2005. That compared with an average 17 percent capex growth rate for North America’s 20 largest semiconductor companies. More important, SanDisk posted a ROGFA of 219 percent in 2005, and a compound annual return of 84 percent for shareholders over the three-year period ending in 2005. Both were tops in its sector.

Judy Bruner, SanDisk’s CFO and executive vice president for administration, says the company’s capex last year actually exceeded the $134 million captured on its cash-flow statement because that figure did not include investments in joint ventures. Those ventures, however, contribute substantially to SanDisk’s strong returns on its investments, and illustrate how even a company in the midst of a boom is being careful with its capex outlays.

“Our long-term model is to own about 70 percent of our memory, in terms of captive supply, and to purchase about 30 percent from third parties,” Bruner says. “By doing that, we significantly mitigate any downside risk if market demand is not as strong as anticipated, because we can pull back on the noncaptive purchases.”

The strategy, of course, also reduces the sums SanDisk must pour into its own plant and equipment, while allowing it to capitalize on unexpected demand for its products. “Instead of having to expand fabrication capacity to capture those opportunities, we can quickly purchase more memory from third parties in order to capture that market share,” Bruner says. In short, by investing enough to meet the majority of its demand — but not necessarily all of it — SanDisk helps to ensure that the plant and equipment it does invest in are fully utilized.

Canada’s IPSCO Inc., a $3 billion steel and tubular-products maker, is also keen to extract maximum returns from its capital investments. Its approach is to focus not only on projects that expand capacity, but also on those that allow it to offer new, higher-value products. “We still serve the same customers,” observes IPSCO senior vice president and CFO Vicki Avril, “but now we can give them products they had to go elsewhere to get in the past.”

High-ROGFA companies don’t skimp on capital spending, but they are generally less capital intensive than their lower-performing peers. IPSCO, for example, increased its capex at a compound annual rate of 15 percent over the three years ending in 2005, but was hardly a spendthrift. Its average peer in the metals group boosted spending by 28 percent over the same period. Perhaps more tellingly, its capital spending equated to just 2.2 percent of its revenue, versus 7 percent for its average peer. “We watch our spending very, very carefully,” Avril says. “Before we make any investment, we stress-test it to make sure it will be a good investment throughout the steel cycle, not just at the peak of the cycle.”

Results have been strong. In 2005, IPSCO had the highest ROGFA (64 percent) of North America’s 20 largest metals companies, and for the three years from 2002 through 2005 it also posted the best compound annual total return to shareholders, 84 percent.

“I think the biggest mistake people make is believing that when they get into a favorable cycle things have changed and the cycle will remain strong,” Avril summarizes. “That’s when they tend to overbuild.”

Some economists have predicted that the slowdown in consumer spending will be partially offset by strong capital outlays in the business sector, but recent figures from the Commerce Department suggest business is becoming more cautious in this regard. Even among capital-intensive industries that have boosted spending, overbuilding seems unlikely. Like SanDisk and IPSCO, most companies will no doubt pick their spots very carefully.

Randy Myers is a contributing editor of CFO.

Measuring Capex

To find out how the 300 companies in its sample fared in terms of return on capital spending, consulting firm PRTM ranked the top and bottom four companies in each industry according to their 2005 earnings before interest, taxes, depreciation, and amortization divided by the book value of their fixed assets, and adjusted to eliminate the balance-sheet effect of operating leases. The resulting ratio — adjusted 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 consulting firm’s scorecard also shows how much those companies spent in 2005 and how that amount has changed since 2002. To complete the picture, the analysis also shows a company’s degree of capital intensiveness 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. — R.M.