Utilities And Other Industries: Capital Expenditures Vs. Depreciation
It is very common among new investors to assume that depreciation equals the capital expenditures required to keep the company in place. Free cash flow is usually calculated by subtracting the full value of the capital expenditures. This can be wildly inaccurate. The utilities industry has capital expenditures and depreciation that are very different. If all capital expenditures by utilities were maintenance, the industry would be bankrupt very quickly. It is important to understand what, where, how, and why the company you are researching is spending money on capital expenditures in order to value it. Capital expenditures (capex) include a wide variety of things companies spend money on. Capex can include buying land, fixing machinery, building a new plant, upgrading the power system, or many other items. Some of these items are to reduce expenses, increase production, or improve the production process. These are called growth capital expenditures because they improve the company above its performance prior to spending them. Other capital expenditures that keep the company at its current steady state are called maintenance capital expenditures. Most companies spend some capex in both the growth and maintenance bucket so it is important to determine how much of each in order to value the company. One of the industries where this is glaringly obvious is the utility industry. Utilities routinely spend lots of money to support new infrastructure as growth capex. They also spend money on maintenance capital expenditures to ensure their existing operations are in good shape and highly reliable. A high level summary of net income, depreciation, and capital expenditures for some of the major utility companies is shown in the following table. Utility Company 2013 Net Income (millions) 2013 Depreciation (millions) 2013 Capex (millions) Capex minus Depreciation (millions) Capex divided by Depreciation Dominion Resources (NYSE: D ) 1,697 1,390 4,104 2,714 2.95x NextEra Energy (NYSE: NEE ) 1,908 2,163 3,228 1,065 1.49x Duke Energy (NYSE: DUK ) 2,665 3,229 5,526 2,297 1.71x Exelon Corp (NYSE: EXC ) 1,719 3,779 5,395 1,616 1.43x Southern Company (NYSE: SO ) 1,644 2,298 5,463 3,165 2.38x As you can see from the table, the capital expenditures of the utility companies exceeds the depreciation charge, typically by several billion dollars for companies this size. If all of these capital expenditures were maintenance capital expenditures, the market would have to be completely insane to assign the earnings multiples shown in the following table. Utility Company Current Price/2013 Earnings Dominion Resources 25x NextEra Energy 27x Duke Energy 23x Exelon Corp 19x Southern Company 28x Average 24x Earnings multiples this high are usually reserved for high growth companies. Many of the new projects these utility companies are investing in will earn a regulated rate of return between 8% and 12% which doesn’t sound like a high growth company. If anything, this is close to an average company’s rate of return and generally average companies trade closer to 15x earnings. Depreciation is a noncash expense that reduces the net income reported. When valuing companies, it is generally advisable to add back depreciation to net income and then subtract maintenance capital expenditures to get a truer view of profit. In the case of utility companies, they generally spend less money on maintenance capital expenditures than they expense on their income statement as depreciation. This deflates their net income number which makes their price/earnings ratios look higher. The following table shows the capex numbers in relation to the net income numbers for the utility companies. Utility Company 2013 Net Income (millions) 2013 Capex (millions) Capex divided by Net Income Dominion Resources 1,697 4,104 2.42x NextEra Energy 1,908 3,228 1.69x Duke Energy 2,665 5,526 2.07x Exelon Corp 1,719 5,395 3.14x Southern Company 1,710 5,463 3.19x By looking at the capex divided by net income column it is very obvious that most of the capex must be growth capex. If most of the capex was maintenance capex and the cost of maintenance was 1.69x to 3.19x the amount of profit each company was making, they would be out of business very quickly. In addition, one of the quirks about the utility industry is that lots of its “maintenance capex” still plays into the regulatory assets that allow future rates to be raised to earn the cost of investment plus a predetermined return on equity. An easier way to track maintenance capex for utility companies is to read their filings and see how much and when the regulatory bodies approve expenditures to be counted towards the regulated rate of return. However, for companies that aren’t in the regulated utility industry, it can be more difficult to determine much of capex was maintenance capex. In general, it is a good idea to use the laws of large numbers when determining maintenance capex for companies that don’t specifically break it out. For example there could be two oil companies. Company A spent an average of $30 million on capex for each of the last few years and kept production flat. Company B spent an average of $30 million on capex for each of the last few years and production grew by 40%. Therefore it stands to reason that Company B was likely spending a much higher percentage of their capex on growth. Some companies half break it out by giving you a list of the major items they spent capex on and you can place each in the growth or maintenance bucket depending on the type. Maintenance capex should generally be determined over several years because things don’t break at the same frequency every year. This is more important for valuing small companies because larger companies generally spend similar amounts of maintenance capex every year. Another common capex that seems to be often included as an expense to reduce a company’s profit is when they buy or construct a new building for their corporate headquarters. This is actually growth capex because it will reduce future rent expense by the company (i.e. increase their profit) and it will appreciate over time. These are the reasons and some advice about making sure to understand the company’s capital expenditures when trying to value a company. It is especially important in the utility industry but even in other industries your valuations could be dramatically off without understanding where and why the company is spending money.