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inpractice capital spending PU T TING A CAP ON CAPEX Even companies that spend big are working harder to make sure they spend smarter. B Y R A N D Y M Y E R S F CONSUMERS SPENT LIKE COMpanies, credit-card debt would vanish. When it comes to capital spending, recent data suggests that CFOs on the whole are scaling back their expectations. And while those employed in the 15 most capital-intensive U.S. industries have relaxed their grips on their checkbooks, caution remains the watchword. For the three-year period from 2002–2005, reports management consulting firm PRTM, all but one of those industries increased capital spending, up from only 6 of 15 in the period 2001–2004. Not surprisingly, the energy and petrochemicals industry, riding what until recently had been a remarkable run-up in energy prices, has been the biggest spender by sheer dollar volume. The 20 largest companies in that sector shelled out an average $3.5 billion each in capital expenditure (capex) in 2005, equal to 12 percent of their revenues. Only the communication-services industry was more capital intensive, channeling 15 percent of revenue to capex, or an average of $2.4 billion per company I among the industry’s 20 biggest players. Metals and chemicals companies couldn’t match those raw dollar figures, but they did ramp up their spending faster than anybody else over the latest three-year period, with compound annual capex growth rates of 28 percent and 20 percent, respectively. While there were strong differences by industry, one common theme emerged: increases to capex spending lagged increases in revenue among North America’s 300 largest companies virtually across the board. Revenue grew at a 12.8 percent compound annual rate from 2002 to 2005, while capex grew only 5.1 percent. That suggests both a healthy capex outlook and, according to PRTM’s director of operational strategy practice, Roger Wery, room for further increases. “The picture today is not completely perfect,” Wery concedes, citing the slumping housing market and volatile energy prices, “and certainly every industry has a different pulse and cycle. But when you look at all the curves together, it’s a sustained and smooth trend that we would expect to C F O J A N U A R Y 2 0 0 7 capital spending continue for at least two years.” As for why capex has not moved in lockstep with revenue growth, Wery suggests that the reasons vary by company. “Assuming the revenue growth correlates with increased profits,” he says, “companies may favor other uses for their increased cash flow: to buy back shares, pay dividends, add to their cash reserves, or pull whatever other operational lever suits their needs at the time.” In short, he says, although there is a long-term relationship between revenue growth and increased capex spending, many other factors explain annual variances. IN SEARCH OF BIGGER PAYOFFS What matters to most companies, however, isn’t how much they spend but how well they spend. To identify those that are most adroit at balancing capital spending with customer demand, PRTM ranks the 20 largest companies in 15 capital-intensive industries by a measure it calls adjusted return on gross fixed assets, or ROGFA, which roughly equates to the ratio of operating profits to capital spending. (For more on the methodology, see “Measuring Capex,” below.) In many industries, a high ROGFA correlates with strong perform- ance in other key areas, such as sales growth and shareholder return. Case in point: $2.3 billion SanDisk Corp., a Milpitas, California-based producer of flash memory cards and related products used in digital cameras, mobile phones, MP3 music players, networking equipment, and other electronic devices. Demand for such gear is soaring, and SanDisk, whose revenues have more than