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Capital Choices: The 2004 Capital-Spending Scorecard

A new study shows which companies are getting the most bang for their capital-investment buck.

Still, Waisanen expects the company to grow as much by dint of acquisitions (it has been buying an average of two companies a year since the mid-1990s) as by new capital investment. He notes that because Lafarge’s aftertax cost of capital is 9 percent, its internal rate of return on new investments is in the midteens, posing a big challenge for a capital-intensive company that must nevertheless meet quarterly earnings expectations. “That’s a significant hurdle for a company like ours,” he says.

For some companies, higher costs will force bigger expenditures. The sharp spike in the price of crude oil, for example, is helping oil companies’ cash flow and earnings, but it has also raised the price of the exploration services they purchase to find oil. Meanwhile, higher steel prices have raised the cost of rig construction and thus extraction costs. As a result, BP Ltd., for one, expects that its spending could rise to $1.5 billion next year. According to PRTM’s analysis, that would represent a 10 percent increase over what it spent last year, and almost two-and-a-half times the annual rate of increase in its capital expenditures since 2000. That would at last bring BP’s rate of spending growth in line with that shown so far this decade by the rest of the energy and utility industry.

Yet BP may find it challenging to get a superior return on those expenditures, as its 2003 return on gross fixed assets was only 16 percent, roughly average for the industry but 5 to 10 percentage points less than that of the top four companies in its group — Statoil, PetroChina, Conoco-Phillips, and Ente Nazionale Idrocarburi. In fact, BP’s share price slid on the day it disclosed the need for higher expenditures next year, despite a big increase in its most recent quarterly earnings.

Other companies are boosting spending to exploit new market opportunities, but even they are more cautious about capital outlays than they were during the 1990s. Corning, for instance, was burned badly by the telecom industry’s implosion around the end of the decade after the company ramped up fiber-optic capacity based exclusively on service providers’ orders. This time, as it hikes spending for LCD screens, the company is placing more weight on third-party research. What’s more, it is requiring upfront deposits on particularly big orders from certain customers, even though LCD panels give Corning more time to adjust to changes in demand, since the production capacity can be up and running within six months, whereas its fiber-optic plants typically required two years to build.

Of course, generating sufficient profits from new capital spending is no sure thing for any company, particularly in a recovery as weak as the current one. But without such spending, and the job growth that accompanies it, a stronger recovery will surely remain elusive. At this point, most companies and consumers still seem to be waiting for the other to open their wallets first.

Ronald Fink is a deputy editor of CFO.

Measuring Capex

To find out how the 300 companies in its sample fared in terms of return on capital spending, Pittiglio Rabin Todd & McGrath (PRTM) ranked the 20 largest companies (by sales) in each of 15 industries according to their 2003 earnings before interest, taxes, depreciation, and amortization (EBITDA) divided by the book value of their fixed assets. The resulting ratio — 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 Waltham, Massachusetts-based consulting firm’s scorecard also shows how much those companies spent in 2003 and how that amount has changed since 2000. To complete the picture, the analysis also shows a company’s degree of capital intensiveness (capital expenditures divided by revenue) 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. ROGFA is most useful, says PRTM director Amram Shapiro, “in assessing the overall productivity of a company’s capex investment.” — R.F.

See the capital-spending scorecard


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