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Free cash flow and Depreciation/Amortization


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There are a few companies that come up in the value investing blogosphere (BDMS, LTM, CLUB) where it is alleged the company consistently reports greatly lower earnings than FCF. It is often due to there being a difference between maintenance cape ex and depreciation and amortization.

 

Can this occur over the long term without it being an accounting trick? Should D&A always equal maintenance capex over the long term?

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Guest wellmont

no. amortization has nothing to do with cap ex. one of the tricks of the trade is look for companies that amortize a lot of intangibles because gaap earnings are understated. exhibit A is VRX. of course it goes without saying you have to understand the business to determine if the cash flows are sustainable and the price is right. Buffett likes EV/EBITA.

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In the end it would usually normalize. If you only spend 1 million/year on capex and you depreciate 2 million/year the amount of PP&E on your balance sheet will shrink over time.

 

But if you are a growing company you can delay when this happens for a very long time, because in that case you will be adding new equipment every year that can be depreciated. But - and depending on the growth trajectory - the new equipment is increasingly a smaller part of all equipment. This effect can by the way be very significant (and long lasting) for companies that regularly acquire other companies. This often creates intangibles on the balance sheet such as "customer contracts" that are depreciated over time, but for most businesses this represents not an economic loss.

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IMHO most D&A is in fact an expense over the long term though it is just an estimate.  For instance you may depreciate some plant over 10 years and it most likely does need to be replaced or the company won't have the same earnings power.  It might last 8 or 12 years instead of 10, so depreciation in one year might understate or overstate the expense, and the new plant might cost more or less, or be more or less efficient, etc. so it isn't an exact science. But companies need assets to run and they wear out.

 

This can get distorted though, for example goodwill can be amortized over a period of years and show up as an expense when in fact it isn't something that wears out and has to be replaced. Fixed assets such as commercial real estate are depreciated over time as if they wear out when in fact they often appreciate in value, so if you hold them for a long time, the difference between carrying value and market value can increase, meanwhile you're recording an expense every year.  Really what you're doing is building up a capital gains liability. There can be situations where a company can buy a business via asset sale and the assets might start at the new company at an artificially high or low price.

 

I was recently looking at a bank CARE which was made up of the combination of about 10 banks, and all of the goodwill accumulated by acquiring all of those banks shows up as an expense, when in fact the amalgamated banks will probably earn more due to lower overhead expenses.

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Thanks for the quick replies. This may be getting too specific now, without knowing the company, but I'm looking at Town Sports International. CLUB.

 

The CFO has stated that 4% of sales, or about 20-25m is what's needed for maintenance cap ex. But their depreciation is around 50m a year. This creates a massive difference between earnings and owner earnings. He has said that "a lot of our depreciation that we incur for the company relates to our leasehold improvements which run over the life of the lease and I would say a smaller degree of our maintenance cap ex reflects a leasehold improvement component as opposed to equipment and other types of maintenance cap ex that we’re spending money on".

 

I am trying to understand if the 20-25m a year includes all cap ex costs that are necessary to maintain the gym and membership base, including replacing leases that expire by outfitting new locations if necessary.

 

They pump out the CFFO so if the maintenance cap ex is correct, the yield becomes attractive. But I still can't understand how there can be such a large discrepancy between D&A and maintenance cap ex over the long term.

 

 

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I mentioned in the CLUB thread that if depreciation is lower than maintenance capex I am suspicious they are underinvesting.  Let me explain a bit more what I meant.

 

Whether depreciation should be the same as maintenance capex really depends on the business and industry.  I think you already know all this, but let's go through it.  Sometimes accounting rules mean that a company will depreciate an asset at a faster rate than its useful life.  So maybe a company has to depreciate over 20 years, but its useful life is 40-50 with minimal maintenance.  This will cause a company to understate earnings, and the difference will show up in FCF/owner earnings as the depreciation charge you add back to get cash from operations is higher than the maintenance capex you deduct.

 

But if the reinvestment requirements are high, the company will eventually have to spend at the level of depreciation (or higher) just to maintain its revenues.  Let's look at CLUB as a possible example.  What concerns me about CLUB is that although their stated maintenance Capex is less than depreciation, they really do need to reinvest at a high rate to maintain a competitive position.  Steve Wynn often slams people who use EBITDA because depreciation is a real expense for his casinos.  If they don't continue to invest in the casinos they will lose customers and revenue.  Fitness clubs are like casinos in this regard - you need to keep spending to keep people coming.  I don't know whether the numbers should be equal but it is something to figure out.  How often do you need to basically rebuild an entire fitness club?  Every 15-20 years maybe?  The building itself is probably good for longer but almost everything inside needs to be replaced and upgraded just to maintain membership and revenues.  I'm a long term member of a club right now that hasn't upgraded locker rooms, fixtures, etc. in like 20 years and I will probably switch next year to the brand new club being built one mile away.  And when you are dealing with a company with high capex requirements and declining revenues, you have to determine if they have continued to invest at the required rate or if they have been cutting back on capex to keep cash flow high.  If they have cut back, eventually that bill will come due.  I don't know enough to say whether CLUB's maintenance capex should equal its depreciation but when there is a discrepancy it needs to be investigated.

