Tag Archives: load

Utilities And Other Industries: Capital Expenditures Vs. Depreciation

It is very common among new investors to assume that depreciation equals the capital expenditures required to keep the company in place. Free cash flow is usually calculated by subtracting the full value of the capital expenditures. This can be wildly inaccurate. The utilities industry has capital expenditures and depreciation that are very different. If all capital expenditures by utilities were maintenance, the industry would be bankrupt very quickly. It is important to understand what, where, how, and why the company you are researching is spending money on capital expenditures in order to value it. Capital expenditures (capex) include a wide variety of things companies spend money on. Capex can include buying land, fixing machinery, building a new plant, upgrading the power system, or many other items. Some of these items are to reduce expenses, increase production, or improve the production process. These are called growth capital expenditures because they improve the company above its performance prior to spending them. Other capital expenditures that keep the company at its current steady state are called maintenance capital expenditures. Most companies spend some capex in both the growth and maintenance bucket so it is important to determine how much of each in order to value the company. One of the industries where this is glaringly obvious is the utility industry. Utilities routinely spend lots of money to support new infrastructure as growth capex. They also spend money on maintenance capital expenditures to ensure their existing operations are in good shape and highly reliable. A high level summary of net income, depreciation, and capital expenditures for some of the major utility companies is shown in the following table. Utility Company 2013 Net Income (millions) 2013 Depreciation (millions) 2013 Capex (millions) Capex minus Depreciation (millions) Capex divided by Depreciation Dominion Resources (NYSE: D ) 1,697 1,390 4,104 2,714 2.95x NextEra Energy (NYSE: NEE ) 1,908 2,163 3,228 1,065 1.49x Duke Energy (NYSE: DUK ) 2,665 3,229 5,526 2,297 1.71x Exelon Corp (NYSE: EXC ) 1,719 3,779 5,395 1,616 1.43x Southern Company (NYSE: SO ) 1,644 2,298 5,463 3,165 2.38x As you can see from the table, the capital expenditures of the utility companies exceeds the depreciation charge, typically by several billion dollars for companies this size. If all of these capital expenditures were maintenance capital expenditures, the market would have to be completely insane to assign the earnings multiples shown in the following table. Utility Company Current Price/2013 Earnings Dominion Resources 25x NextEra Energy 27x Duke Energy 23x Exelon Corp 19x Southern Company 28x Average 24x Earnings multiples this high are usually reserved for high growth companies. Many of the new projects these utility companies are investing in will earn a regulated rate of return between 8% and 12% which doesn’t sound like a high growth company. If anything, this is close to an average company’s rate of return and generally average companies trade closer to 15x earnings. Depreciation is a noncash expense that reduces the net income reported. When valuing companies, it is generally advisable to add back depreciation to net income and then subtract maintenance capital expenditures to get a truer view of profit. In the case of utility companies, they generally spend less money on maintenance capital expenditures than they expense on their income statement as depreciation. This deflates their net income number which makes their price/earnings ratios look higher. The following table shows the capex numbers in relation to the net income numbers for the utility companies. Utility Company 2013 Net Income (millions) 2013 Capex (millions) Capex divided by Net Income Dominion Resources 1,697 4,104 2.42x NextEra Energy 1,908 3,228 1.69x Duke Energy 2,665 5,526 2.07x Exelon Corp 1,719 5,395 3.14x Southern Company 1,710 5,463 3.19x By looking at the capex divided by net income column it is very obvious that most of the capex must be growth capex. If most of the capex was maintenance capex and the cost of maintenance was 1.69x to 3.19x the amount of profit each company was making, they would be out of business very quickly. In addition, one of the quirks about the utility industry is that lots of its “maintenance capex” still plays into the regulatory assets that allow future rates to be raised to earn the cost of investment plus a predetermined return on equity. An easier way to track maintenance capex for utility companies is to read their filings and see how much and when the regulatory bodies approve expenditures to be counted towards the regulated rate of return. However, for companies that aren’t in the regulated utility industry, it can be more difficult to determine much of capex was maintenance capex. In general, it is a good idea to use the laws of large numbers when determining maintenance capex for companies that don’t specifically break it out. For example there could be two oil companies. Company A spent an average of $30 million on capex for each of the last few years and kept production flat. Company B spent an average of $30 million on capex for each of the last few years and production grew by 40%. Therefore it stands to reason that Company B was likely spending a much higher percentage of their capex on growth. Some companies half break it out by giving you a list of the major items they spent capex on and you can place each in the growth or maintenance bucket depending on the type. Maintenance capex should generally be determined over several years because things don’t break at the same frequency every year. This is more important for valuing small companies because larger companies generally spend similar amounts of maintenance capex every year. Another common capex that seems to be often included as an expense to reduce a company’s profit is when they buy or construct a new building for their corporate headquarters. This is actually growth capex because it will reduce future rent expense by the company (i.e. increase their profit) and it will appreciate over time. These are the reasons and some advice about making sure to understand the company’s capital expenditures when trying to value a company. It is especially important in the utility industry but even in other industries your valuations could be dramatically off without understanding where and why the company is spending money.