doubled in the past three years, has been investing furiously to keep pace. For the most-recent three-year period tracked by PRTM, it increased capex at a compound annual rate of 101 percent, shelling out $134 million in 2005. That compared with an average 17 percent capex growth rate for North America’s 20 largest semiconductor companies. More important, SanDisk posted a ROGFA of 219 percent in 2005, and a compound annual return of 84 percent for shareholders over the three-year period ending in 2005. Both were tops in its sector. Judy Bruner, SanDisk’s CFO and executive vice president for administration, says the company’s capex last year actually exceeded the $134 million captured on its cash-flow statement because that figure did not include investments in joint ventures. Those ventures, however, contribute sub- A WORLD OF SAMENESS: REVENUE VS. CAPEX GROWTH Revenue growth outpaced capitalexpenditure growth in all three regions of the world tracked by consulting firm PRTM, based on data for the 50 companies in each region with the highest levels of capex during the period from 2002 through 2005. ASIA Capex growth Revenue growth EUROPE Capex growth Revenue growth NORTH AMERICA Capex growth Revenue growth Source: PRTM 5.2% 6.6% 4.6% 6.5% 4.9% 8.0% Measuring Capex To find out how the 300 companies in its sample fared in terms of return on capital spending, consulting firm PRTM ranked the top and bottom four companies in each industry according to their 2005 earnings before interest, taxes, depreciation, and amortization divided by the book value of their fixed assets, and adjusted to eliminate the balance-sheet effect of operating leases. The resulting ratio—adjusted 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 consulting firm’s scorecard also shows how much those companies spent in 2005 and how that amount has changed since 2002. To complete the picture, the analysis also shows a company’s degree of capital intensiveness 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. — R.M. stantially to SanDisk’s strong returns on its investments, and illustrate how even a company in the midst of a boom is being careful with its capex outlays. “Our long-term model is to own about 70 percent of our memory, in terms of captive supply, and to purchase about 30 percent from third parties,” Bruner says. “By doing that, we significantly mitigate any downside risk if market demand is not as strong as anticipated, because we can pull back on the noncaptive purchases.” The strategy, of course, also reduces the sums SanDisk must pour into its own plant and equipment, while allowing it to capitalize on unexpected demand for its products. “Instead of having to expand fabrication capacity to capture those opportunities, we can quickly purchase more memory from third parties in order to capture that market share,” Bruner says. In short, by investing enough to meet the majority of its demand—but not necessarily all of it—SanDisk helps to ensure that the plant and equipment it does invest in are fully utilized. Canada’s IPSCO Inc., a $3 billion steel and tubular-products maker, is also keen to extract maximum returns from its cap- C F O J A N U A R Y 2 0 0 7 WEB EXCLUSIVE For more on the survey’s findings, go to www.cfo.com. To learn more about ROGFA, go to www.prtm.com. ital investments. Its approach is to focus not only on projects that expand capacity, but also on those that allow it to offer new, higher-value products. “We still serve the same customers,” observes IPSCO senior vice president and CFO Vicki Avril, “but now we can give them products they had to go elsewhere to get in the past.” High-ROGFA companies don’t skimp on capital spending, but they are generally less capital intensive than their lowerperforming peers. IPSCO, for example, increased its capex at a compound