Captains of Capex

Some companies have outpaced the field in capital investments even as they've kept the cash flowing. What are their secrets?
David M. Katz - CFO Magazine
September 1, 2010

To reverse the cliché, every silver lining is covered by a cloud. That's something CFOs should remember as they focus on a metric that most hold dear: free cash flow. For many finance chiefs, the ability to liberate cash from revenue and its attendant costs gets at the very heart of their value to the organization.

Investors, boards, and chief executives tend to regard such free money as a cloudless benefit. But free cash flow isn't completely free, particularly if it is generated at the expense of a company's (not to mention an economy's) ability to grow.

During the financial crisis, many corporations shifted into survival mode, slashing expenses in order to maintain enough liquidity to pay down debt or provide a backstop against future financial meltdowns. Unfortunately, a big portion of that ax-wielding entailed cuts to long-term productive corporate assets like property, plant, and equipment.

Two diverging trends tell the story. After reaching a three-year low of $14 million in December 2008, reported median free cash flow for about 4,000 U.S. public non-financial-services companies soared, doubling to about $28 million by March 2010 (according to a study by the Georgia Tech Financial Analysis Lab using data provided by Cash Flow Analytics).

That marked the highest level of free cash flow in at least 10 years. On the other hand, starting in March 2008, reported median net capital expenditures (capex) as a percentage of revenue plunged to less than 3% in March 2010, a 10+ year low.

Together those two metrics tell a dark tale indeed, say some experts: the drastic cutbacks in capex amount to firms swapping long-range economic health for a short-term glow to please (or at least appease) investors. "Over the last few quarters, free cash has been growing for many companies, but they've been achieving it in nonrecurring ways," says Charles Mulford, a professor of accounting at Georgia Tech and managing director of research for Cash Flow Analytics. Those ways include "the crutch of reducing capex to grow free cash flow," he says, along with reducing inventory and expenses.



There is no denying that in this still-uncertain economy, holding tightly to your cash can make a great deal of sense (see "Time to Get Off Your Cash?" July/August). And, along with preserving liquidity, another reason for capex caution may be that boosting capex could run counter to the perpetual push for manufacturing efficiency: how "lean" can a company be if it's pouring money into plants and equipment?

Pretty lean, as it turns out — at least in some cases. A few large public companies have maintained an upward trend in capex as well as healthy free cash flow over a relatively long period, according to an analysis of Cash Flow Analytics data conducted for CFO by Mulford. Six U.S. public, non-financial-services companies with market caps of more than $1 billion grew their capex/revenue ratios by more than 10% over the one-year and three-year periods ending in March 2010, even as they maintained positive free cash flow.

And several dozen other companies, while showing some quarter-to-quarter fluctuations, also maintained stable capex growth at a time when most of their peers were loath to part with cash for any reason. What kinds of companies are they? What are their strategies? How have they managed to keep investing for the long term in the face of a powerful economic downturn? And what can your company learn from them as the crisis abates and strategies pivot slowly away from cost-cutting and toward growth? Based on interviews with finance executives, here are six common traits of companies that have bucked the trend.

1) They Are in the Right Place at the Right Time.
There is no denying that when it comes to spending big, or at least bigger, on capex, it certainly helps to be in an industry that is outpacing the general economy. These days that largely means health care, energy, aerospace, and business-process outsourcing. For many companies in these sectors, steady increases in capex are almost mandatory because they are the market leaders and they want to keep the competition at a distance. Esterline Technologies, for instance, is a specialized manufacturing company that derives about 80% of its sales from the aerospace and defense industries and 20% from the application of its technology elsewhere. While the
commercial-airline industry that it serves has been hit hard by the recession, the company's defense contracts assure it a solid base of revenue for years to come.

Virtually all of Esterline's operating units are number one or number two in their niches, according to Bob George, the company's CFO. The finance chief freely acknowledges that Esterline's strong market position has enabled it to boost its capex-to-sales ratio over the last three years. "I don't think you can take any company's investment decisions out of context from the industry it competes in," he says.
But Esterline is also spending with an eye toward further growth. Recently, for instance, it built new facilities in Middle Wallop, England, and Everett, Washington, and expanded its existing facilities in Mexico and in Coeur d'Alene, Idaho. "The expenditures were all based on current demand and/or projections of future demand," George says.

