Posts tagged ‘CAPEX’
Fink & Capitalism: Need 4 Kitchens in Your House?
Do you need four kitchens in your house? Apparently financial industry titan Larry Fink does. If Mr. Fink were a designer for millionaire homeowners, he would advise them to use their millions to build more kitchens in their house (reinvest) rather than distribute those monies to family members (dividends) or use that money to pay back an equity loan from mom and dad for the down payment (share buybacks). Essentially that is exactly what is happening in the stock market. Companies that are generating record profits and margins (millionaires) are increasingly choosing to pay out larger percentages of profits to stockholders (family members) in the form of rising dividends and share buybacks. Contrary to Mr. Fink’s belief, corporate America is actually doing plenty with room additions, landscaping, and roof replacements – I will describe more later.
As a consequence of corporate America’s increasingly shareholder friendly practices of returning cash, Fink believes this trend will stifle innovation and long-term growth in American companies. Here’s a snapshot of the supposed dividend/buyback problem Mr. Fink describes:
Source: Financial Times
Fink Mails Letter from Soapbox
For those of you who do not know who Larry Fink is, he is the successful Chairman and CEO of BlackRock Inc. (BLK), an investment manager which oversees about $4.65 trillion in investment assets. Mr. Fink ignited this recent financial controversy when he jumped on his soapbox by mailing letters to 500 CEOs lecturing them on the importance of long-term investing. What is Mr. Fink’s beef? Fink’s issues revolve around his belief that CEOs and corporations are too short-term oriented.
In his letter, Mr. Fink had this to say:
“This pressure [to meet short-term financial goals] originates from a number of sources—the proliferation of activist shareholders seeking immediate returns, the ever-increasing velocity of capital, a media landscape defined by the 24/7 news cycle and a shrinking attention span, and public policy that fails to encourage truly long-term investment.”
He goes on to bolster his argument with the following:
“More and more corporate leaders have responded with actions that can deliver immediate returns to shareholders, such as buybacks or dividend increases, while underinvesting in innovation, skilled workforces or essential capital expenditures necessary to sustain long-term growth.”
What Mr. Fink does not say in his letter is that large, multinational S&P 500 corporations driving this six-year bull run are sitting on a record hoard of cash, exceeding $1.4 trillion (see chart below). In this light, it should come as no surprise that CEOs are forking over more cash to investors in the forms of dividends and share repurchases.
What’s more, despite Fink’s assertion that share buybacks and dividends are killing innovation, he also fails to mention in his letter that 2014 capital expenditures of $730 billion are also at a record level. That’s right, CAPEX has not been cut to the bone as he implies, but rather risen to all-time highs.
It’s true that generationally low (and declining) interest rates have accelerated the pace of dividends/repurchases, however dividend payout ratios (the percentage of profits distributed to shareholders) of about 32% remain firmly below the long-term payout ratio of approximately 54% (see chart below) – see also Dividend Floodgates Widen. I find it difficult to fault many companies doing something with the gargantuan piles of inflation-losing cash anchoring their balance sheets. Don’t cash-rich companies have a fiduciary duty to borrow reasonable amounts of near-0% debt today (see Bunny Rabbit Market) in exchange for share buybacks currently providing returns of about 5.5% (inverse of 18x P/E ratio) and likely yielding 7%+ returns five years from now?
Source: Financial Times
The “Short-Term” Poster Child – Apple
There is no arguing that excessive debt eventually can catch up to a company. Our multi-year expanding economy is eventually due for another recession in the coming years, and there will be hell to pay for irresponsible, overleveraged companies. With that said, let’s take a look at the poster child of “short-termism” according to Mr. Fink …Apple Inc. (AAPL).
Of the roughly $500 billion in buybacks spent by S&P 500 companies in 2014, Apple accounted for approximately $45 billion of that figure. On top of that, CEO Tim Cook and his board generously decided to return another $11 billion to shareholders in the form of dividends. Has this “short-term” return of capital stifled innovation from the company that has launched iPhone version 6, iPad, Apple Watch, Apple Pay, and is investing into exciting areas like Apple Television, Apple Car, and who knows what else?
To put these Apple numbers into perspective, consider that last year Apple spent over $6 billion on research and development (R&D); $10 billion on capital expenditures; and hired over 12,000 new full-time employees. This doesn’t exactly sound like the death of innovation to me. Even after doling out roughly -$28 billion in expenditures and -$56 billion in dividends/share repurchases, Apple was amazingly able to keep their net cash position flat at an eye-popping +$141 billion!
