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Notes from Prof Bakshi's ( @Sanjay__Bakshi) Lecture on Maintenance Capex - https://vimeo.com/456037800
It’s important to understand maintenance capex to understand the economics of the business and from a valuation perspective. (1/n)
Notes from Prof Bakshi's ( @Sanjay__Bakshi) Lecture on Maintenance Capex - https://vimeo.com/456037800
It’s important to understand maintenance capex to understand the economics of the business and from a valuation perspective. (1/n)
This is about businesses or industries which have a high rate of obsolescence. Such Businesses, therefore, have to keep investing money to keep up with changes. This usually results in a low or no free cash flow. (2/n)
What we are not talking about:
Businesses which are not capital intensive - don’t require a lot of capital to grow eg: FMCG or businesses which require high working capital intensity. Eg: Gems and Jewellery which require a lot of high-value inventory. (3/n)
Businesses which are not capital intensive - don’t require a lot of capital to grow eg: FMCG or businesses which require high working capital intensity. Eg: Gems and Jewellery which require a lot of high-value inventory. (3/n)
We are looking at companies from the perspective of money laid out in Fixed Assets of the business. We refer to addition to Fixed assets as Capex here.
Capex can be split into two different categories -
1. Growth Capex
2. Maintenance Capex
(4/n)
Capex can be split into two different categories -
1. Growth Capex
2. Maintenance Capex
(4/n)
Growth Capex - Capex on Fixed Assets like Plant and Machinery etc which may add to the earnings capacity of the business. Actual stream of earnings may not materialise as expected but that is part of the risk of doing business. (5/n)
Maintenance Capex - Money spent to stay where you are. Here the CAPEX does not result in new streams of earnings or add to the existing one. This does not result in any addition to the earnings capacity of the business. This is the money spent just to stay in the game. (6/n)
This is the money spent to replace dying capacity. Plant and Machinery have a finite life and have to be replaced before the end of life. So the money spent here is to maintain the production capacity - earnings capacity of the business. (7/n)
That is the reason it is called Maintenance Capex - helps you maintain what you are already earning. (8/n)
In accounting, there is no bifurcation of Capex between Growth and Maintenance. This is something which the analyst has to work out on his own. Therefore there is an element of subjectivity here. (9/n)
Just because it is subjective or difficult to get a precise answer, we shouldn't let go of the idea. “It is better to be roughly right than precisely wrong.” - John Maynard Keynes (10/n)
We might not be precisely right when calculating maintenance capex but we will be closer to the truth. (11/n)
Two reasons why companies need to spend money on maintenance Capex:
1. Depreciation: Assets productive capacity is depleting & Capex would be needed to maintain its life. In accounting, we do a non-cash expense on Profit and Loss as ‘Depreciation’ to account for it (12/n)
1. Depreciation: Assets productive capacity is depleting & Capex would be needed to maintain its life. In accounting, we do a non-cash expense on Profit and Loss as ‘Depreciation’ to account for it (12/n)
Obsolescence: The mistake is when people think that maintenance CAPEX is always in lieu of depreciation. The physical life of an asset may be long and accounting principles lay down a lower rate of depreciation, but ... (13/n)
in practice, the asset may not be of much use after relatively short time spans due to obsolescence. While the physical life of the asset maybe longer, the economic life may be shorter. (14/n)
In such cases, if we depreciate the earnings over its physical life and if the economic life is short we overstate the earnings. This is quite common in companies operating in industries which have a high degree of obsolescence. (15/n)
If we have a high degree of obsolescence in a capital intensive industry, then the accounting profits may be overstated due to the phenomenon mentioned above. Accounting profits > Economic Profits (16/n)
In the end, it is the true economic earnings that truly matter. Economic Earnings are important for understanding how good or bad the business is and also from the point of view of valuations. In Valuations, we should use economic earnings and not accounting earnings. (17/n)
Maintenance capex is the enemy for investors. As investors, we would want maintenance capex to be lower. Maintenance capex is determined by the structure of the industry. In some industries - it’s high, while in some its low. (18/n)
Low maintenance eg: Hydro-Electric power station - a lot of upfront capex and very low maintenance capex. Here the maintenance capex < Accounting depreciation. The asset may still have a long life even when the book value has been largely depreciated. (19/n)
Whenever we are observing or studying something - its important to ask two things - 1) What does it remind me of, 2) Why does it remind me of it.
When a high rate of obsolescence - Think Maintenance capex
Seek patterns (20/n)
When a high rate of obsolescence - Think Maintenance capex
Seek patterns (20/n)
Exceptions: When maintenance capex is not in response to competition and defensive but aggression undertaken by the leader with a strong balance sheet and margins to increase the barriers to entry in an industry eg: Intel (21/n)
Intel - it has spent a huge amount of money in producing cutting edge technology. The leader has the balance sheet strength and the margins to stay ahead in the game, spend huge amounts and be an aggressor. (22/n)
Also, check the post by @jvembuna on Maintenance Capex
https://janav.wordpress.com/2015/07/08/calculating-maintenance-capital-expenditure/ (23/n)
https://janav.wordpress.com/2015/07/08/calculating-maintenance-capital-expenditure/ (23/n)
You can read the notes on this lecture here.
https://investorclub.substack.com/p/notes-prof-bakshis-lecture-on-maintenance (24/n)
https://investorclub.substack.com/p/notes-prof-bakshis-lecture-on-maintenance (24/n)
