Capital intensive companies (II): pros and cons

on the plus side…

1.  The high cost of entry into a capital-intensive business can act as a barrier to competition.  For example, almost anyone can come up with the money to open a restaurant.  But if a big semi-submersible offshore drilling rig costs $100 million, the number of new parties that can give the industry a try is very limited.

2.  First mover advantage can be considerable.  Site location can be important, for example, for proximity to raw materials, customers or transportation of the final product.  A beachfront or a spectacular view can make a difference to a hotel.

Just as important, if a market is only big enough to support one entrant, an intelligent competitor will realize that his entry may create chronic overcapacity and eliminate the possibility of profits for either.  So he’ll look elsewhere.  If he can’t figure this out, his bankers or potential equity investors may withhold the funds he needs.

3.  Lead times for new capacity can be long.  This is not a question of the time it takes to raise capital.  But permitting for new construction may be arduous–a locality may not want another new chemical plant.  Actual construction may take a year or two.  Therefore, even if booming demand justifies adding new capacity, it can be several years before it arrives on the market.

4.  High operating and financial leverage means profits in good times can be enormous.  A hotel, for example, may have to run at about 50% of capacity to cover its cash operating costs, and at about 60% to break even if we include depreciation of the plant and equipment.  But, since the out-of-pocket cost of renting a room is, say, $12 (cleaning, and replacing the soap) the income from selling one more room is high.  And, when occupancy rises high enough, the hotel can hike the price of all the rooms it rents–raising profits exponentially.  There have been times in Manhattan, for example, when, in a strong economy, hotel rooms have rented for over $800 a night.

…and the minus

It’s a characteristic of capital-intensive businesses that the owners take the risk of buying the long-lived assets that will drive the profits of the firm at the outset.  So they may not have a lot of control or flexibility in what happens afterward.  They may be price takers.  They have fixed capacity and demand rises and falls with the business cycle.

From an investor’s point of view, this is perfectly acceptable.  These companies can be very rewarding investments.  You just have to keep in mind that they may be highly cyclical and you can’t fall in love with them and forget this.  There’s a time to sell as well as a time to buy.

There are two big worries for the capital-intensive company, though, other than the fickleness of stockholders:  overcapacity and technological change.

overcapacity

Overcapacity is not just the cyclical ebb and flow of demand.  Say you operate a mid-range hotel located at the intersection of two highways and catering to traveling businessmen.  You have 200 rooms, which are occupied 80% of the time during the work week, and you’ve almost completed construction of a new wing with another 75.

One day, a competitor chain starts to build a 250 room hotel right across the street.  This makes no sense.  There isn’t enough business for two hotels of any type, let alone two targeting exactly the same audience.

When the new hotel is open, occupancy for both you and the other guy will probably max out at 40%–not enough to cover out-of-pocket costs.  Even worse, a price war will inevitably break out as you both vie to capture what traffic there is.

When the competitor realizes he’s made a horrible mistake, his goal shifts from making a profit to extracting as much of his capital from the location as possible.  This is bad.

Even worse (for you and the overall market), suppose you “win” the price war and the other guy goes into bankruptcy.  The physical assets will still be there.  They’ll be sold at auction, probably at a bargain price, to a new competitor who will probably have a lower cost of ownership than you do.

That’s overcapacity.

technological change

I’ll write about the internet in another post.  It’s the mother of all technological change.

The more traditional example of the effects of technological change on an industry is the advent of the electric arc furnace in the steel mini-mill.

Up until the mini-mill, steel had been produced in blast furnace mills.  These plants can cost several billion dollars, take years to build, have mammoth capacity and must run 24 hours a day.  Location is invariably a compromise among access to raw materials and the need to transport end products to many different customers.  None of this mattered, because for a long time it was the only game in town.

Then in the 1980s, a better mousetrap in the form of the electric arc furnace came along.  A plant cost about 20% of what a blast furnace did and used cheaper inputs and labor.  It could be located closer to a customer, lowering transportation costs.  And it didn’t need to run continuously.  It very quickly took a third of the steel market in the US away from the blast furnaces.

The advent of the mini-mill caused a twenty-year slump in the traditional steel industry, one it only came out of at the beginning of the new century.

More tomorrow.

How expensive is US housing?

residential real estate

Many observers (including myself) think that the housing market in the US began to bottom a little more than a year ago, as savvy property buyers began to return to key markets to pick up prime properties at prices they (correctly) thought would not go much lower.

Soon after midyear, overall housing-related indices began to bottom and then to rise.

Recently, signs of stabilization have emerged even in the worst-hit markets, like Miami, which suffered from wild speculation, massive overbuilding and heavy reliance on large multi-unit residential structures.  (In south Florida, unlike the case in most of the US, projects take longer to complete and when they’re done you don’t just have one unsalable detached house. You have maybe 100 unsalable condominium units.)

Despite all this good news, the question still arises whether this is simply an elaborate technical movement–sidewise price action based mostly on the market needing time to absorb the stunning depth of the declines of the past three years, but to be followed again by another fall off the table.

the Economist analysis

In a recent issue, the Economist observes these phenomena and addresses the valuation question.  For a variety of countries, it calculates the historical relationship between rental income and house prices.  It then uses this figure to figure what home prices should be, given today’s rents.  The results?

the US

1.  For the US, the magazine does three calculations.

Using the Case-Shiller ten-city index, house prices are 3.9% overvalued.

On on the Case-Shiller national index, house prices are 3.7% undervalued.

Taking the Federal Housing Finance Agency index, which eliminates anything financed with a sub-prime loan–in other words, is really biased to the upside–house prices are 13.1% overvalued.

If this simple measurement is close to correct, then the US housing market is on relatively firm footing.  It may not go up, but the floor is unlikely to disappear from beneath us.

undervalued markets

2.  Other fairly-/undervalued markets?

Japan, 33.7% undervalued

Germany, 14.6% undervalued

Switzerland, 7.1% undervalued

China, 2.7% overvalued.

I’m not sure where the data come for China.  This certainly cuts against the conventional wisdom, though, and lines up with the brave few who are arguing that the rise in property prices in the Middle Kingdom are just keeping pace with its rip-roaring economic growth.

overvalued markets

3.  Overvalued markets?

Australia,  56.1% overvalued

Spain,  53.4% overvalued

Hong Kong,  49.1% overvalued

France, Sweden, Britain and Belgium, all 30%+ overvalued.

Of  these, prices in Hong Kong, Australia, Britain and Sweden are rising.

what to make of this

The US, the first place where housing troubles emerged, appears to be most of the way back out of the woods.  This doesn’t mean that prices will be going back up much from here.  Who knows?  But it suggests that housing is not going to provide more negative economic surprises.

The undervalued markets are by and large in moribund economies.  China is an outlier.  It’s hard to know what to say about it.

The overvalued markets are split between fast-growing areas in the Pacific and the euro-zone.  Sounds like more potential trouble brewing in Euroland–as if they needed more.