Mr. Fink abhors “activist shareholders seeking immediate returns” but rather than deriding them perhaps he should send the greedy, capitalist Carl Icahn a personal thank you letter. Since Icahn’s vocal plea for a large Apple share buyback, the shares have skyrocketed about +85%, catapulting BlackRock’s ownership value in Apple to over $19 billion.
With respect to these increasing outlays, Mr. Fink also notes:
“Returning excessive amounts of capital to investors—who will enjoy comparatively meager benefits from it in this environment—sends a discouraging message.”
This would be true if investors took the dividends and stuffed them under their mattress, but an important message Mr. Fink neglects to address as it relates to dividends and share buybacks is demographics. There are 76 million Baby Boomers born between 1946 – 1964 and a Boomer is turning age 65 every 8 seconds. With many bonds trading at near 0% yields (even negative yields) it is no wonder many income starving retirees are demanding many of these cash-rich corporations to share more of the growing spoils via rising dividends.
Capitalism Works
After looking at a few centuries of our country’s history, one of the main lessons we can learn is that capitalism works – especially over the long-run. With about 200 countries across the globe, there is a reason the U.S. is #1…we’re good at capitalism. As our economy has matured over the decades, it is true our priorities and challenges have changed. It is also true that other countries may be narrowing the gap with the U.S., due to certain advantages (e.g., demographics, lower entitlements, easier regulations, etc), but the U.S. will continue to evolve.
In many respects, capitalism is very much like Darwinism – corporations either adapt with the competition…or they die. I repeatedly hear from pessimists that the U.S. is in a secular state of decline, but if that’s the case, how come the U.S. continues to dominate and innovate in major industries like biotechnology, mobile technology, networking, internet, aviation, energy, media, and transportation? Quite simply, we are the best and most experienced practitioners of capitalism.
Certainly, capitalism will continue to cultivate cyclical periods of excess investment/leverage and insufficient regulation. But guess what? Investors, including the public, eventually lose their shirts and behaviors/regulations adjust. At least for a little while, until the next period of excess takes hold. If Apple, and other balance sheet healthy companies allocate capital irresponsibly, capital will flow towards more aggressive and innovative companies. BlackBerry Limited (BBRY) knows a little bit about the consequences of cutthroat competition and suboptimal capital allocation.
While I emphatically share Mr. Fink’s focus on long-term investing values (including his self-serving tax reform ideas), I vigorously disagree with his attacks on shareholder friendly actions and his characterization of rising dividends/buybacks as short-term in nature. In fact, increasing dividends and share buybacks can very much coexist as a long-term investment and capital allocation strategy.
The question of proper capital allocation should have more to do with the age of a company. It only makes sense that younger companies on average should reinvest more of their profits into growth and innovation. On the other hand, more mature S&P 500-like companies will be in a better position to distribute higher percentages of profits to shareholders – especially as cash levels continue to rise to record levels and leverage remains in check.
BlackRock’s Larry Fink may continue to urge CEOs to reinvest their growing cash hoards into superfluous corporate kitchens, but Sidoxia and other prudent capitalist investors will continue to exhort CEOs to opportunistically take advantage of near-free borrowing rates and responsibly share the accretive gains with shareholders. That’s a message Mr. Fink should include in a letter to CEOs – he can use BlackRock’s lofty, above-average dividend to cover the cost of postage.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) including AAPL and iShares ETFs, but at the time of publishing, SCM had no direct position in BLK, BBRY or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Short Arms, Deep Pockets
Companies have deep pockets flush with cash, but are plagued with short arms, unwilling to reach into their wallets to make substantive new hires. I have talked about “unemployment hypochondria” in the past but is this cautious behavior rational?
The short answer is yes, and it is very typical in light of the similar “jobless recoveries” we experienced in 1991 and 2001. After suffering the worst financial crisis in a generation, employers’ wounds are still not completely healed and the frightening memories of 2008-2009 are still fresh in their minds.
Linchpin Labor
The globalization cat is out of the bag, and technology is only accelerating the commoditization of labor. When labor can be purchased for $1 per hour in China or $.50 per hour in India , and in many instances no strategic benefit lost, then why are so many people surprised about the hemorrhaging of $25 per hour manufacturing jobs to cheaper locales? Agriculture and related industries used to account for more than 90% of our economy about 150 years ago – today agriculture makes up about 2% of our economic output. Even though this dominating sector withered away on a relative basis, the United States became the global powerhouse innovator of the 20th century.