3 Promising India Focused ETFs

Summary India will overtake China’s GDP growth rate in 201 according to IMF and I believe that Indian equities are positioned for a multi-year bull market. Infrastructure is India’s biggest challenge as well as the biggest opportunity and I believe that the sector will perform well amidst lower interest rates in the foreseeable future. India’s consumption story has just commenced and with very favorable demographics, India’s consumption is likely to grow at a robust pace making the consumer related ETF attractive. While the focus has been on large companies in the recent rally in Indian markets, the small companies hold immense long-term potential and the small-cap ETF looks attractive. India is poised to overtake China’s GDP growth in 2016 according to the IMF and I have been bullish on India since the new government came to power in 2014. Recently, I wrote an article on IMFs GDP outlook for 2015 and 2016 where I opined that India and the US are the bright spots in the global economy and I also opined that India is likely to be the best performing equity market in 2015. I had also provided two stock picks and one ETF for exposure to Indian markets. In this article, I will be discussing three more ETFs that look very interesting considering a 2-3 year time horizon. I believe that these ETFs can serve as catalyst for the portfolio and investors need to diversify to India in order to boost overall portfolio returns. EG Shares India Infrastructure ETF (NYSEARCA: INXX ) The India Infrastructure ETF is designed to measure the market performance of companies in the infrastructure industry in India. For 2014, the ETF provided returns of 20% and I believe that the ETF will provide returns in excess of 20% in 2015. The reasons are as follows – The Indian central bank cut interest rates by 25 basis points recently and another 75-100 basis points interest rate cut is likely. Lower interest rates will trigger upside for the interest rate sensitive infrastructure sector. As the chart below shows, India needs infrastructure investment of nearly $1.25 trillion over the next 10-years and as the pace of investment grows under the new government, infrastructure companies are likely to outperform. (click to enlarge) The ETF has high exposure to large and very large infrastructure companies in India and therefore the exposure is with companies having strong fundamentals. The trailing PE ratio of the ETF holdings is 17.9, which is lower than the broader NIFTY PE of 22.2. Therefore, on a relative basis, the sector is still undervalued and has upside potential. For these strong reasons, the EG Shares India Infrastructure ETF is an interesting ETF to consider not only for 2015, but with a long-term investment horizon. EGShares India Consumer ETF (NYSEARCA: INCO ) As the name suggests, the India Consumer ETF is focused on the consumption theme. For 2014, the ETF provided an extraordinary return of 48%. While the same performance might not be replicated in 2015, the fund still looks very promising for strong returns over the next 3-5 years and a return of 15% to 20% in 2015 on a conservative basis. The Indian consumption theme has just commenced and Amazon (NASDAQ: AMZN ) clocking gross sales of $1 billion in the first year of operation in India is an indication of the potential the broad consumption theme holds in India. The PwC report is also upbeat on the media and entertainment sector in India for the next 5 years. Further, India is set to become the youngest country in the world by 2020 and the favourable demographics mean that India has huge potential when it come to consumption themes such as personal goods, automobiles, media and entertainment. The India Consumer ETF provides exposure to all these sectors of the economy with exposure to all the big players in the respective industries. I therefore expect the ETF to provide stellar returns considering a time horizon of 3-5 years. India Small-Cap Index ETF (NYSEARCA: SCIF ) I believe that the Indian Small-Cap Index ETF, which has provided returns of 43% in the last one year, is another excellent ETF to consider for 2015 as well as for the next 3-5 years. The above mentioned ETFs would give investors exposure to large or very large companies in India in the respective sectors. However, there is immense potential in some of the small or mid-sized companies in India. The growth for these companies can be robust if overall economic growth and sector growth is strong. With the ETF currently having 30.1% exposure to the financial sector, 21.1% exposure to the consumer discretionary sector and 17.6% exposure to the industrials sector, the outlook for the ETF will certainly be robust in 2015. In particular, the financial sector will surge on low inflation and rate cuts and both these factors will also impact the consumer discretionary and industrials sector. As of December 2014, the ETF had a very low PE of 11.24 and I believe that the ETF has strong upside in the coming quarters. In general, the broad market rally is led by large-caps followed by mid-caps and small-caps. Therefore, I expect the ETF to start moving significantly higher based on current valuations. Conclusion India is certainly one of the most attractive markets for 2015 and I believe that the Indian economy is on a path to sustained and robust growth in the next 5-10 years. Therefore, investors need to have Indian stocks in their portfolio and the ETFs discussed have the potential of providing 15% to 30% annual returns if the government keeps its promise on drastic policy changes in the coming months.