 

Growing retailers are similar.  They have huge capex for growth as they build out stores.  Maintenance capex on these new stores is usually very low at first, while depreciation charges increase, making FCF look good.  But eventually stores get old and stale and the company needs to reinvest if they haven't been doing it all along.  Capex either shoots higher or the store will start losing customers.  If it gets really bad, you could be looking at a death spiral where failure to reinvest results in loss sales which dries up funds for reinvestment.  There's a certain popular stock on this board where I believe that is happening, and people are left valuing the company based on the land underneath its decaying stores (oh yes, and some brands, don't forget the brands).  Maybe the real estate/asset thing will work out, I don't have an opinion, but a retail turnaround cannot happen without massive reinvestment.

 

So the answer is it depends.  If maintenance capex is less than depreciation, you really need to know why and whether any problems may be created down the road.  I hope this advances the discussion.

 

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Thanks for the quick replies. This may be getting too specific now, without knowing the company, but I'm looking at Town Sports International. CLUB.

 

The CFO has stated that 4% of sales, or about 20-25m is what's needed for maintenance cap ex. But their depreciation is around 50m a year. This creates a massive difference between earnings and owner earnings. He has said that "a lot of our depreciation that we incur for the company relates to our leasehold improvements which run over the life of the lease and I would say a smaller degree of our maintenance cap ex reflects a leasehold improvement component as opposed to equipment and other types of maintenance cap ex that we’re spending money on".

 

I am trying to understand if the 20-25m a year includes all cap ex costs that are necessary to maintain the gym and membership base, including replacing leases that expire by outfitting new locations if necessary.

 

They pump out the CFFO so if the maintenance cap ex is correct, the yield becomes attractive. But I still can't understand how there can be such a large discrepancy between D&A and maintenance cap ex over the long term.

 

I wrote my last response before seeing this, but one of the questions I haven't figured out is how they break up the improvements between leasehold vs. other building improvements and equipment, fixtures, etc, and how these numbers get reflected in the depreciation/amortization charges.  I don't think you will have to rebuild the entire new club every 20 years but lots needs to be replaced.  What falls into what category?  I don't know.

 

It's also interesting that they are spending $20-22m on new clubs while also looking at closing 5% of their clubs this year.  Will this increase revenues and profits or just maintain them?  If the latter, it gives credence to the idea you do need to replace the clubs completely.

 

 

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nd the price is right. Buffett likes EV/EBITA.

 

huh, you sure about that? I distinctly remember Munger calling EBITDA bullshit earnings (I presume you mean EBITDA) And I am sure Buffett feels the same but would be so explicit in his description.

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nd the price is right. Buffett likes EV/EBITA.

 

huh, you sure about that? I distinctly remember Munger calling EBITDA bullshit earnings (I presume you mean EBITDA) And I am sure Buffett feels the same but would be so explicit in his description.

 

I'm pretty sure he means EBITA. It's the D that should not be added back to measure cash flow (unless making an appropriate adjustment for ongoing capex). The A is typically related to intangible assets that do not wear out.

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some cases where actual cash charges are lower then depreciation:

Leasing: If they enjoy lower utilization, and models dont really change much. Emeco is a good case. Sometimes trucks are in the garage without being used much in bad years, but they are still depreciated. But models right now are about the same as models 20 years ago. So they dont really  need to be updated.

 

Buildings: I think 25 years is the standard here? or 40 years? But there are a lot of pre-world war 2 buildings around now in excellent state.

 

Special cases or industry's where it is not clear what exact depreciation period is because of unusual equipment: I think Outerwall is a good example. They have kiosks in service far past the depreciation period.

 

Liquidation: If they are in slow liquidation, then assets will be sold anyway if they have run out. They might even make a bit of profit on them after they are fully depreciated.

 

Telecoms/cable company's: I think depreciation period is like 25 years? But usually equipment lasts much longer then that.

 

With amortization I would be carefull to blindly write this off. Sometimes they are contracts that need to be renewed to make money. But if it is goodwill then you can safely assume it is something that doesnt actually exist. Software sometimes has to be updated at steep costs but mostly will still function with little capital invested after it is amortized.

 

Regarding gyms, Im not sure. If it is highly priced then I think they need to be replaced, or else it will look v old and shabby. But I cannot imagine weight machines really breaking down fast. If you give them a paint job they look as good as new? Plus it takes little to make the building inside look good. You don't need to buy new expensive interior's every 5 or 10 years. So I think overall they are lower. And I also don't think they compare with casino's.