Innovative companies understand that true value is created by those workers who make themselves indispensable – or what Seth Godin calls “Linchpins.” Apple Inc. (AAPL) understands these trends. If you don’t believe me, just flip over an iPhone and read where it clearly states, “Designed by Apple in California. Assembled in China.” (see BELOW).
We are falling further behind our global brethren in math and science, and our immigration policy is all backwards (Keys to Success). Education, creativity, ingenuity, and entrepreneurial spirit are the main ingredients necessary to climb the labor food chain. For those workers that make themselves linchpins, their services will be in demand during good times and bad times.
Jobs = Heavy Hiking Boots
Like scared hikers jettisoning heavy hiking boots to escape a pursuing grizzly bear, business owners will eventually need to purchase a new pair of boots, if they want to hike the mountain to face the next challenge. Right now, businesses are content waiting it out, more worried about the potential of a bear jumping out to devour them.
Although businesses may not be plunging into hiring a substantial number of new workers, positive leading indicators are becoming more apparent. Beyond the obvious improvement in the explicit job numbers (e.g., nine consecutive months of private job creation), other factors such as increased temporary workers, accelerating job listings, and increased capital expenditures are the precursors to sustained job hiring.
Quarterly Capital Carrots
Capital expenditures generally lead to more immediate productivity improvements and do not have a complete negative and immediate impact on the sacred EPS (earnings per share) and income statement metrics. On the other hand, hiring a new employee has an instant depressing effect on expenses, thereby dragging down the beloved EPS figure. What’s more, new employees do not typically become productive or sales generative for months. If you consider the heavy explicit wages coupled with implicit training costs, until the coast is clear and confidence overcomes fear, businesses are not going to dip their hands into their cash-filled pockets to hire workers willy-nilly.
As previously mentioned, improved business confidence is being signaled by increased capital spending. Just over the last week, investors have witnessed significantly expanded capital expenditures across a broad array of industries. Here are a few random samplings:
September 2010 – Quarterly Capital Expenditures
Q3 – 2010 Q3 – 2009 YOY%
Apple Inc. (AAPL) $760 mil vs. $459 mil +66%
Halliburton Company (HAL) $557 mil vs. $440 mil +27%
Coca Cola Company (KO) $442 mil vs. $419 mil +5%
Dominos Pizza Inc. (DPZ) $5.2 mil vs. $4.1 mil +26%
Intel Corp. (INTC) $1.4 bill vs $944 mil +44%
Although the pace of the recovery is losing steam, companies’ health persists to strengthen, as evidenced in part by the +45% growth in 2010 S&P 500 profits, swelling record cash piles, and increasing corporate confidence (rising capital expenditures). Despite these positive leading indicators, business owners are reluctant to dip their short arms into their deep cash-filled pockets to hire new employees. Given our experience over the last few decades this corporate behavior is perfectly consistent with recent jobless recoveries. Until its clear the economic bear is hibernating, businesses will continue building their cash warchests. Everyone will be happier once we are done running from bears, and instead chasing bulls.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and AAPL, but at the time of publishing SCM had no direct position in HAL, KO, DPZ, INTC, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Taking Facebook and Twitter Public
Facebook CEO Mark Zuckerberg
Valuing high growth companies is similar to answering a typical open-ended question posed to me during business school interviews: “Wade, how many ping pong balls can you fit in an empty 747 airplane?” Obviously, the estimation process is not an exact science, but rather an artistic exercise in which various techniques and strategies may be implemented to form a more educated guess. The same estimation principles apply to the tricky challenge of valuing high growth companies like Facebook and Twitter.
Cash is King
Where does one start? Conceptually, one method used to determine a company’s value is by taking the present value of all future cash flows. For growth companies, earnings and cash flows can vary dramatically and small changes in assumptions (i.e., revenue growth rates, profit margins, discount rates, taxes, etc.) can lead to drastically different valuations. As I have mentioned in the past, cash flow analysis is a great way to value companies across a broad array of industries – excluding financial companies (see previous article on cash flow investing).
Mature companies operating in stable industries may be piling up cash because of limited revenue growth opportunities. Such companies may choose to pay out dividends, buyback stock, or possibly make acquisitions of target competitors. However, for hyper-growth companies earlier in their business life-cycles, (e.g., Facebook and Twitter), discretionary cash flow may be directly reinvested back into the company, and/or allocated towards numerous growth projects. If these growth companies are not generating a lot of excess free cash flow (cash flow from operations minus capital expenditures), then how does one value such companies? Typically, under a traditional DCF (discounted cash flow model), modest early year cash flows are forecasted until more substantial cash flows are generated in the future, at which point all cash flows are discounted back to today. This process is philosophically pure, but very imprecise and subject to the manipulation and bias of many inputs.
