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John Emerson
John Emerson
Articles (106) 

Understanding Free Cash Flow Series: Growth vs. Maintenance Capex

June 30, 2011 | About:

When my worldly journey is finished and I depart to the place where all value investors permanently reside, I expect I will encounter a great deal of discussion about the proper method of separating growth and maintenance capital expenditures (capex). I also hope I encounter a few CFOs so I can ask them why reporting capex in such terms is not standard operating procedure.

Why Is It Important to Separate Growth and Maintenance Capex?

The answer is simple; in most cases growth capex is an investment, while maintenance capex is a cost. If a business decided to suspend its growth operations, its capex would quickly decline and the result would be increased free cash. The key is to make sure that the reinvested capital is earning a sufficient rate of return to justify the growth expenditures, that is a story left for another day.

Allow me to revisit the hypothetical one-man trucking company which I invented in my last article. http://www.gurufocus.com/news/137384/understanding-free-cash-flow-series-depreciation-and-accounts-receivable Suppose that instead of selling the business the owner decides he wants to expand by adding additional rigs and hiring drivers.

Common sense dictates that buying a new rig is a different type of capital expenditure than installing a replacement set of tires on tractor-trailer. The new rig represents an investment in growth capex, while replacing the tires is a classic example of maintenance capex.

Growth capex can be defined as any expenditure which is undertaken in the interest of increasing revenues and profits, while maintenance capex can be defined as any expenditure which is undertaken to sustain current revenues and profits. Bear in mind the lines can become blurred between the two distinctions.

Suppose I decide to continue my one-rig operation and after 10 years my rig is no longer suitable for hauling freight. Under those conditions the purchase of the new rig would be considered as maintenance capex spending since it would merely maintain rather than increase my existing profits.

How Is Growth and Maintenance Capex Separated?

Most companies do not breakdown growth vs maintenance capital expenditures in their annual or quarterly reports. That reality forces investors to do some guess work when attempting to separate the two entities.

Two common methods are used to separate capital expenditures; the most simplistic method is to merely deduct depreciation from total capital expenditures. Depreciation is assumed to be maintenance capex, the remaining balance is assumed to be growth capex (Growth Capex = Total Capex less Depreciation).

The effectiveness of that formula is dependent upon the companies ability to correctly state its depreciation. If the company is understating depreciation in an attempt to manage earnings upward or if they are overly optimistic about the longevity of their fixed assets, growth capex will be materially overstated.

Back to the one-rig trucker for a moment; one of his biggest maintenance expenditures is buying new tires. Let's say that in the past the owner has depreciated them over a three-year period but since he changed his route to a hotter region, they are only lasting an average of two years.

Although he did it inadvertently, he had materially understated his depreciation expense, thus his prior accrual earnings have been inflated. If we had used his old depreciation estimate to approximate maintenance capex, we would have underestimated the "true cost" of maintaining his stream of free cash flow.

An alternative method for calculating maintenance capex has been suggested by Bruce Greenwald and summarized by Jae Jun as follows:

  • Calculate the Average Gross Property Plant and Equipment (PPE)/ sales ratio over 7 years
  • Calculate current year’s increase in sales
  • Multiply PPE/Sales ratio by increase in sales to arrive to growth capex
  • Maintenance capital expenditure is the capex figure from the cash flow statement less growth capex calculated above, which is the true depreciation for the company

I believe that for most companies the Greenwald system for calculating maintenance capex is superior than merely substituting depreciation for maintenance capex, however as you will see in the in my upcoming discussion of Casey's (NASDAQ:CASY), it is far from perfect. The more intimately an investor understands a business, the easier it is to estimate its maintenance capex requirements.

Estimating Maintenance Capex for CASY

Casey's owns and operates a string of convenience stores throughout the Midwest which provide gas and sell cigarettes and a limited supply of groceries; they are also one of the country's largest pizza outlets. They also fry their own donuts and sell them at their outlets.

The company generates the majority of its revenues (61% ) from gasoline sales however the gross margin of those sales is only about 5%. The groceries generate gross margins of around 30%; the real money-maker is prepared foods items which generate gross margin in excess of 60%. The latter two categories generate 74% of the profits.

The business model for CASY involves setting up stores in smaller rural communities where less competition exists; over 60% of their stores reside in communities with populations of 5000 or less. More recently they have been purchasing stores in larger communities and rebranding them under the Casey's logo.

The strategy involves constructing new stores as well as buying competing stores at reasonable prices, rebranding them and building a kitchen which allows them to prepare pizza, donuts and other food items. The construction of new stores and the rebranding and remodeling to facilitate their restaurant sales in recently purchased stores, is a perfect example of growth capex. Clearly that type of activity needs to be separated from capex which is necessary to maintain existing stores if one hopes to ascertain the true profitability of the enterprise.

If CASY was to quit constructing new stores as well as buying and remodeling new stores, the result would be a quick reduction of capital expenditures (as soon as the remodeling was completed), the effect would be almost an immediate increase in free cash. In essence, the company would be sacrificing future growth in favor of increasing its near term production of free cash. This is a decision that almost every business faces at some point in time after it matures sufficiently and runs out of opportunities to expand without changing it business model in some material form.

