Pulling the Capex Lever
Companies across all industries have room to grow in optimizing "return on capex." The fundamental questions of how much to spend, what to spend it on, and how to transform the investment into real returns must be answered in a radically different way.
Capex spending—never far from a CFO's agenda—has been getting more than its usual amount of attention lately. One reason is its sheer size. Global capital expenditures currently run at a level of more than $10 trillion per year and are expected to rise by one-third over the next five years, to equal approximately the size of today's entire U.S. economy, according to financial analysis firm IHS Global Insight. These aggregated numbers translate into millions of investment decisions made by governments and companies worldwide—decisions that must be made during unprecedented times of uncertainty as companies and CFOs, by extension, are pummeled by regulatory changes, government (stimulus) programs, fluctuating commodity prices and exchange rates, and a litany of disruptive technologies. Despite these uncertain times—or perhaps because of them—there are also extraordinary opportunities for companies that have the advantage of flexibility when making their capital planning decisions. More than capex levels—which can vary in size from one year to the next—depreciation levels are a good indicator of this pivotal driver of business success (see figure 1). Because capex is one of the most substantial drivers of long-term profitability, the short-term effects of capex-level adjustments are often underestimated. While a change in capex levels has immediate effects on cash-flow and liquidity, the P&L effect comes with some time lag, depending on the average depreciation period and time to realization of related top-line effects. However, as capital markets discount the series of future cash flows or apply multiples to projected earnings, the consequences in cash value—or shareholder value as reflected in the stock prices for that matter—can materialize very rapidly. Therefore, analysts have been focusing more on capex strategies and the resulting cash-flow indicators in company valuations. By evaluating returns compared to the cost of capital employed, key performance ratios can deteriorate quickly as a result of balance sheet extensions prior to materialization of expected positive P&L effects.
While internal liquidity and external capital market pressure increases, recent A.T. Kearney research across companies in multiple industries finds opportunities in optimizing capex management.
Evaluation techniques widely used around the globe revolve around the basic concept of discounting future cash inflows (returns) with an interest rate reflecting the risk-adjusted cost of capital to compare the resulting cash value with the required cash outflow (expenditure). If the resulting net present value (NPV) is positive, this means "go"; If not then it means "no go."
That's the theory. However, the reality for CFOs is not as straightforward. The following areas and subsequent questions have led to some sleepless nights:
- Spend volume: How much should be spent?
- Capital allocation: What should it be spent for?
- Project execution: How does spend transform into real returns?
Given the challenges and the potential opportunities, it is more than time for companies and CFOs to "pull the capex lever."
The first step is to perform a quick assessment of capex programs to clean up the project portfolio. This is helpful to increase company-wide transparency and to achieve quick wins. The existing capex portfolio is categorized along two dimensions: Status of the investment and an assessment of each project's value—determining whether or not the project increases value and is operationally necessary. Based on the assessment, actions are determined; and from the assessment and improved transparency, companies can reduce or reallocate their capex spend by up to 10 percent for the first planning year and thereafter.
Now we are ready to pull the capex lever by targeting all three areas-spend volume, capital allocation and project execution-using a comprehensive long-term target model. The following offers a discussion of each.
1. Spend Volume: How Much Should Be Spent?
Determining the correct level of investment can be a daunting exercise. One popular and proven approach is to perform competitor benchmarking. But while benchmarking works well in many areas related to operational expenditures, the approach is not as successful when making capex comparisons. That's because different investment cycles can make annual comparisons difficult to perform and misleading. Also, capex composition is extremely heterogeneous across companies, as there are various applied principles for capitalization of services, splits in growth and replacement capex, and others. Additionally, degrees and types of outsourcing or different depreciation periods can also make results difficult to compare. Above all, the aggregation level of the well-known "capex-to-sales" ratio is so high that few insights can be gleaned from high-level benchmarks.
In a recent A.T. Kearney study, Excellence in Capital Projects, we found that the majority of companies continue to base their capex allocations on isolated, bottom-up requests.1 The resulting silo mentalities and lack of company-wide transparency often stifle efforts to establish integrated corporate capital planning processes. There is a vertical focus on managing one project at a time within a specific business unit instead of a horizontal focus on managing a portfolio of projects.