annual rate of 15 percent over the three years ending in 2005, but was hardly a spendthrift. Its average peer in the metals group boosted spending by 28 percent over the same period. Perhaps more tellingly, its capital spending equated to just 2.2 percent of its revenue, versus 7 percent for its average peer. “We watch our spending very, very carefully,” Avril says. “Before we make any investment, we stress-test it to make sure it will be a good investment throughout the steel cycle, not just at the peak of the cycle.” Results have been strong. In 2005, IPSCO had the highest ROGFA (64 percent) of North America’s 20 largest metals companies, and for the three years from 2002 through 2005 it also posted the best compound annual total return to shareholders, 84 percent. “I think the biggest mistake people make is believing that when they get into a favorable cycle things have changed and the cycle will remain strong,” Avril summarizes. “That’s when they tend to overbuild.” Some economists have predicted that the slowdown in consumer spending will be partially offset by strong capital outlays in the business sector, but recent figures from the Commerce Department suggest business is becoming more cautious in this regard. Even among capital-intensive industries that have boosted spending, overbuilding seems unlikely. Like SanDisk and IPSCO, most companies will no doubt pick their spots very carefully. CFO RANDY MYERS IS A CONTRIBUTING EDITOR OF CFO. The 2006 Capital Spending Scorecard TOP PERFORMERS* BOTTOM PERFORMERS* COMPANIES AEROSPACE & DEFENSE MANTECH INTERNATIONAL ARMOR HOLDINGS L-3 COMMUNICATIONS HOLDINGS DRS TECHNOLOGIES MOOG BOEING SEQUA BOMBARDIER AVERAGE PERFORMANCE AUTOMOTIVE & TRANSPORT OSHKOSH TRUCK GENUINE PARTS HARLEY-DAVIDSON PACCAR DANA TOWER AUTOMOTIVE DELPHI LEAR AVERAGE PERFORMANCE CHEMICALS ASHLAND SHERWIN-WILLIAMS ECOLAB AGRIUM AIR PRODUCTS AND CHEMICALS EASTMAN CHEMICAL CHEMTURA NOVA CHEMICALS AVERAGE PERFORMANCE *Ranked by ROGFA CAPEX in $ millions (2005) $6 16 120 35 41 1,547 77 334 $297 $43 86 198 849 297 153 1,183 568 $1,146 $380 143 269 181 930 343 104 433 $440 CAPEX CAGR (2002–2005) 28% 38 25 36 15 16 2 -39 10% 40% 10 -15 36 -7 -1 5 28 6% 27% 4 8 37 14 -7 1 66 20% Capital Intensiveness (2005) 1% 1 1 3 4 3 4 2 2% 1% 1 3 6 3 5 4 3 4% 4% 2 6 5 11 5 3 7 5% ROGFA (2005) 274% 227 117 78 26 24 15 9 66% 90% 86 76 67 5 -4 -7 -14 26% 49% 46 39 24 14 11 8 5 21% Revenue Growth (CAGR 2002–2005) 25% 75 33 36 14 0 6 -2 18% 19% 6 10 25 -3 6 -1 6 8% 7% 12 10 7 15 10 5 12 17% Shareholder Return (2002–2005) 13% 46 19 18 27 31 21 -42 23% 43% 16 5 37 -12 -25 -61 -3 10% 30% 19 15 14 14 16 31 12 18% C F O J A N U A R Y 2 0 0 7 TOP PERFORMERS* BOTTOM PERFORMERS* capital spending COMPANIES COMMUNICATION SERVICES ECHOSTAR COMMUNICATIONS DIRECTV GROUP COMCAST ALLTEL AT&T QWEST COMMUNICATIONS INTERNATIONAL LEVEL 3 COMMUNICATIONS IDT AVERAGE PERFORMANCE ELECTRONICS DELL APPLE COMPUTER EMC INGRAM MICRO SYMBOL TECHNOLOGIES AGILENT TECHNOLOGIES SUN MICROSYSTEMS GATEWAY AVERAGE PERFORMANCE ENERGY & PETROCHEMICALS HALLIBURTON VALERO ENERGY SCHLUMBERGER TESORO PLAINS ALL AMERICAN PIPELINE HESS KINDER MORGAN ENERGY PARTNERS WILLIAMS AVERAGE PERFORMANCE FOOD & BEVERAGE COCA-COLA† GENERAL MILLS PEPSICO H. J. HEINZ MOLSON COORS BREWING TYSON FOODS COCA-COLA ENTERPRISES ARCHER-DANIELS-MIDLAND AVERAGE PERFORMANCE INDUSTRIALS INGERSOLL-RAND DANAHER TEREX ILLINOIS TOOL WORKS HONEYWELL INTERNATIONAL BALL TIMKEN NACCO INDUSTRIES AVERAGE PERFORMANCE MEDICAL DEVICES PATTERSON BIOMET† OWENS & MINOR C.R. BARD BAXTER INTERNATIONAL HOSPIRA DENTSPLY INTERNATIONAL HILLENBRAND INDUSTRIES AVERAGE PERFORMANCE CAPEX in $ millions (2005) CAPEX CAGR (2002–2005) Capital Intensiveness (2005) ROGFA (2005) Revenue Growth (CAGR 2002–2005) Shareholder Return (2002–2005) $1,506 889 3,621 1,302 5,576 1,613 305 