Capital-intensive companies (I): general

Throughout my career in the stock market, I’ve had an interest in capital-intensive companies.  Early on, I analyzed many of them in the natural resources industries.  I renewed my acquaintance with them when I began to look at foreign markets as a portfolio manager, where property companies–including owners of office buildings and hotels–are typically key sectors.

I’ve always been fascinated by what appears to be the sudden, apparently irrational, decision of most participants in such industries to all expand at the same time, creating overcapacity that destroys industry profits for years.  I think there’s some method to the madness, which I’ll talk about in al ter post in this series.

What prompts me to write about this now is that, as regular readers will know, I like casino stocks (I’ve never done casino gambling, however; it has always seemed too much like work).  I’ve been watching with morbid fascination the mammoth expansion of hotel/gaming capacity in Las Vegas over he past couple of years.  What finally compelled me to put fingers to keyboard is a recent Moody’s credit report stating that although most of the thousands of casinos in the US have recently restructured their (considerable) debt, they are still by and large not out of trouble.  That’s another  post, as well.

One more preliminary.  There are two banes of capital-intensive companies:  overcapacity and technological change, which can render existing capital structures either irrelevant or obsolete.  Depending on how far you want to push the concept of capital (does it include brand names and distribution networks), the latest of the latter plagues has been the internet, which allows people like me to publish their views at little cost, and anyone with the price of a web storefront, to distribute merchandise all over the world.

Here goes.

what they are

expensive, long-lived assets

In its simplest form, a capital-intensive business is one that requires a very large initial outlay of money to get it up and running.  The upfront expenditure is made on an asset that has a very long useful life.  The cost of this asset dominates the business.

Typically, this involves buying/building a lot of plant and equipment, as in the case of a blast furnace steel mill, a semiconductor foundry, an oil refinery, a cement plant or a hotel.  But it may also involve purchase of a license or a right, as in the case of a toll road or a permit to do deep-water offshore drilling for oil.

not portable

For massive plants, like a blast furnace, once they’re built it may be physically impossible to move them.  But the assets–like a mine–may equally well need to be close to mineral deposits, or to sources of power or means of transporting output to markets.  Even if they could be moved, NIMBY (not in my backyard) may be an issue.  Few people want an oil refinery or even a brewery next door.  Airplanes and ships are exceptions, but even here they require airfields and ports to be able to operate.

financial leverage

Because their assets are typically very expensive to acquire, capital-intensive companies often use debt capital to fund themselves, in addition to equity.  Tax laws may encourage this.  In most parts of the world, loans collateralized by real estate are non-recourse to the borrower, meaning that if the project fails the lenders can seize only the real estate, and are unable to make a claim on the borrower’s other assets.  As a result, real estate projects are typically very highly leveraged.

vs. labor intensive

Capital-intensive companies are often contrasted with labor-intensive ones, with the traditional model being piece-work assembly such as is done with electronic devices.  The older analog would be a garment district sweat shop or a bunch of people with hand tools digging a ditch.  In today’s world, a firm that provides security guards or temporary help are also good examples.

The assumption behind capital-intensive vs. labor intensive is that the two kinds of inputs an entrepreneur has available to him for his business are: manual labor and expensive machinery.   If this year were 1910 and not a century later, that would be okay.  But not now.

The old joke about an advertising or public relations agency is that the assets leave the building in the elevator every night.  They’re clearly labor intensive, but they employ highly specialized and skilled workers.  But what about software firms that have unusually talented workers and which have amassed large amounts of intellectual property–MSFT Windows or Office, for example.  What about GOOG or AMZN?  What do we do with pharmaceutical research firms, again with substantial intellectual property and patented drugs?  Are they labor-intensive or capital-intensive?

The fact that the distinction has begun to break down at the edges–fodder for another post–doesn’t mean it isn’t still useful for an investor in understanding many industries.

More tomorrow.

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