The other side of Capital Expenditures

The other side of Capital Expenditures

The amount of money a firm invests in itself (capital expenditures) may understate or overstate a companies free cash flows, as not all capital expenditures are created equal. The difference between investment in future growth and maintenance cap ex often goes unnoticed.

Maintenance cap ex are investments required for a company to maintain its current sales level.  A company that has a high level of maintenance cap ex is unlikely to generate higher free cash flows - even after it stops growing sales - since it will keep pouring money into fixed assets to keep existing sales from declining. 

These companies will usually have poor returns on invested capital since they are essentially investing money in their business to keep their revenues at an even level. This makes them them poor long-term investments and a lousy hedge against inflation. Most resource orientated companies fall into this category, think of oil and mining companies. Semiconductor firms too, would have high maintenance cap ex requirements as they constantly have to upgrade their product offerings.

If you invert your thinking about all of this (Charley Munger style) you could take advantage of this situation. Start investigating companies that sell capital equipment to these high cap ex firms. This will help these service companies generate a recurring revenue stream making it easier to predict their own growth rates in the future. This could make them interesting long-term investments. Check out the annual report of the high capital expenditure firms and find out who their suppliers are. These suppliers could be fertile ground for future investing opportunities.