112 $2,392 $728 260 601 39 72 139 257 45 $281 $651 2,133 1,593 258 164 2,341 863 1,299 $3,459 $899 414 1,736 241 406 571 914 624 $590 $112 121 49 293 684 292 221 71 $391 $32 97 30 97 444 256 45 121 $181 51% -12 22 -34 -6 -16 12 42 1% 34% 14 15 -11 28 -23 -23 -17 7% -5% 50 5 8 59 15 17 -11 18% 2% -6 7 4 19 4 -4 21 7% -3% 23 19 3 1 23 37 8 10% 41% 16 84 33 -19 10 -8 8 25% 18% 7 16 14 13 12 8 5 15% 1% 2 6 0 4 3 2 1 3% 3% 3 11 2 1 10 9 10 12% 4% 4 5 3 7 2 5 2 4% 1% 2 1 2 2 5 4 2 3% 1% 5 1 5 5 10 3 6 5% 44% 29 29 24 10 8 6 -1 18% 152% 103 69 64 21 13 11 11 48% 50% 39 38 37 18 17 14 11 26% 71% 51 45 40 19 18 17 16 30% 83% 79 79 54 27 22 18 16 41% 224% 121 119 109 28 23 22 2 76% 20% 14 21 6 1 -3 5 17 9% 16% 34 21 9 8 -5 -4 -3 10% 19% 45 2 33 55 24 32 31 29% 6% 12 9 -2 14 4 3 15 8% 6% 20 31 11 7 14 27 7 13% 20% 16 7 12 7 0 4 -3 13% 7% 56 3 10 2 4 -16 -13 11% 4% 116 30 17 16 23 10 -7 22% 51% 78 34 139 26 34 18 106 48% -0.4% 4 14 5 5 16 -3 28 11% 25% 19 75 12 19 17 21 41 24% 15% 9 21 33 12 28 14 3 21% *Ranked by ROGFA †Denotes companies for which ROGFA has not been adjusted for operating-lease expenses, due to lack of data. (Since the present value of operating leases usually makes up less than 1% of adjusted gross fixed assets, ROGFA is unlikely to be materially affected.) C F O J A N U A R Y 2 0 0 7 TOP PERFORMERS* BOTTOM PERFORMERS* COMPANIES METALS IPSCO RELIANCE STEEL & ALUMINUM COMMERCIAL METALS SOUTHERN COPPER† ALCOA INCO ALCAN AK STEEL HOLDING AVERAGE PERFORMANCE NETWORK EQUIPMENT RESEARCH IN MOTION PLANTRONICS JUNIPER NETWORKS CISCO SYSTEMS 3COM JDS UNIPHASE NORTEL NETWORKS UTSTARCOM AVERAGE PERFORMANCE PHARMACEUTICALS GILEAD SCIENCES FOREST LABORATORIES ALLERGAN KING PHARMACEUTICALS ELI LILLY MEDIMMUNE SCHERING-PLOUGH CEPHALON AVERAGE PERFORMANCE CAPEX in $ millions (2005) $69 54 110 471 2,138 1,207 1,897 174 $560 $104 28 98 692 21 36 267 64 $126 $48 89 79 53 1,298 92 478 118 $718 CAPEX CAGR (2002–2005) 15% 42 33 83 19 14 25 23 28% 3% 35 40 -36 -61 -35 -16 -5 4% 40% 35 0 -10 5 4 -15 63 12% 101% 29 60 51 12 -12 18 -9 17% 44% 19 35 10 -29 -14 -39 44 12% 7% 6 -19 -22 10 17 -7 -42 -4% Capital Intensiveness (2005) 2.2% 1.6 1.7 11 8 26 9 3 7% 7% 5 5 3 3 5 2 2 3% 2% 3 3 3 9 7 5 10 7% 6% 2 10 6 22 8 10 7 8% 0.4% 0.1 5 5 3 5 3 3 9% 10% 2 10 14 15 23 16 8 13% ROGFA (2005) 64% 57 48 55 13 13 9 7 31% 151% 134 133 113 -37 -43 -54 -63 44% 299% 273 84 83 28 20 4 -35 73% 219% 205 185 152 14 11 10 9 73% 318% 276 30 28 4 -6 -11 -97 35% 18% 18 17 16 9 9 9 -43 10% Revenue Growth (CAGR 2002–2005) 29% 24 39 84 9 17 8 10 28% 55% 22 56 9 -24 -13 -8 44 12% 63% 25 18 15 10 14 -2 34 19% 62% 17 23 49 24 -8 12 0.3 18% 20% 78 -4 11 6 7 9 7 14% -0.4% 82 9 2 13 -6 7 11 13% Shareholder Return (2002–2005) 84% 44 68 76 12 15 6 -0.2 50% 62% 23 49 9 -8 -2 12 -26 19% 46% -6 24 -1 -1 9 -1 10 12% 84% 49 34 81 11 -4 11 16 32% 35% 50 20 8 50 -60 -58 -13 15% 18% 16 74 17 15 16 18 -60 28% SEMICONDUCTORS SANDISK $134 LAM RESEARCH 23 QUALCOMM 576 MARVELL TECHNOLOGY GROUP 99 MICRON TECHNOLOGY 1,065 AGERE SYSTEMS 131 ATMEL 169 FAIRCHILD SEMICONDUCTOR INTERNATIONAL 97 AVERAGE PERFORMANCE $602 TRANSPORTATION C.H. ROBINSON WORLDWIDE WORLD FUEL SERVICES CON-WAY UNITED PARCEL SERVICE AMR DELTA AIR LINES NORTHWEST AIRLINES UAL AVERAGE PERFORMANCE UTILITIES FIRSTENERGY ONEOK AES DUKE ENERGY FPL GROUP AMERICAN ELECTRIC POWER ENTERGY CALPINE AVERAGE PERFORMANCE *Ranked by ROGFA $22 5 210 2,187 681 814 359 470 $924 $1,208 250 1,143 2,309 1,718 2,764 1,620 774 $1,591 (#13291) Adapted from the January 2007 issue of CFO. ©2007 CFO Publishing Corp. For more information about reprints from CFO, contact PARS International Corp. at 212-221-9595. Pacific Region Roger Wery, Director PRTM Management Consultants rwery@prtm.com (650) 967-2900 Atlantic Region Rick Hoole, Director PRTM Management Consultants rhoole@prtm.com (781) 434-1200