Comment 

How to check out the profits of asset-intensive companies

How to check out the profits of asset-intensive companies

When you are looking at any company it’s important to have some confidence that its profits are believable and realistic. By this I mean an amount of money that can be used to pay lenders and shareholders. 

Ebitda (earnings before interest, tax, depreciation and amortisation) is not a useful measure of profit, but it is used by companies all the time. The main reason it is not useful is because it ignores the real expense of replacing assets – something known as depreciation – which helps the company make money in the first place. 

Investors ignore the significance of depreciation at their peril and should be suspicious of companies that talk about Ebitda too much. To get an informed view on a company’s performance and valuation, depreciation or some measure of the amount of money needed to stay in business needs to be taken into account. 

Depreciation itself is not without its problems. It can give companies a convenient way to boost their profits by under-depreciating. Depreciation can also be too low – and profits too high – if companies underinvest and allow assets to become worn out. 

Investors therefore need a way of checking whether depreciation, and therefore company profits, are realistic. This is particularly important when you are looking at industries that use a lot of fixed assets, such as property, fixtures, fittings, plant and machinery to make money, such as: 

  • Supermarkets 
  • Mining 
  • Asset rental companies 
  • Transport 
  • Manufacturers 
  • Telecoms 
  • Pubs 

 

What is depreciation? 

Depreciation is an accounting measure used to match the cost of a fixed asset against the revenues it generates over its useful life. 

There are different ways to calculate the annual depreciation of a fixed asset, but the most common method is known as straight line depreciation. This is when the amount of depreciation is spread evenly over the useful life of the asset. Straight line depreciation is calculated as follows: 

(cost less residual value)/Useful life 

So, if an asset costs £10m and has no residual or scrap value and will last 10 years, the annual depreciation expense that is charged against revenues will be £1m per year for 10 years. 

 

Warren Buffett on depreciation and Ebitda 

He was damning when talking about the subject at the 2003 Berkshire Hathaway annual meeting: “Not thinking of depreciation as an expense is crazy. I can think of a few businesses where one could ignore depreciation charges, but not many.” 

He summed up what depreciation is quite nicely when he said: “It [depreciation] is reverse float — you lay out money before you get cash.  It’s not a non-cash expense — it’s a cash expense, but you spend it first. It’s a delayed recording of a cash expense.” 

I think Buffett is spot on in his comments about the importance of depreciation. It’s a bit of a dry subject, but one that investors would do well to try to understand.  

 

Analysing a company’s depreciation expense 

You will find figures for depreciation in lots of different places in a company’s financial statements. If you want to understand a company’s depreciation expense then the most useful place will be in the property, plant and equipment note to the balance sheet. This typically looks something like the example shown below for pub company JD Wetherspoon (JDW)

 

 

This note contains a wealth of information that can help the diligent investor spot problems with the condition of a company’s assets and whether its profits are believable or not. I’ve highlighted the fixtures and fittings assets. The key numbers to use are: 

  • The original cost of the assets – £617.8m. 
  • Additions – the amount spent on new assets – £56.65m in 2018. 
  • The depreciation provided during the period – this is the expense charged in the income statement of £37.66m. 
  • Accumulated depreciation – all the depreciation that has been provided against the assets over their lives – £426.3m 
  • Net book value (NBV) – the original cost of the assets less their accumulated depreciation. This is the figure shown on the face of the balance sheet – £191.4m. 

These numbers can be used to calculate some very useful ratios: 

Depreciation rate = annual depreciation charge/Average original cost of asset 

This tells us how quickly an asset is being depreciated. Short-life assets should have higher depreciation rates than long-life assets. 

You take the annual depreciation rate and divide by the average of the opening and closing cost of the assets. For JD Weatherspoon the current rate on fixtures and fittings is 7.04 per cent per year. Assuming zero scrap value, this implies that the assets are being depreciated over a life of just over 14 years (100/7.04) 

Asset age = Accumulated depreciation/Annual depreciation charge 

An ageing asset base can be a sign that a company has been cutting back on investing, which might have to be put right with a large replacement spending plan in the future.  

The average asset age is estimated at 10.3 years. 

Cumulative depreciation ratio = Accumulated depreciation/Original Cost 

Alternatively, you can calculate the percentage of the original cost that has been written off as a way of seeing how worn out a company’s assets might be. JDW’s fixtures and fittings are just over 69 per cent depreciated. 

Capex to depreciation ratio = Additions/Annual depreciation charge 

Generally speaking, companies need to spend (known as capital expenditure or capex for short) at least their depreciation expense on replacing assets to keep their revenue-generating capabilities in good shape. A company that is investing to grow will spend much more. A declining business or one in difficulty will spend less. JDW spent 1.36 times its depreciation expense in 2018. 

Like many financial ratios, they are more informative if compared over a reasonable period of time and with similar companies. 

 

Analysing the depreciation of UK pub assets – JD Wetherspoon compared with Mitchells & Butlers 

Pubs are asset-intensive businesses. Yet the sector also contains quoted companies that bang on about Ebitda a lot.  

The most important part of a pub’s assets are its fixtures and fittings – the things you see inside a pub such as bars, flooring, lighting, tables, chairs and toilets, as well as things you don’t see, such as kitchen equipment. These assets wear out and need replacing regularly. This costs money – money that cannot be paid to shareholders. Depreciation is therefore a real cost to pub companies. But is it high enough? 

Keeping a pub’s fixtures and fittings well maintained is crucial. If they are not, the appearance of the pub quickly goes downhill and people go elsewhere for a drink or a meal. Investment is a key driver of like-for-like (LFL) sales in the pub sector. Companies often report a boost to LFL sales after pubs have been refurbished. Poorly invested pubs often see declining LFL sales. 

