Maintenance vs. growth CAPEX for Valuation and M&A

Maintenance vs. growth CAPEX for Valuation and M&A

Author: Joris Kersten, MSc

Kersten CF: M&A advisory and valuations at The Netherlands. Deal value: 5 to 100 million enterprise value, in all industries. www.kerstencf.nl

Training: Business Valuation & Deal Structuring (5 days). 4th – 8th November 2024 @ Amsterdam South. Training manual & registration form: www.joriskersten.nl – 130 recommendations: https://www.joriskersten.nl/nl/reviews

Source used: Morgan Stanley, Investment Management, Counterpoint Global Insights. Underestimating the red queen: Measuring Growth and Maintenance investments. Michael J. Mauboussin & Dan Callahan, 2022.

?

Introduction

How do we know whether a company understates its capital spending?

A method to calculate this is by the “cumulative capacity cost”.

This is a measure of maintenance spending and it is the sum of:

·???????? Depreciation & Amortisation (D&A);

·???????? Asset write downs;

·???????? Loss on the sale of assets;

·???????? Goodwill impairment;

·???????? Intangible asset impairments.

And this over a period of 5 years.

Then the cumulative capacity cost is divided over the cumulative sales of the same period of 5 years.

And this ratio provides an estimate of the cost of assets required to generate 1 dollar worth of sales.

So multiplying this ratio by the current year sales gives a measure of maintenance capital expenditures (CAPEX).

It was found (please check source I have used) that for 1974 to 2016 maintenance capital exceed D&A by about 20% !

So this maintenance capital expenditure surpass means that less capital is going to growth capex than investors think !

This understatement of D&A is attributed to technological obsolescence.

Inflation also has the same effect.

And deflation has the opposite effect.

?

Growth vs. Maintenance spending

For the analysis above sorting growth vs maintenance spending is essential.

The approach above struggles with a few issues do.

For example, concerning M&A there was an evolution in accounting rules.

Prior to 2001 companies could either use the “purchase method” or “pooling of interest method” for M&A.

With purchase accounting any premium to book value was put on the balance sheet as goodwill and amortised over up to 40 years.

And with “pooling”, two companies simply combined their balance sheets.

Since 2001 pooling was not possible anymore, and the “amortisation of goodwill” was replaced with a “goodwill impairment test”.

As a result, amortisation as a percentage of D&A plummeted from 22 percent in 2001 to about 10% in 2002.

This is relevant, because it changes the calculation of the “cumulative capacity cost”, as mentioned above.

So due to impairment of goodwill, instead of amortisation, the cumulative capacity cost goes down (assuming no impairment).

On the other hand, since 2007, more specificity about how to record intangible assets was provided by FASB (financial accounting standards board).

Intangible assets are amortised, and goodwill impaired.

And the result was a rise in intangible assets on the balance sheet, including amortisation of these “acquired intangibles” in the income statement.

And this was even reinforced by lots of M&A activity.

?

Further rise of intangibles

The formula for growth is the same for “tangible assets” as for “intangible assets”.

So companies spend on intangible assets, and the money is allocated between “growth” and “maintenance” of these intangible assets.

Many people assume that R&D is all about growth, and has nothing to do with maintenance.

But careful analysis shows that a meaningful percentage of R&D spending, especially for large digital technology companies, is in fact necessary to just maintain the current operations.

So understanding this ratio (growth/ maintenance) for R&D, as well as for other categories of intangible investments, is absolutely essential for a company’s prospects !

?

Intangibles

The analysis concerning the “cumulative capacity cost”, as mentioned above, was done for “tangible assets”.

But the task for intangible assets is much more complex !!

This because (organic) intangible investments, and maintenance spending, are expensed in the income statement.

Acquired intangible assets are recorded on the balance sheet after an M&A deal (purchase price allocation). But again, the ongoing spending to maintain the value of these (acquired) intangibles is expensed in the income statement.

So for example, a company puts an (acquired) customer list on the balance sheet and amortises it over its estimated useful life. But the costs to maintain and grow the list are expensed in the income statement under SG&A.

So that is why we use EBITA, instead of EBIT, to calculate NOPAT !

The appearance of the customer list on the balance sheet is a "one time event", as a result of an M&A deal.

And future spending on this will sit in the income statement.

?

Growth vs maintenance investments within intangibles

It is estimated (see source used for this blog) that for companies in the Russell 3000 1.8 trillion USD of total SG&A expense was in the form of “intangible asset investments”.

Intangible assets are put on the balance sheet following an M&A deal. These intangible assets need to meet one of two criteria:

·???????? The assets arise from contractual or legal rights;

·???????? The assets can be separated from the company.

Acquired intangible assets have averaged about 1/3 of M&A deal value in recent years.

Assets that do not meet those criteria are recorded as goodwill, which is:

·???????? Purchase price of the deal -/- fair value of tangible assets -/- fair value of intangible assets (net of liabilities).

As an investor must think about growth and maintenance CAPEX (tangible assets), they must do the same for:

·???????? Investment SG&A expenses;

·???????? Investment maintenance SG&A expenses.

Here for SG&A needs to be separated in two parts:

1.????? The sum of research & development (R&D) and advertising (intangible investments);

2.????? Main SG&A.

And Main SG&A needs to be further separated in:

·???????? Maintenance Main SG&A;

·???????? Investment Main SG&A.

Maintenance Main SG&A expenses support existing operations and are calculated by matching them with current revenues in the time period. Examples are: Office rent and distributions centres rent, delivery costs, sales commissions etc.

Left over is “Investment Main SG&A” and this is the source for future earnings.

"Maintenance Main SG&A" is what a company has to spend to stay in place. And Investment Main SG&A is what the company spends to pursue value creating growth.

Summarised:

·???????? Intangible investments = The sum of R&D, advertising and Investment Main SG&A;

·???????? Maintenance SG&A = Maintenance Main SG&A.

?

Investment SG&A vs. Maintenance SG&A

Investment SG&A and maintenance SG&A grew similarly up to about the year 2000.

But then the intangible investments started to grow faster !

After the financial crises of 2008-2009 they even started to grow faster.

?

Summarised

Understanding growth vs maintenance spending is essential for corporate finance professionals, and even more for executives and investors.

But only a few have a clear sense of these numbers !

This holds for "tangible assets", as the example on “cumulative capacity cost” above demonstrates.

But probably this holds even more for intangible assets such as R&D and certain aspects of SG&A.

This because generally these are expensed instead of capitalised.

The unravelling work here needs to be done by the corporate finance advisor, executive or CFO.

But probably many experts do not know their maintenance CAPEX number.

I personally advise you to keep track of the work of Michael J. Mauboussin since he is doing great work in unravelling "real NOPATs" and “invested capital” numbers. This by unravelling expenses that should be capitalised as intangibles.

And this is important since intangible assets keep rising and rising within companies !

Hope this was useful, see you next week again with a new blog,

Best Joris????

Kersten Corporate Finance

?

Source used: Morgan Stanley, Investment Management, Counterpoint Global Insights. Underestimating the red queen: Measuring Growth and Maintenance investments. Michael J. Mauboussin & Dan Callahan, 2022.