Monday, October 03, 2005

What in the world is CapEx?

After reading the last post, if you’re confused about CapEx, let me help explain more about what that term means.

CapEx is short for “capital expenditures.” In its simplest terms, a capital expenditure is what the company pays (usually in cash) when it buys, for example, a new shelving unit to go in one of its stores. The new shelving unit is an asset, and, as such, the purchase of the shelving unit is not an expense (like the electricity bill) but rather an investment (a capital expenditure) in a new asset. That new shelving unit has a value and the value of the shelving unit needs to be placed on the balance sheet as an asset. Expensed items, on the other hand, are never placed on the balance sheet as they simply pass through the income statement as expenses.

Returning to the shelving fixture… Buying a new shelving unit would generally cost more than buying a used shelving unit. This is the same principle that applies to new and used automobiles. A used car is usually worth less than a new car of the same make and model. The used car is worth less because it has “depreciated” due to the passage of time and the general usage that occurred during the passage of that time. This “depreciation” occurs with many (although certainly not all) assets placed on a company’s balance sheet. Shelving units depreciate. Forklifts depreciate. Buildings depreciate. The land underneath buildings does not depreciate. Bars of gold do not depreciate. And so you can think of a “capital expenditure” as a transfer of capital from a non-depreciable asset (like cash) to another non-depreciable asset (like land) or to a depreciable asset (like a shelving unit).

When Wal-Mart buys a shelving unit, the unit depreciates on a fixed schedule from its purchase price (the capex amount) all the way down to zero value. Each year Wal-Mart recognizes a portion of that depreciation according to the depreciation schedule. The schedule determines how much Wal-Mart will recognize each year in depreciation on its capital expenditure. The depreciation itself is recognized as an expense and all expenses pass through the income statement as, yes, you guessed it, expenses.

When Wal-Mart builds a new store it buys a lot of new shelving units to go into that new store. Because these shelving units are going into a new store, we can categorize the capital expenditure for the shelving units as a “growth capital expenditure” or “growth capex”. Wal-Mart is investing capital (the shareholder's capital) in its own growth by building the new store and buying the new shelving units. There will be a new income stream from this new store once it opens, and once all the bills are paid (expenses for things like electricity), Wal-Mart can see how much money it has left over at the end of the year in profits. The net profit from that store divided by the growth capex will be the year 1 return on our invested capital (i.e. the shareholder's capital). …Remember the growth capex is what Wal-Mart invested to create a new revenue stream. The profits from that revenue stream show us how successful they were in making the investment. If they lose money at the new store, they will have made a poor investment. If they make money at the new store, they will have made a good investment based on how much they earn above a more risk free rate of return such as putting the money in a bank CD earning 3.50%.

Okay, I think we’ve covered growth capex fairly well.

Now let’s say we're Wal-Mart managers and we go back and visit that same store in ten years. Let's also say that during the time that passed, we never spruced the store up. We never bought any new units for the store or made any changes or additions to the store’s infrastructure. That Wal-Mart store would be looking pretty shabby by now and customers would not be having a great experience shopping there. Certainly Wal-Mart does not want its customers to be repulsed by the condition of its stores. Therefore, in order to prevent its stores from looking shabby, Wal-Mart invests new capital in its existing stores every couple of years or so to keep them looking good. This investment is called “maintenance capex”. It involves capital expenditures to maintain a store.

All retail operations require significant amounts of maintenance capex. You can’t just build a store and leave it alone to depreciate through time. After a while customers are just not going to want to shop there.

So in order to keep all of its stores looking good, Wal-Mart has to invest capital in the form of maintenance capex every year back into its stores.

Note that we have now broken down overall capital expenditures (“capex”) into two subcategories, growth capex and maintenance capex. Most companies (Wal-Mart included) do not break out or disclose their growth capex versus their maintenance capex as a percentage of their overall capex.

If we knew the growth capex figure we could then analyze the increase in sales or the increase in operating income in the following fiscal year as a function of the current year’s growth capex. This would allow us to directly see how profitable Wal-Mart is in re-investing capital on behalf of the shareholders into its own growth.

Also, if we knew the maintenance capex amount we could arrive at a normalized free cash flow figure and then come to understand the company on a free cash flow basis. Normalized free cash flow would be net income + depreciation – maintenance capex. This would give us a good idea of how much the company would be making in cold hard cash if it suddenly stopped growing.

And so the key here is to understand Wal-Mart as almost two kinds of businesses..
1. the Wal-Mart as it physically exists right now, already formed and out there in the world, and
2. the future physical Wal-Mart, the piece that will be added via growth.

Maintenance capex is the use of capital by category 1.
Growth capex is the use of capital by category 2.

If we could break out the growth capex from the maintenance capex, wow, we would really have a cool insight into the profitability and efficiency of Wal-Mart as a financial entity. …I will attempt to do this in the next post.

6 Comments:

Anonymous Anonymous said...

Great site you have here. I don't see any discussion about the valuation of Walmart. As I figure it, off the top of my head, there is about $15 billion in cash flow minus $12 billion in capex, so 75c of owner earnings. It looks from your information about Walmart, that most of the capex is going to the Supercenters. Correct me if I'm wrong, but it looks like the supercenters are replacing older stores, not really adding new capacity. That being the case, isn't walmart actually terribly overvalued? 75c of owner earnings on a $48 stock is rather paltry, certainly nothing to get Warren Buffett interested.

November 12, 2005 5:56 AM  
Anonymous Anonymous said...

What is important is how much earnings increased on the Capex invested. If Walmart had invested 35Billion in Capex(independently if is for maintenance of unit volume or growth) in the last 5 years and earnings had grown 7 Billion, the it's return on Capex is 20%.

November 02, 2006 10:01 AM  
Anonymous Anonymous said...

Great post, I've been trying to grapple with the whole maintainance capex and growth capex concepts and this does clear things up. I'm looking forward to your next post on how to differentiate the two. That i think is the key. Thanks and keep up the geat work.

Mark

December 04, 2007 10:50 PM  
Anonymous Anonymous said...

I'm assuming the maintenance capex vs growth capex concept is extendable to various other non retail businesses too and can give an insight into their profitability. Am i right?

Mark

December 04, 2007 10:52 PM  
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