Determining the "right" level of capex spend. Determining the right levels of capex spend requires an integrated and iterative capital planning process over multiple years-taking into account organizational limitations to execute projects and financial limitations to raise cash at favorable terms.
Disposition of capex. In most industries, replacement capex constitutes a large part of the total capex budget. When determining the right level of investment, this area is suited for any type of benchmarking because it is decoupled from potentially large differences in growth capex levels for which it would be difficult to determine a good or a bad level of investment. Growth capex levels largely depend on a company's particular strategy, project portfolio, available organizational resources, or preference for greenfield ventures over M&A, not allowing for conclusions as to the right level.
On the other hand, comparing replacement capex levels can provide insights on the origins of differences in asset turnover and on the efficiency of asset optimization programs. Substantial savings potential can typically be derived by switching from time-based to risk-based replacement cycles. Replacements are then no longer a result of time-in-use elapsed but of statistical reliability and economic default risk of an asset.
To ensure the validity of (replacement) capex benchmarks it is pivotal to apply consistent criteria for separating replacement and growth capex across benchmarking participants. This separation has to be performed in an asset- or asset-class-specific way (for example, technological progress can lead to at least partial reclassification of an outdated asset replacement as growth capex based on improved efficiency).
Additionally, it is necessary to increase the level of granularity when comparing capex elements such as production machinery, buildings, IT or sales force equipment. Depending on industry similarities, it may be necessary to go even deeper in select areas such as types of IT equipment. Furthermore, the comparisons need to be performed for multi-year periods, although no less than a minimum of three to-five years. Effects of capex-opex shifts—for example, asset outsourcing and capitalization of services—can be significant and best accounted for by combining capex with opex benchmarks. In this respect, A.T. Kearney's Global Cost Benchmarking has become a powerful tool applicable to multiple industries (see sidebar: Global Cost Benchmarking for Telecom Operators).
The migration toward risk-based asset management (RBAM) can reduce the required spend for asset maintenance and replacements. Both replacement capex cost and asset default risk can be optimized by focusing investments on important but less reliable assets (see figure 2). We determine asset reliability based on default and age statistics, which yield age-dependent default rates. Asset importance is derived from the expected economic damage in case of default. Economic damage refers to the cost of repair, lost revenues, regulatory or contractual penalties, damage to persons, property or nature, and loss of image, among other things. Based on this reliability-importance assessment, we devise overall replacement strategies, which are rated based on their expected long-term cost and risk development. An optimal strategy is devised that also take into account regulatory and budget constraints.
Once the "right" level of replacement capex is determined (based on benchmarking and risk-based asset management), additional elements to the total capex budget are added. For instance, M&A capex and growth capex in fixed assets are added and compete against each other.
A company should do any investment that eclipses its hurdle rate as long as it fits within its overall strategy.Sounds trivial—but it isnot. Few companies ask the radical bottom-up question: How much cash do we need to fund qualifying projects? Instead, a top-down answer is often given based on historic levels and high-level benchmarks, thus possibly cutting numerous value-adding projects before they ever get started.
Companies that first pull a profitability lever by establishing project portfolio transparency, and let it then determine capital requirements, will establish what can be done within their financial limitations.
Funding of capex. How much of the wish list capex can actually be funded? The answer depends on availability of sources.The first source is excess cash on hand above the minimum requirements for net working capital and safety margins. The second source is free cash flow from operations after provisions to settle outstanding debt and to pay dividends to equity holders. This source is inherently uncertain as it reflects future cash flows during the capital planning period. Conservative scenario modeling needs to ensure a strategic capex plan that remains constant and enforceable even if conditions worsen.
The third source of funding, debt financing, is rarely touched when it comes to capex financing since capital planning is not always considered an iterative process. Capital structure modeling, however, can reveal to which level additional gearing can make sense, taking into account specific risk-management policies, availability of funds, impact on rating agency evaluations, and effect on interest rate premiums for the company's debt facilities.
