Capex for growth?

Yesterday, one of my blog readers commented on one of my posts. He asked a question on capital expenditure. I really need to thank him for asking such a question as it allowed me to reinforce my value investing knowledge. I would post the question by the reader and also my reply below. Why I’m doing this is to open this up for discussion and to allow seasoned value investors to comment on this for all to learn and improve ourselves in this journey (hopefully, they give their two cents). Here goes:

Reader:

Hi,

Thanks for the explanation.

However, I disagree with the understanding that capex should be as low as possible. Capex or “cash flows from investing activities” should be at a reasonable level for a growth company. A good company is one that has a significant level of growth and for that to happen, they must invest for growth. So high capex does not necessary mean that the company is bad. In fact, I would be happy for a coy to put in 70% of earnings into capex as long as it reaps returns in the next few years.

Just like the TMC analysis, if TMC consistently have very low capex, then I know for sure they’re not serious about expanding overseas. And it’s not a company I will be interested in investing in. If they were to build a hospital in china for example, their capex will soar and to me, that’s a good sign. I hope you get what I mean. Cheers.

Me:

Hi,

Firstly, capex is not equal to cash flow from investing activities. Capex is only part of cash flow from investing activities in accounting terms.

Secondly, capex means capital expenditure in full. It means “funds used by a company to acquire or upgrade physical assets such as property, industrial buildings or equipment. This type of outlay is made by companies to maintain or increase the scope of their operations. These expenditures can include everything from repairing a roof to building a brand new factory.” (courtesy of Investopedia). As you can see from the definition, it includes things that does not promote company growth like repairing a roof, etc. Yes, it includes purchasing of factories which may be needed to increase production for growth for manufacturing companies but does it ALWAYS promote growth? To answer that, you need to look at other metrics as discussed below.

Next, I agree with your statement “A good company is one that has a significant level of growth and for that to happen, they must invest for growth.” To see if a company is re-investing into its own business for growth, you don’t look at capex but look at “Retained Earnings” under the Balance Sheet. You can also calculate its ROE and CROIC (Cash Return On Invested Capital) to see if a company is re-investing in itself.

Do you think Coca-Cola is a good company? I certainly think so from their financial statements and also by how famous their drinks are. Did u know that Coca-Cola has extremely low capex? Their capex amounted to only US$1.5 mil on average over the last 5 years (I can only quote 5 years data as that’s what I got from the net. It was much lesser historically). Their revenue for FY2009 was around US$31 mil. Their capex was only 4.8% of total revenue. Their capex is very low as they have outsourced their bottling enterprise which is capital intensive (high capex). Coca-Cola’s stock price is up 3602.58% every since listing. In the long run, rise in stock price is equal to rise in value of company. Coca-Cola certainly has grown tremendously even with low capex.

Low capex and high operating cash flow gives u lots of free cash flow. Free cash flow is what is essential for a company to grow and pay dividends and not high capex. This is the reason Warren Buffett shuns companies with high capex. Capex should not be seen as a figure alone but with revenue. For example, airline companies don’t do well in the long run due to high capex to maintain their aircraft fleet. SIA replaces its planes every six years on average. When money is tied up to buy new planes, how can the company re-invest to generate more growth? This is just one example. There are many such examples I can quote. I’m lazy to type all those in and I’m sure you will get bored reading those examples.

Now, let’s come to TMC. I’m afraid to say you are wrong when you say TMC “not serious about expanding overseas”? Do you know that they are going to have a hospital in Vietnam launching soon and a second one in the pipeline with such low capex? They have chosen Vietnam as Vietnam is an untapped market with huge potential. Vietnam has a birth rate of 17.73 births/1,000 population vs Singapore’s 8.82 births/1,000 population. Also, the hospital in Vietnam is located in one of the most affluent parts of Vietnam. Now, tell me if they serious in the growth of their business?

I sincerely hope I have answered your question.

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4 thoughts on “Capex for growth?

  1. Hi!

    Nice topic, wonder if I may make some comments myself on what I understand about capex.

    Capital Expenditure, as the name implies, will include all manner of fixed assets such as plant, machinery and renovations which can upgrade or enhance existing assets. It usually does NOT include repairs and maintenance which I feel is an operating expense and not capital expense; hence under Investing Cash Flows I believe capex consists almost solely of asset purchases and/or upgrades/enhancements. Most companies use a different line to signify investments in associated companies, JV or subsidiaries; hence this is separate from investing in Fixed Assets per se.

    Capex should not just be viewed with respect to revenues (though that is of course a correct comparison); but also in relation to the industry. When FFN’s reader mentioned that capex is related to growth, he is not wrong. However, one must question the natire of the growth, the dynamics and characteristics of the industry in which the company is in; as well as the source of funds for such growth (capex). Some industries like Oil and Gas E&P and also support vessels for O&G (e.g. Swiber, Ezra) need very high capex to ensure specialized vessels can be purchased/built to service their clients. Other industries such as shipbuilding or property also require heavy upfront capex to build before collecting cash. So the capex requirement is also a function of the industry; and to a certain extent the company itself.

    There are actually companies which have low capex yet are able to generate high ROE consistently. How do they do this? By recycling their capital consistently and deploying it well! Although capex is a function to grow for many industries, it does not always apply. For example, service-oriented companies which repair do not require heavy capex except to change/upgrade machinery. Most of the expenses are in manpower and skills training (i.e. people investment).

    FCF is important for dividends but Management also needs to ensure the cash does not become a drag on ROE. It’s a fine balancing act to be sure!

    As for TMC, I can’t comment much as I don’t know the company well. But what you can do is to observe how much they intend to spend, how they are going to spend it, and how will the funds be obtained. That will give some idea as to the potential growth.

  2. hello,

    first of all, i believe there is a decent need for every company to have some capex so as to maintain to expand their business. the only question is how much.

    to me, the amount of capex how much a company deploy partly depend on how mature the business is.

    as you have mentioned, coca cola only has that little capex simply because their business is fully matured. Unlike other small caps or companies who have just started out for a few years, coca cola’s capex might be just to repair the machine that adds CO2 to the black water.

    I have not checked out coca cola’s financial statement way back into the 70s or 80s, but i strongly believed that when it first started out initially, a substantial amount of capex was deployed as well.

  3. Hi MW,

    Yes, capex is related to the industry. Service industries have low capex while companies involved shipbuilding and ship-chartering, for example, may have high capex. I’ve seen this myself with some shipping companies. Recycling capital consistently and deploying it well without hoarding on to too much cash shows a competent management.

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