Similarly, Owens-Illinois, a maker of glass containers for soft drinks, spirits, and pharmaceuticals, continued to boost its capex/revenue ratio, hitting a peak for recent years of nearly 8% in the second quarter. It hasn't been immune to the recession: last year, the company's sales were off 10% and it cut both its inventory and its workforce (from about 25,000 to 22,000), while also decreasing its machine lines. (CFO Edward White insists, however, that head-count reductions and machine-line shutdowns are part of a three-year restructuring effort and not driven by the recession.)

Unlike many other companies, however, Owens-Illinois isn't sitting on the cash it's wrung from those cuts. The company's goal has been to "have working capital as a source of cash, not a use of cash," says White. The company plans to expand its existing operations in South America, Southeast Asia, and China; already, 70% of its revenue comes from outside the United States.

Another firm that has used its capex to expand globally is Maximus Inc., a health-and-human-services business-process outsourcer that specializes in the government sector. Massive public-sector budget-cutting has been good for outsourcers; Maximus, for instance, helps states administer welfare-to-work programs and public-health insurance programs such as Medicaid and the Children's Health Insurance Program, and tracks down deadbeat dads.

"Our solutions export quite well. The states study each other and the [governments of the] world study each other, and they land on similar models," says David Walker, the company's finance chief. The BPO company will end the year with about 30% of its revenue coming from outside the United States, up from 8% five years ago and 15% in 2008.

2) They Used the Recession to Plan for Growth.
Although companies with a high capex/sales ratio and good cash flow were battered less by the economic crisis than were other companies, many suffered from cash constriction for a quarter or two during 2008 and 2009. Some responded by decreasing capex, but they tended to regard such cuts as a pause in their long-term spending plans rather than a departure from them.

For some, it was a pause that refreshed. Integra LifeSciences Holdings registered a dip in its normally robust capex/sales ratio from the second quarter of 2008 through the third quarter of 2009. "We certainly went through a period of being cautious, particularly during the most challenging part of the credit crisis," John Henneman, the company's CFO, acknowledges. "Like a lot of companies, we wanted to be very careful about the possibility that borrowing money in the future would be difficult, so we ran the company carefully and spent that time paying down a lot of debt."

But the company, which makes surgical implants and medical instruments, was also "at a natural point of transition in a number of areas of our business," he says. "We spent some time thinking about what we should do next, rather than just doing it." Out of that period came a decision to boost capex to fund two new projects: the construction of an internal enterprise-resource-planning (ERP) system and the deployment of instruments that surgeons use to put in the company's implants. Deployment of those instruments should help the company spur sales of the implants, its core business. As of first-quarter 2010, the company had increased its capex ratio to more than 4%, a high for at least four years.

3) They Spend Through Business Cycles.
Last year, Esterline's capex hit an all-time high in the company's 43-year history, says CFO George. That was a brief departure from what had been a very consistent pattern. For 10 straight quarters through the first quarter of 2009, Esterline's capex ratio had hovered between 2.16% and 2.67%.

Such predictability is music to George's ears. It represents the company's intention to keep capex on a straight line regardless of its industry's fortunes. "We believe that it gives us a competitive advantage as the cycle turns. Having been in aerospace and defense for a long, long time, we have great faith and confidence that those cycles will turn," he says. "And when they begin to turn up, we'll be able to respond to our customers."

Owens-Illinois's White agrees that companies should stay the course on long-range capital spending. "Can you really afford not to innovate for years?" he asks. "If you have a three-to-five-year strategic plan, you can't put that plan on the shelf."

Adhering to long-range plans, however, requires a hefty stash of cash, confidence in a decent return — and a strong stomach. The Shaw Group, a custom-engineering and pipe-fabrication firm serving nuclear-power plants and other energy projects, for instance, absorbed a stiff descent in its free cash flow, to $338 million in the third quarter of 2010 from $646 million in the year-ago quarter.

Brian Ferraioli, Shaw's CFO, attributes the drop to the company's involvement in an intrinsically "lumpy business" involving large projects with milestone payments. That lumpiness means that cash flow will vary strongly from one quarter to the next. But he insists "that cash is still strong at this company," noting that Shaw's operating cash flow was at $249 million through May, on the heels of a record $717 million in 2009.
The company's confidence in the long-term global demand for cheaper energy allows it to plan for steady capex growth in the face of fluctuations in cash flow, according to Ferraioli. Indeed, the company's capex ratio has continued to rise for more than three years.