In regard to CASY, I believe that Greenblatt's model of estimating maintenance capex is inappropriate since gas sales represent over 60% of revenues. For most businesses, the ratio between plant, property, and equipment (P,P&E) and revenues represents a pretty stable figure. No such stability exists at CASY due to the volatility of gas prices. Higher gas prices result in increased revenues but not necessarily in higher profits.

Greenblatt's formula would have to be reformed to factor out fluctuating gas prices; figuring revenues for groceries and prepared foods as a percentage of P,P&E might work, but for practical purposes, equating maintenance capex with depreciation is the best solution for.

CASY breaks down its capital expenditures by separately listing its purchases of property and equipment, from its payments for acquisitions of businesses, before adding back its property and equipment sales.

Cash flows from investing activities

Purchase of property and equipment
(129,233 ) (136,351)(82,498)

Payments for acquisition of businesses
(45,688 ) (11,813)(8,858)

Proceeds from sales of property and equipment
1,769 3,2003,223

Net cash used in investing activities
(173,152 ) (144,964)(88,133)

That provides little information as to the cost of remodeling a store although past CASY annuals have disclosed the average construction cost for building a new store. Theoretically, one could multiply the new store constructions by the average cost and whittle away at the figure but in the end it is unlikely that a figure more accurate than the companies stated depreciation could be attained.

So what is CASY's adjusted FCF average for the past three years when growth capex is factored out?

Net cash provided by operating activities
214,068 170,624177,422

Depreciation and amortization
73,546 69,45167,893

The company has averaged just under 117 million per year in FCF in the past three years. That puts the multiple at around 14.3X its market cap or about 19.6x its enterprise value. That sounds a little pricey to me but one does need to consider the fact that the company owns virtually all the land on which its stores reside, and many of its stores are located in areas which provide the company with a significant moat.


1) It is impossible to estimate the intrinsic value of a business in terms of free cash flow if one does not separate growth vs maintenance capital expenditures.

2) If growth capital expenditures were discontinued, the free cash would almost certainly increase for most businesses.

3) Growth Capex should be viewed as an investment, maintenance capex should be viewed as an expense.

4) Two methods are commonly used to estimate maintenance capex: the simple methods assumes maintenance capex = listed depreciation, the second uses a formula which involves using P,P&E as a percentage of revenues.

5) Calculating maintenance capex is an estimation, having an intimate understanding of a companies' business model is important in deciding which method to use.

I currently hold no position in CASY

About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

Rating: 3.9/5 (25 votes)



Hoang Quoc Anh
Hoang Quoc Anh - 5 years ago    Report SPAM

Thanks for the article, it was quite good one. And it involves with reinvested capital. I've got two questions going along:

1. How to define the return on reinvested earnings?

2. Look at AMT, the ROE over years are quite small, but it is said to have large return on reinvested earnings. I would like to hear ur ideas on that.


John Emerson
John Emerson - 5 years ago    Report SPAM

Hi Anh,

First of all I know little about AMT since it is the type of stock I systematically avoid. In other words, its historic FCF trailing earnings yield is so low that I refuse to spend the time to seek out its potential growth and durable competitive advantage. Remember I am old and conservative and I like to have a margin of safety in the form of tangible assets.

In terms of your question, in my opinion when judging the returns of company in terms of ROE, the following adjustments need to be made: 1) adding in debt minus cash to the equity figure 2) subtracting out intangibles which are not really costs from the equity figure.

Leverage adds risk and needs to be factored in, while amortizing intangibles which do not really represent true costs looking forward, makes little sense either. I am going to talk about removing intangible costs from the FCF equation in the next article.

Finally since ROE is based upon accrual earnings rather than FCF, I think its computation is pointless for most media companies which rely on a high amount on intangible assets like AMT. CROIC would be the correct metric to us in judging its return on reinvested earnings. In other words, how much future cash (not earnings) will be generated for every dollar reinvested.

Khursheed - 3 years ago    Report SPAM
In Mr Greenwald's book, he gave the example of WD-40. He, however, didn't use GROSS PPE/Sales ratio. I think he used NET PPE/Sales ratio. If you look at the WD-40 financial statements (as presented in the book), GROSS values for PPE are not even mentioned. Jay Jun, on his website, used GROSS numbers for PPE.

Khursheed - 3 years ago    Report SPAM
As everyone knows, the objective of calculating Maintenance Capex, is to arrive at 'Owner Earnings' if the business were in a steady state condition -- not growing or shrinking. So we add depreciation and amortization and growth capex to the owner's earning pot and subtract maintenance capex.

I was wondering if we can use the same line of thinking about SGA and R&D expenses. I've never seen an example of anyone doing that. But it would make sense. Some part of SGA and R&D is spent to maintain the business and the remainder to grow the business. In a steady state, we've to separate the growth part of these two expenses and add them to the owner's earning pot.

Bruce Greenwald performed adjustments to SGA and R&D when calculating Asset Reproduction Value but not for the Earning Power Value.

The same goes for changes in Working Capital but that has been addressed by Warren Buffet in one of his letters.

I'm not a finance student etc but the above adjustments to SGA/RD appear logical. May be I'm missing something, in which case, a lesson will be appreciated.

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