You just got hired as a junior analyst for a hedge fund. Your boss calls you in and asks for your opinion on whether he should buy IRDM. He heard about it from a hedgie friend in New York who heard about it from another hedgie friend in New York who heard about it from…….you get the picture–a daisy chain of independent-thinkers.
You remember something about Buffett saying that the tooth fairy doesn’t pay for capex? What will you tell your boss this afternoon?
If you want more clues (after trying hard) go to the search box on this blog and type in IRDM–follow the links.
PS: I will resend the book folder to new students and I will send value vault folders to the folks who have been asking for the past three weeks. I try only to check email once a day and I group the various email requests over time.
I will be next focusing on ROIC for Chapter Four in Deep Value because we already covered EBITDA and its use and ABUSE. And EV/EBITDA multiples. Remember that multiples are simply a short-hand for cost of capital. I remember when Blockbuster(US Video Chain) looked cheap in an EV/EBITDA analysis (from a broker report) but Blockbuster was being dis-intermediated by Netflix and planned to reinvest in its stores to sell popcorn and toys along with DVDs. How do you think that turned out? Rear-view looking at past multiples may mean being entombed in a value trap. When I heard of Blockbuster’s plan, I thought of entering a mule in a horse race–what are my chances?
Have faith but don’t be overconfident! Have a great weekend from sub-zero New England.
A hedge fund made a case for investing in IRDM’s growth, but we made the case that true capital expenditures were not being accounted for and thus true owner earnings were being overstated. I repeat this case since the concept of true MCX is so important. Look at the lost opportunity cost for this hedge fund.
One method of learning is to EXHAUSTIVELY analyze and read about a subject so we can master the topic and understand the principles and subtleties in applying those principles.
We are focused on Return on Invested Capital which has been defined one way as Operating Earnings (Earnings before Interest Expense and Taxes, EBIT) or better yet, (Earnings before Interest Expense, Taxes and Depreciation & Amortization, “EBITDA” – MCX) divided by tangible capital or (Net Working Capital + Net Property, Plant and Equipment). We have covered EBITDA thoroughly in a 36 page discussion here: http://www.scribd.com/doc/66843869/Placing-EBITDA-Into-Perspective.
Now we review MCX as part of the (EBITDA – MCX) calculation.
The link below has a PDF that further analyzes how to calculate one aspect of Return on Invested Capital–(EBITDA – MCX) divided by Tangible Capital.
I’ve been wondering more about the estimate of Maintenance Capex Greenwald gives on slides 13-14 and its reliance on revenue. A company could theoretically grow revenue, but due to higher costs, end up with about the same EBITDA. In that case, I’d want to assume that all was Maintenance Capex despite the revenue growth. So I’m wondering if it might be better to estimate Growth Capex from the delta in EBITDA that CapEx produces, not the delta in revenue.
From page 96, fn. 1: Value Investing From Graham to Buffett and Beyond by Bruce C. Greenwald
Companies generally report capex in their statement of cash flows. We assume that each year, a part of this outlay supports the business at its sales level for the prior year, and part is needed for whatever increase e in sales it has achieved. Companies generally have a stable relationship between the level of sales and the amount of plant, property, and equipment (PPE) it takes to support each dollar of sales. We then multiply this ratio by the growth (or decrease) in sales dollars the company has achieved in the current year. The result of that calculation is capex. We then subtract it from total capex to arrive at maintenance capex.
Also, you can simply ask the company’s CFO what amount of total capex goes to maintenance capital expenditures. Certain companies like Iron Mountain “IRM”(Document Storage-physical and digital) will specifically break out the two type of capital expenditures. In IRM’s case, its maintenance capital expenditures are low compared to revenues or any other accounting metrics because their storage facilities have long lives with minimal upkeep.
To: Lumilog, you do not want to assume in your example (A company could theoretically grow revenue, but due to higher costs, end up with about the same EBITDA. In that case, I’d want to assume that all CapEx was Maintenance Capex despite the revenue growth) that all capex is maintenance capital expenditures (“MCX”) because you want to segment the company’s capital spending. You could have non-productive growth capex with stable MCX. For example, what does it cost to maintain old stores at their current sales level vs. the cost to build and develop new stores?
Another point, you have to understand the industry and competitive forces to calculate/estimate true MCX. Take, Iridium, the satellite company that is launching new satellites into orbit, for example. That company may need to replace their new satellites sooner than expected due to new technology in competing telecom industries. Investors who own Iridium could be vastly underestimating MCX and therefore, overestimating normalized earnings. Earning power value and thus asset value may be lower than what current investors estimate.