To combat the multi-year wiggle room of a subjective DCF, I choose to calculate what I call “adjusted free cash flow” (cash flow from operations minus depreciation and amortization). The adjusted free cash flow approach provides a perspective on how much cash a growth company theoretically can generate if it decides to not pursue incremental growth projects in excess of maintenance capital expenditures. In other words, I use depreciation and amortization as a proxy for maintenance CAPEX. I believe cash flow figures are much more reliable in valuing growth companies because such cash-based metrics are less subject to manipulation compared to traditional measures like earnings per share (EPS) and net income from the income statement.
Rationalizing Ratios
Other valuation methods to consider for growth companies*:
- PE Ratio: The price-earnings ratio indicates how expensive a stock is by comparing its share price to the company’s earnings.
- PEG Ratio (PE-to-Growth): This metric compares the PE ratio to the earnings growth rate percentage. As a rule of thumb, PEG ratios less than one are considered attractive to some investors, regardless of the absolute PE level.
- Price-to-Sales: This ratio is less precise in my mind because companies can’t pay investors dividends, buy back stock, or make acquisitions with “sales” – discretionary capital comes from earnings and cash flows.
- Price-to-Book: Compares the market capitalization (price) of the company with the book value (or equity) component on the balance sheet.
- EV/EBITDA: Enterprise value (EV) is the total value of the market capitalization plus the value of the debt, divided by EBITDA (Earnings Before Interest Taxes Depreciation and Amortization). Some investors use EBITDA as an income-based surrogate of cash flow.
- FCF Yield: One of my personal favorites – you can think of this percentage as an inverted PE ratio that substitutes free cash flow for earnings. Rather than a yield on a bond, this ratio effectively provides investors with a discretionary cash yield on a stock.
*All The ratios above should be reviewed both on an absolute basis and relative basis in conjunction with comparable companies in an industry. Faster growing industries, in general, should carry higher ratio metrics.
Taking Facebook and Twitter Public
Before we can even take a stab at some of these growth company valuations, we need to look at the historical financial statements (income statement, balance sheet, and cash flow statement). In the case of Facebook and Twitter, since these companies are private, there are no publically available financial statements to peruse. Private investors are generally left in the dark, limited to public news related to what other early investors have paid for ownership stakes. For example, in July, a Russian internet company paid $100 million for a stake in Facebook, implying a $6.5 billion valuation for the total company. Twitter recently obtained a $100 million investment from T. Rowe Price and Insight Venture Partners thereby valuing the total company at $1 billion.
Valuing growth companies is quite different than assessing traditional value companies. Because of the earnings and cash flow volatility in growth companies, the short-term financial results can be distorted. I choose to find market leading franchises that can sustain above average growth for longer periods of time (i.e., companies with “long runways”). For a minority of companies that can grow earnings and cash flows sustainably at above-average rates, I will take advantage of the perception surrounding current short-term “expensive” metrics, because eventually growth will convert valuation perception to “cheap.” Google Inc. (GOOG) is a perfect example – what many investors thought was ridiculously expensive, at the $85 per share Initial Public Offering (IPO) price, ended up skyrocketing to over $700 per share and continues to trade near a very respectable level of $500 per share.
The IPO market is heating up and A123 Systems Inc (AONE) is a fresh example. Often these companies are volatile growth companies that require a deep dive into the financial statements. There is no silver bullet, so different valuation metrics and techniques need to be reviewed in order to come up with more reasonable valuation estimates. Valuation measuring is no cakewalk, but I’ll take this challenge over estimating the number of ping pong balls I can fit in an airplane, any day. Valuing growth companies just requires an understanding of how the essential earnings and cash flow metrics integrate with the fundamental dynamics surrounding a particular company and industry. Now that you have graduated with a degree in Growth Company Valuation 101, you are ready to open your boutique investment bank and advise Facebook and Twitter on their IPO price (the fees can be lucrative if you are not under TARP regulations).
DISCLOSURE: Sidoxia Capital Management and client accounts do not have direct long positions AONE, however some Sidoxia client accounts do hold GOOG securities at the time this article was published. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
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