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With amortization I would be carefull to blindly write this off. Sometimes they are contracts that need to be renewed to make money. But if it is goodwill then you can safely assume it is something that doesnt actually exist. Software sometimes has to be updated at steep costs but mostly will still function with little capital invested after it is amortized.

 

Good point - I didn't mean to imply you should blindly use EBITA (I actually prefer EBIT over EBITDA or EBITA), but that the A is not anything like the D in terms of future cash requirements and their impacts on FCF and ROIC.

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Buffett and Munger have harsh things to say about EBITDA but I think what they mean is that valuing a company based strictly on its EBITDA is a bad idea because those I, T, D, and A expenses are real expenses especially for a long term owner.  They are differentiating themselves from many private equity shops that buy companies based primarily on their EBITDA multiple.  Part of the reason is probably that most private equity buyers probably plan on selling the business before the chickens come home to roost, and part of it is that most PE buyers are buying with debt and EBITDA gives an idea of how much they can lever them up.

 

However as we have been discussing here there is a lot of variance / slop in the D&A numbers and if you want to compare to businesses on an apples-for-apples basis, EBITDA is a fine metric, as long as you ultimately account for the cap ex, D&A, etc.

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I think regarding CLUB, a break down of assets at cost:

 

Leasehold improvement: 503 million

Club equipment: 99 million

furniture & computer equipment: 61 million

software: 20 million

buildings: 5 million

 

456 million of 700 million is depreciated. I guess you can do market research and find out yourself in what states these gyms are? Most of them seem to be in new york. If they look still v new and crisp to you, and depreciation was lower in the last 5-10 years (after they expanded basicly) then you could probably safely say that current maintenance capex is sustainable.

 

 

About period of leashold improvement:

Leasehold improvements are amortized over the shorter of their estimated useful lives or the remaining period of the lease

 

Seems like a lot of gym interior can last like 20 years or so easily with a little maintenance. Not sure how long those leases are? And this is most of depreciation.

 

So it looks like customizing a building into a gym  is the largest cost, and it is mostly a one time charge.

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Really good post. Thanks for trying to help me understand this.

 

1.Why would accounting rules dictate that sometimes an asset is depreciated faster than its useful life?

 

2.From the 10-Q: "Leasehold improvements are amortized over the shorter of their estimated useful lives or the remaining period of the lease." Are LHI amortized because they relate more to design layout, installing fixtures, etc., and their useful life is more inexact given the intangible nature of their value?

 

3.The answer the CFO and other analysts have said when the question comes up why there is such a difference between depreciation and maintenance cap ex is: Leasehold improvements are significant and depreciated over the life of the asset but maintenance cap ex is spent more on equipment and other costs. Or another similar answer is that they over depreciate their assets and the assets actually last a lot longer.

 

4.It seems to me the crux is LHI. When they open a new location they have to spend on LHI - the upfront costs that are not so much maintenance as they are building the place out to be a gym--more one time costs even though of course the place will have to be maintained. They obviously need to do maintenance on that over the years to keep it looking like a good gym. If they expand to a new location without closing an old location that would be under growth LHI and would not relate to OE (only the yearly maintenance on that location would relate to OE of a new location) . If they close an old location and open a new location, that LHI has to be under maintenance cap ex, and that has to affect OE.

 

5. Their location numbers have not expanded since 2008 but there will still be a big difference between depreciation and maintenance cap ex given the amortization of the LHI is over the life of the lease. In theory, if they did not open any new locations going forward, after the LHI are amortized off the books D&A and maintenance cap ex would converge.  They have plans to open new centres in areas they have a proven market and economies of scale working in their favour. And they have plans to open boutique studious. So this won't happen.

 

6.If they keep the same lease, same location, when the lease expires, they get a lot of value from the original LHI because they do not need to spend the investment in LHI at a new place, they can just spend on maintenance cap ex, about 20-25m a year, and reap all the cash flows. If they can keep the vast majority of their locations without having to open a new location to replace an expired lease, then maintenance cap ex is likely accurate. Given their history and the industry trends, I am betting and hoping they can do so.

 

I believe I understand this investment a lot more after writing this down. But please look to poke holes in it. The key to OE being roughly accurate is keeping the same number (or more) of gyms in the same lease locations, without having to spend money on LHI to replace expired leases/locations. If they can do this (and manage debt, membership numbers, lease renewals, etc.,--of which I am less concerned) OE should be fairly accurate. They don't need to be very accurate for a massive yield. LHI should really be seen as growth IF the gym count is kept constant (or increased) and the gym's locations are kept constant by lease renewal.

 

The company may face lease re-ratings. The company has a lot of debt. The company is facing competitive headwinds. So there is a company that has been around for 40 years in a business that is easily understood. Offering better than a 20% OE yield with a 10% dividend and half its share price in cash, that has bought back large amount of its stock during sell off times, and operates in a growing industry. Any contrarian investors out there? :)

 

Thanks.

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