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.

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.