Finally, equity financing may also add substantial value to the company, again depending on the expected project portfolio returns and valuation of the company to compare the dilution effect with the expected investment returns. As part of an iterative capital planning process, it should play an active role in capex funding taking into account gearing-ratio limitations, availability of funds, and effects of planned M&A transactions based on equity swaps.
To summarize, the full power of a capital planning process is unleashed when it is approached in an iterative manner. All funding options, including external funding, should be on the table depending on the attractiveness ofthe company's project and M&A portfolio.
2. Capital Allocation: What Should It Be Spent For?
Apart from the overall challenge in defining spend volume, the second major reason for a CFO's sleepless nights is the question of how to allocate scarce capex resources. While there are still multinational companies not using consistent capital allocation criteria such as NPV, IRR, and hurdle rates, the vast majority of firms are steering based on leading value-based management key performance indicators (KPIs) such as EVA and CVA. However, apart from the overall lack of corporate-level capex transparency, the sole focus on NPV and hurdle rates as a basis for capital decisions is met with more skepticism as it tends to inhibit innovation and growth:
"Most innovative ventures die from overly high profit hurdles." —Jack Welch Former CEO, General Electric
This statement, from the man who is arguably one of the world's most prolific creators of shareholder wealth, signifies that high-risk, high-return projects cannot be properly modeled by reducing them to one risk-adjusted interest rate and assumed cash-flow stream.
Why doesn't an exclusive focus on one value-based financial criterion work? There are several reasons. For one thing, adhering to the NPV principle can impede growth and innovation by cutting projects that do not meet the requisite hurdle rate. However, as stock markets tend to attribute a significant part of value to (revenue) growth, and even more to the assumed potential to exceed planned growth (positive surprises), what seems a correct decision from a value perspective does not necessarily create shareholder value. Important side effects include the impediment of positive accretion effects with reduced dilution in future M&A transactions or the risk of becoming a "cheap" takeover target.
Another reason is that what seems correct from a value perspective actually is not. Traditional discounted cash flow (DCF) models factor in all kinds of different risks and uncertainties in a markup to the discount rate—very global and in the wrong place, given that the uncertainty lies with all the different parts of future cash flows, which can include, among other things, the price of end products, exchange rates and commodity prices. Even worse, a simple rate markup suggests that all future uncertainty be negative (risk), neglecting that it could just as well be positive (upside potential).
How to allocate. A horizontal and rolling 24-month capital planning process spanning the entire project portfolio is essential to react to changing market and cash-flow situations and to define the how much (spend volume) as well as the what (capital allocation). Both are cross-referential in the sense that exogenous limitations can cap the project budget (top-down), while on the other hand a very good project portfolio should expand preset budgets within given limitations (bottom-up).
Project scenario modeling is performed to address shortcomings in the traditional NPV method, using explicit statements on probability. Projects are classified as to their inherent level of uncertainty and future business flexibility to reflect and capture the value of future alternatives (see figure 3).
A.T. Kearney's Dynamic Decision Management approach highlights different stages of excellence from the traditional NPV stage with risk reduction, through the scenario-based stage and lump-sum and specific probabilities, to the total value stage (see figure 4). The approach incorporates all project scenarios, including the do-nothing scenario, with explicitly identified probabilities and incorporates volatility as risk measurement instead of a general project-specific weighted average cost of capital (WACC). For more predictable projects with little flexibility, the classic scenario-based discounted cash flow model is still relevant; however, its applicability decreases dramatically as the degree of project uncertainty and business flexibility rises. Because the Dynamic Decision Management approach reflects any number of alternative options—thus putting a value on decision flexibility—projects that might not seem to meet the internal hurdle rate from an NPV perspective can turn out to be excellent investments if their total value is considered.
Therefore, it is critical for best-practice capital allocation to segment the overall project portfolio in a first step and then apply the different evaluation techniques as they fit. Combined with overall transparency into the project portfolio and a stringent, strategic-fit assessment, this approach will ensure proper demand management and prioritization.
While the extension of the DCF approach with real options analyses has met with skepticism in the past due to-feared complexities and lack of support tools or practical case examples, A.T. Kearney has successfully pioneered this approach in numerous recent capex projects. Figure 5 illustrates how the Dynamic Decision Management approach was used successfully to model "mothballing" for a 300-megawatt gas turbine.