4) They Are Ready to Move — Literally.
To maintain efficient use of capital and a flexible approach to markets, companies investing in capital equipment are attempting to make sure that equipment is as light and portable as possible. The idea is to be able to quickly shift manufacturing to adapt to new markets. "If you walked into any of our production facilities on day one and you went back there in a year, it would be different," says George of Esterline. "We're continually looking at ways to improve how we move our product through."

Similarly, Shaw Group has just built a facility in Lake Charles, Louisiana, that will use modular techniques in constructing nuclear-power plants. Rather than building a plant entirely on site, the company will assemble large sections in the factory and ship them to the construction site to be put together. "It's cheaper, more efficient, and safer doing these things in the plant," said Ferraioli, noting that the company has spent $100 million on the plant.

5) They Believe That Information Technology Matters.
Increasingly, companies are learning that gaining a foothold in new markets requires a more tightly integrated IT architecture. So they are investing in ERP and other back-end systems that can provide a foundation for a truly global business by better managing all corporate data.

In the next three years, Integra LifeSciences will lay out "significant capex" to implement an ERP system, says CFO Henneman. "This company runs off more different systems than it should because we've done a fair number of acquisitions over the years. The time has come for us to develop a global system to operate more efficiently."

Companies also invest in IT to better interact with an expanding client base. Maximus sank money into its ERP system to meld an array of legacy systems into "a common framework that allows us to plug and play with client systems," says Walker. The company wants to be "shovel ready" if the expansion of Medicaid and other federal-state programs under the new health-care law spawns new demand for its services.

6) They Are Focused on Returns.
One of the biggest reasons companies with hefty amounts of cash on hand put it into capex is that they feel it provides the best return on their investments. "We're extremely focused on return on invested capital, and when we look at different ways to make investments of our cash or earnings," says Jeff Hall, the CFO of Express Scripts, "investments in capex come at the top of the list because they have the highest return."

Good acquisitions rank second, he says, "and if we still have cash remaining after we fill the first two buckets, then we're left with looking at how do we want to return that cash to shareholders," including dividends and share buybacks.

But investment in one of those categories does not necessarily conflict with investment in another. After recently buying a glass company in Argentina, Owens-Illinois will triple the size of the acquisition to serve what the company regards as an underserved market for fine wines. "So you make the acquisition. And then you go in with another $20 million or $30 million of capital to modernize and expand," says CFO White. "Capex goes hand in hand with M&A."

David M. Katz is New York bureau chief of CFO.


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Going Without the Flow

Sustaining rising capital expenditures (capex) demands strong corporate will — and, often, steady cash flow. Sometimes, however, companies keep spending even when their free cash flow is declining.

How often is such an approach strategic, rather than obligatory? An analysis done for CFO by Charles Mulford, a Georgia Tech accounting professor and managing director of research at Cash Flow Analytics, suggests the answer may be "rarely."

The search unearthed seven public, non-financial-services companies with rising capex and falling free cash flow over one- and three-year periods ending in March 2010. The companies (all of which have market caps greater than $1 billion, increases in reported capex to revenue of greater than 20%, and decline in reported free cash flow of up to 20%) are: Dendreon, NCR, MEMC Electronic Materials, Overseas Shipholding Group, Patterson-UTI Energy, Pride International, and Royal Caribbean Cruises.

Most seem locked into capex increases by the nature of their businesses. Dendreon, a biotechnology firm, endured steady losses as it developed a prostate-cancer drug that went on the market in May. NCR contributes to a reserve fund devoted to potential environmental liabilities.

Two oil drillers, Pride and Patterson, and Overseas, a bulk shipper, spent to keep their equipment in shape even as the economic downturn threatened sales. And, even as tourism took a dive, Royal Caribbean still was contractually obliged to pay for ships as well as to pay off maturing debt.

Sometimes, though, atypically high capex in the face of weak cash flow is a bet on the future: MEMC, a chipmaker, invested in new raw-materials production and solar energy despite uncertain demand in its industry. In a July earnings release, Ahmad Chatila, the company's chief executive, said the outlays are "all meant to catalyze future growth." — D.M.K.