Is Retail In Retreat?

By Robert Goldsborough As fourth-quarter earnings reports have started coming across the wire, several themes already have begun emerging. One of the biggest themes, however, has been not company-specific, but rather a government report showing surprisingly weak retail sales numbers for December and a downward revision for November’s numbers. According to United States Commerce Department data, retail sales fell nearly 1% in December on a month-to-month basis (and were down fully 1% month-to-month excluding autos), while consumer core sales (retail sales less autos, gasoline, building materials, and food services) were down 0.4% month-to-month. The news surprised both the markets and economists, who had forecast basically flat retail sales in aggregate and a 0.4% rise in consumer core sales on a month-to-month basis. And it indicated that consumers enjoying lower gasoline prices did not take that extra cash in their pockets and spend it at other retailers. Some economists contend that the retail weakness simply is a matter of the calendar and timing differences involved in making seasonal adjustments to economic data. By other measures, they suggest, such as the Federal Reserve’s Beige Book or the National Retail Federation’s data, retail spending is solid. My colleague Robert Johnson, Morningstar’s director of economic analysis, acknowledges that on a headline basis, the retail sales numbers didn’t look great, but he notes that on a year-over-year basis, retail sales growth continues to be strong, exceeding 4% on a nominal basis and growing close to 3.5% on an inflation-adjusted basis. Going forward, he doesn’t see dramatic improvement ahead in retail sales, but he does anticipate generally solid data. Although the retail sector has outperformed the broader market over the past few months, the most recent news in the retail space has pressured the share prices of many retailers a bit. For investors who see this as a buying opportunity in a generally well-valued broader market, there are several exchange-traded funds that investors can consider. An Overview of Retail ETFs There are three passively managed, unleveraged ETFs devoted to the retail industry: SPDR S&P Retail ETF (NYSEARCA: XRT ) , Market Vectors Retail ETF (NYSEARCA: RTH ) , and PowerShares Dynamic Retail ETF (NYSEARCA: PMR ) . Easily the largest and most liquid retail ETF, XRT also offers broad exposure, tracking an equally weighted index of 102 U.S. retail firms. Because XRT’s index is equally weighted, heavyweights like Wal-Mart (NYSE: WMT ) sit shoulder to shoulder in the fund with relative pipsqueaks like women’s fashion specialty retailer Cato Corp. (NYSE: CATO ) . As a result, large-cap companies make up just 15% of assets, while mid-cap firms comprise 30.5% of the fund. Small- and micro-cap companies make up 35.5% and 16% of assets, respectively. XRT holds both defensive retailers, such as Wal-Mart, Costco (NASDAQ: COST ) , and Walgreens Boots Alliance (NASDAQ: WBA ) , and nondefensive retailers, such as specialty retailers and apparel stores. XRT also holds Amazon (NASDAQ: AMZN ) , but it does not hold home-improvement retailers such as Home Depot (NYSE: HD ) and Lowe’s (NYSE: LOW ) . The fund’s 0.35% price tag is appealing, but given the exposure to smaller firms, would-be investors should expect higher beta exposure relative to a more traditional, market-cap-weighted ETF that tilts toward larger firms. RTH tracks a market-cap-weighted benchmark of 25 retail companies. That means that the largest firms, such as Wal-Mart, CVS Health (NYSE: CVS ) , Amazon, and Walgreens Boots Alliance, hold the most sway. RTH is devoted almost entirely to large-cap names, with mega-cap retailers making up 35% of the fund and large-cap companies comprising another 59% of assets. Unlike XRT, RTH holds home-improvement retailers, which gives the fund more exposure to the housing market than XRT. RTH charges 0.35%. Finally, PMR is a small, thinly traded strategic beta ETF that tracks an enhanced index of 30 retailers. The index evaluates firms based on price momentum, earnings momentum, quality, and value, among other factors. The index rebalances and