Finally, based on both the DCF and the Dynamic Decision Management approaches, one important point should not be overlooked: It might pay to invest in projects that have neither a positive NPV nor a positive total value. Indeed, there is a lot to be said for innovation. Consider the following examples of people and publications that underestimated the power of innovation:
"There will never be a mass market for automobiles—I estimate about 1,000 in Europe—because that is the limit on the number of chauffeurs available." —Gottfried Daimler, 1889
"There is no need for this product. The average American family doesn't have time for television." —The New York Times, 1939
Therefore, a golden rule should be to reserve a fraction of the total growth capex budget (maximum 10 to 20 percent) for projects that do not seem to pay off based on valuation techniques in the first place. Such projects, however, must possess positive qualitative factors such as high strategic relevance, (very) high uncertainty, and options for upside potential. This pension fund-like asset allocation approach can ensure that growth and innovation are not inhibited and that what might begin as a manager's "gut feeling" can turn into the next billion-dollar business unit.
3. Project Execution: How Does Spend Transform into Real Returns?
The question of "How much do I actually get for my investment" is rarely answered in a satisfactory way, as project returns are often less than originally anticipated or less than possible. Despite its lower profile, project execution is clearly one of the main drivers of capex productivity and thus overall business success. That it has traditionally been in the background is one more reason to shed light on it now for needed improvements. Poorly managed or budget-busting projects will eat up precisely the capex that would be needed for other value-adding projects. Companies with a core competence in project execution can derive substantial competitive advantage and excel in value creation. A.T. Kearney's Excellence in Capital Projects study, first launched in 2008, continually examines capital project management techniques at nearly 30 global companies across multiple industries. Participants complete comprehensive online surveys with just under 200 questions across 11 key areas of project management. The results have culminated in four stages of excellence for each dimension against which participating companies can rank their performance and receive detailed feedback for areas of improvement (see figure 6).
In addition, a hypothesis-driven, quantitative KPI benchmarking sets the basis for further in-depth analyses. Example benchmarking dimensions include:
- Business performance: capital project budget compliance, maintenance to capex
- Capital planning and cost: unit labor cost, contractor penalties, engineer utilization rate
- Work process: demand forecasting accuracy, revisit rate, defective installation rate
- Organization: full-time in-house engineers per total engineers
Initial benchmarking results will support drill-down analyses into key performance improvement levers. Example analyses include:
- Contractor and vendor management: Component benchmarking, vendor management best practices, third-party labor rates comparisons by skill
- Non-quality cost: Net benefit of preventive activity and regional benchmarks
- Resource productivity and utilization: Contract spend by region and utilization across regions
- Organizational effectiveness: RACI analyses per activity and root cause analyses of cycle time
From the analysis, a capex reduction opportunity assessment provides a detailed quantification and rationale for identified improvement areas. It is complemented by risk and trade-off assessments and an action plan to ensure a thorough implementation. On average, companies across multiple industries have been able to reduce their capex spend by 10 to 20 percent on a sustainable basis, leading to an increase in return on capex.
Maybe Not Overnight. But Over Time.
Growth in global capex is expected to outpace global GDP growth over the next 10 years as large asset-intensive industries continue to feed the world's hunger for energy, mobility, and staying connected anytime and anywhere. This coupled with rising global capital mobility and demands in capital markets will continue to make capex optimization one of the hot topics for corporate leaders worldwide for years to come.
The competitive challenge is in a changed and iterative capital planning process, capital allocation based on total value considerations, risk-oriented asset management, and better project execution, which will require more fundamental change. The requisite organizational, process and system changes will only be successful if driven with clear determination from the top. No doubt fully pulling the capex lever will be a challenge to organizations and leadership alike. However, it has been said before that "where the willingness is great, the difficulties cannot be great." To ensure smooth organizational transition not all change elements can or should be addressed simultaneously. As long as full leadership determination drives the sequential implementation of needed changes, a company can be sure to optimize its "return on capex." Maybe not overnight, but over time.
1See Excellence in Capital Projects at www.atkearney.com.