Cash Management

Slow with the Flow

Most companies applied the brakes to capex as recession lurked. Don't expect them to accelerate soon.
Randy MyersNovember 1, 2008

Valero Energy Corp., a $95 billion oil refiner headquartered in San Antonio, funneled only a tiny fraction of its cash into capital spending last year. Stingy by comparison with rivals in the North American oil-and-gas industry (which committed seven times as much, on average), Valero earmarked just 2.4 percent of its 2007 sales to capital expenditures. A conservative laggard? Hardly. Valero’s stock delivered a stellar total return of 213 percent over three years through December 2007, versus an industry average of 149 percent.

But even companies with capital at their disposal proceeded very cautiously in 2007, and certainly nothing that has happened lately is likely to change that. “We try to be realistic,” says Valero CFO Mike Ciskowski. By “realistic” he means “rigorous.” The company has put more emphasis on prespending analysis, and works harder to standardize its cost estimates so that comparisons across potential investments will be more accurate. Valero also applies different hurdle rates to different kinds of projects, seeking, for example, at least a 20 percent return on strategic projects and a 12 to 14 percent return on cost-cutting projects.

Using analysis by PRTM, a global management-consulting firm focused on operational strategy, our 2008 capex scorecard takes vital measures of capex performance and ranks companies by their returns on gross fixed assets, or ROGFA. Based on that measure, companies have clearly reined in spending; after increasing by 15 percent in 2005 and 18 percent in 2006, last year capital spending grew a scant 3 percent.

But even at a mere 3 percent growth, capex still outpaced revenue growth, a fragile trend in normal times and far less sustainable in today’s climate. High energy prices and a vanishing credit pool will make it very difficult to fund capital investments, adding yet more urgency to the never-ending need to hone a competitive edge, conserve financial resources, and generate adequate returns for investors.

Only 4 of the 14 capital-intensive industries — communication services, network-equipment manufacturers, medical devices, and food and beverage — grew capital spending faster last year than in the prior two years. Two sectors, industrials and automotive, posted a net reduction. For the outliers, the numbers tended to be driven by industry specifics rather than broad economic themes. In the telecommunications sector, for example, the changeover to third-generation wireless systems and fiber-optic networks has kept capital spending high, while in the auto industry, slumping sales of fuel-thirsty trucks and SUVs, long the best-selling models for North American automakers, have dampened the need for manufacturing capacity.

Bright Spots

Amid the gloom, however, some companies manage to thrive the old-fashioned way: by spending more to make more. Garmin Ltd., the $3.2 billion maker of GPS navigation devices, tops all electronics companies in this year’s capex scorecard, having poured 4.9 percent of sales into capex last year. While CFO and treasurer Kevin Rauckman says, “We spend only what’s needed to support the business,” Garmin bucked the outsourcing trend and instead spent around $2 million to expand company-owned production facilities in Taiwan. That investment, Rauckman says, generated $75 million in revenue.

Allegheny Technologies follows a very similar approach. The $5.5 billion specialty metals manufacturer grew capex at an annualized rate of 108 percent over the past three years, outpacing the peer-group average by more than two-to-one; its 58 percent ROGFA puts it right behind Reliance Steel (67 percent) in the scorecard.

“Most of our investments over the past three or four years have been strategic,” says CFO Richard Harshman, positioning the company “for growth opportunities as opposed to making necessary replacements in plant or equipment.” The company boosted its titanium-production capacity, for example, to keep pace with increasing demand from the aircraft industry.

Like Valero, Allegheny applies a rigorous battery of metrics to capex projects, including a flexible hurdle rate that varies by the nature of the project. When Allegheny controls most cost variables, a 15 percent hurdle rate applies; for projects with more market risk or competitive pressure, the floor may be 20 percent or more.

In all cases, Allegheny charts estimated versus actual returns for two years following completion of capital projects “to make sure we’re executing to plan,” Harshman says.

One possible complication for capex decisions going forward will be the effects of a switch from generally accepted accounting principles to international financial reporting standards. IFRS allows fixed assets to be valued at historic cost or at fair value, less accumulated depreciation and impairment under either approach. By contrast, U.S. GAAP requires such assets to be valued at historic cost.

Margaret Smyth, controller for $54.8 billion global conglomerate United Technologies Corp., says that while UTC is looking at the potential impact of IFRS on capital spending, nothing it has found to date gives cause for concern. And accounting, she says, does not drive business decisions at UTC.

Reports from abroad sound mixed notes about capex. European companies grew their capital spending just 6 percent in 2007, on the heels of 15 percent and 14 percent gains in 2006 and 2005, respectively. Based on revenue trends, PRTM expects further slippage over the next two years. The Asia-Pacific region showed more strength, according to PRTM. Asian capital spending rose 16 percent following gains of 12 percent and 11 percent in the prior two years.

Macroeconomic considerations aside, at least one CFO cautions that smart capex decisions hinge on people as much as on capital. “The ability to manage multiple projects requires people who can bring them in on budget and on schedule,” says Allegheny’s Harshman. “That’s the bigger constraint for us.” These days, that almost sounds like a nice problem to have.

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 2007 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 2007 and how that amount has changed since 2004. 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.

To see the results of the 2008 Capital Spending Scorecard, click here.