reconstitutes quarterly, ensuring higher turnover. In addition, PMR has a pronounced small-cap tilt, devoting almost 27% of assets to small-cap firms, 11% to micro-cap companies, and another 21.5% to mid-cap retailers. PMR’s performance has lagged that of RTH in the trailing one- and three-year periods ending Jan. 16, 2015 (RTH has not traded for five years), and while it has nicely outperformed XRT in the trailing one-year period, it’s underperformed XRT in the trailing three- and five-year periods. It’s not clear whether investors can count on outperformance from this fund going forward. PMR charges a relatively high expense ratio of 0.63%. What the Economic Outlook for 2015 Means for Retail ETFs In general, Morningstar’s analysts anticipate a healthier and stronger U.S. consumer in 2015 and beyond, which portends well for retail ETFs. A strengthening consumer in particular would favor ETFs with small- and mid-cap tilts, as they hold fewer defensive names and more discretionary, higher-beta firms. So that dynamic could make XRT and PMR more appealing options. At the same time, investors should pay close attention to some retail trends that are less favorable for smaller players. Some of these include the need for retailers to have both a brick-and-mortar business and an e-commerce presence–a requirement that in general requires firms to be larger and have more scale–and a broader trend of the millennial generation spending less money on high-priced items found at specialty retailers offering apparel or luxury goods and instead spending more on experiential items and more expensive places to live. Although any generational shift plays out over a much longer-term time horizon, it’s worth watching closely. E-Commerce Growth Continuing Unabated In addition to disappointing December results, traditional bricks-and-mortar retailers continue to face challenges from online shopping. Many traditional retailers have struggled to keep up with Amazon’s strong fulfillment capabilities and price competition. Although Amazon continues to grow and take share from traditional retailers, it also has problems of its own, as it continues to search for ways to grow its business profitably. In the first few weeks of 2015, the firm’s share price is down sharply. Over the longer term, we have some concerns about smaller retailers’ ability to compete with Amazon from a fulfillment standpoint. Morningstar’s equity analysts note that a variety of retailers have increased their emphasis on logistics and delivery speeds, but even so, only a few retailers at this time can match Amazon’s capacity and geographic reach. The transition to e-commerce is continuing slowly for bricks-and-mortar retailers, as many of their fulfillment centers were not designed for e-commerce. For investors, what this means is that smaller-cap retail names–which are found more in XRT and PMR–may well find themselves more susceptible to the growth in online shopping. So while broader macroeconomic trends–a stronger consumer with more disposable income–could benefit those funds, e-commerce growth could come at the expense of some, if not many, of the smaller firms in those ETFs. Other Options Because retail makes up a large chunk of the consumer discretionary industry, investors seeking broad exposure to the retail space also could consider a consumer discretionary ETF. Consumer Discretionary Select Sector SPDR (NYSEARCA: XLY ) , which charges 0.16% and holds about 85 companies, is a large and liquid fund that devotes about one third of its assets to retailers. Similarly, Vanguard Consumer Discretionary ETF (NYSEARCA: VCR ) costs just 0.12%, holds a broader portfolio of 382 firms, and also invests about a third of its assets in retail firms. Investors interested in ETFs with meaningful exposures to Amazon can consider one of two Internet ETFs, both of which devote between 7% and 8% of assets to Amazon: First Trust Dow Jones Internet (NYSEARCA: FDN ) (0.60% expense ratio) and PowerShares NASDAQ Internet (NASDAQ: PNQI ) (0.60% expense ratio). Internet and catalog retailers like Amazon make up between 20% and 25% of the assets of each ETF. Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.