Fixtures and fittings are therefore a major part of a company’s capex and depreciation figures. If a company is underinvesting or under-depreciating then its profits may look good for a while, but sooner or later this will be reflected in a deteriorating financial performance. 

Let’s look at the key depreciation ratios for the major pub groups in the UK and see if there is anything interesting going on. Interpreting these ratios can tell you that something could be amiss, but may also tell you that things may not be as they first appear. 

 

UK pubs fixtures & fittings assets

 

JDW 

MAB 

FSMT 

YNG 

MRST 

GNK 

Depreciation rate % 

7.04 

9.55 

9.7 

15.1 

8.9 

8.4 

Capex to Dep 

1.36 

1.12 

1.01 

1.07 

1.75 

1.32 

% written off 

69 

49.8 

62.8 

42.5 

47.8 

58.3 

Est Age (years) 

10.3 

5.3 

5.5 

 

Based on figures in the latest annual reports, it seems that Young & Co’s (YNGA) has the highest depreciation rate and the youngest asset base. JD Wetherspoon has the lowest depreciation rate and the oldest asset base. 

Yet, JD Wetherspoon has been the sector’s star performer in recent times in terms of like-for-like sales growth. How can it be doing this if its assets appear to be very old compared with its peers? Are its profits believable if its depreciation rate appears to be so low?  

To try to answer these questions, I am going to look at what’s been going on over time. I’ll also compare it with Mitchells & Butlers (MAB), a company that has been struggling in comparison. I’ve chosen this company because like JDW it is a pure pub company and does not have any brewing operations. 

 

Depreciation rate 

JD Wetherspoon used to be the benchmark setter in terms of prudent depreciation policies. During the early 2000s it was depreciating the value of its fixtures and fittings assets at 13-14 per cent per year.  

This would have left them fully depreciated in seven to eight years. Now it has one of the lowest depreciation rates in the sector. Possibly because it has some fully written-off assets, but maybe because it has a depreciation problem as well. 

This doesn’t seem to make sense. The company’s pubs are growing their sales faster than most. If they were tatty and shabby surely people would go elsewhere. JDW also prides itself on keeping its pubs in very good condition. How can this be the case based on its apparent old assets? 

M&B’s depreciation rate has been relatively steady. It was over 11 per cent towards the end of the last decade, but is now just over 9 per cent which is not out of kilter with others in the sector. 

There are three main reasons for a depreciation rate to fall. 

  • Management extends the useful life of the asset. This is acceptable if the asset life was too low, but extending asset lives can be a source of profit manipulation by lowering depreciation expenses. 
  • An increase in the amount of fully depreciated assets. This happens when the original cost number of assets contains some that have been fully depreciated. They are in the denominator of the depreciation rate ratio but there is no depreciation on them in the numerator. This depresses the ratio. Large amounts of fully depreciated assets will need to be replaced and so a falling depreciation ratio due to this can be a sign of a big capex bill on the way. Is this the fate that awaits JD Wetherspoon? 
  • Estimates of residual value are increased. When it comes to pub fixtures and fittings this is unlikely in my view. 

I think there is a reasonable explanation for JD Wetherspoon’s low depreciation rate – and old asset base – which has started to rise again. It spends over 4 per cent of its sales (£71.3m in 2018) on repairs and maintenance. This is expensed in the income statement and could be causing assets to be retained for longer rather than being replaced. If so, this could explain its low depreciation rate and why it could not be inflating its profits. 

 

Capex to depreciation 

Both companies went through a period of very low capex spending on new assets, which was considerably lower than their depreciation charge during the last recession. Capex has been rising in recent years, but Wetherspoon’s capex to depreciation ratio has been higher than M&B’s for most of the past decade. 

How worn out are each company’s fixtures and fittings? M&B’s fixtures and fittings assets look reasonably well invested. They are only around 50 per cent written off, whereas JDW’s are nearly 70 per cent written off. This would normally be a concern, but can be explained by a significant repairs and maintenance expense. 

 

Asset age 

The estimated age of M&B’s fixtures and fittings is around five years. JDW’s are almost twice as old, but its average age has been getting younger in recent years. 

 

What about cash flow? 

Cumulative 5y cash flow and profits £m 

JDW 

MAB 

FSMT 

YNG 

GNK 

MRST 

Net cash flow from ops 

793.5 

1120 

276.8 

245.5 

1211.4 

855.9 

Capex 

-439.4 

-785 

-188.2 

-161.7 

-912.3 

-775.7 

Asset sales 

48.6 

62 

26.2 

9.4 

420.8 

365 

Free cash flow 

402.7 

397 

114.8 

93.2 

719.9 

445.2 

Net income 

260.4 

476 

158.8 

135.5 

690.5 

187.2 

Difference between FCF and profits 

142.3 

-79 

-44 

-42.3 

29.4 

258 

 

Taking a closer look at a company’s assets and depreciation is a very worthwhile exercise – especially if you base your investment decision on the basis of profitability. It can also be an early warning sign that a company is underinvesting or manipulating its profits. 

Sometimes, though, it can give misleading signs. JDW’s depreciation rate and asset age would normally be a cause for concern, but on further investigation it seems that there is a reasonable explanation for it.  

One of the best checks on profit quality for asset-intensive companies is to look at the cumulative cash flows over a period of five years and compare it with its cumulative profits. What you ideally want to see is profits and cash flows not being too far away from each other in the hope that the cash spent on new assets and the cash flows generated from them even themselves out. 

As we can see, JDW’s free cash flows have been larger than its reported profits. This would have been the case even if asset sales had been excluded from free cash flow. This is a good sign of profit quality. Greene King and Marston’s have achieved a similar result, but only after selling lots of their pubs. 

 

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