Running It into the Ground
Aerospace companies with aging assets
We are all for frugality. However, while skimping on capital investment may help boost profits in the short run, it can lead to big operating problems down the road. During Covid, many companies understandably slashed their capital spending budgets given the uncertainty facing them at the time. However, we have noticed that many have yet to rebuild their capital budgets to pre-Covid levels. This can provide an earnings boost in the short run as depreciation flatlines or even falls when older assets become fully depreciated but are left in service. However, the short-term benefits may be far outweighed by the disadvantages that the company faces when trying to compete with peers who are wielding newer and more efficient plant and equipment. We are seeing many companies with lagging capex now forecasting higher capital spending which will reverse this past tailwind and could catch some investors off guard when rising depreciation becomes a drag on earnings growth.
This prompted us to begin looking at depreciation and capex trends for capital-intensive companies. There are several areas analysts should be monitoring for signs of depressed deprecation expense. As with all earnings quality analysis tools, no one ratio tells the whole story. Rather, they must be interpreted in light of multiple capital-related items, company-specific issues, and industry trends. Here are several things to keep in mind when assessing a company’s deprecation numbers:
Depreciation expense as a percentage of gross property, plant, and equipment
A declining trend could indicate the company has lengthened the estimated useful lives over which it is depreciating its assets
Also, a declining deprecation expense could indicate that some assets have become fully depreciated but are still in service at an advanced age
This figure should be compared to peers. An unusually low number is a sign the company is utilizing longer depreciable lives which is resulting in artificially inflated earnings
Capital spending versus depreciation
A sustained decline in capital spending or capital spending that consistently lags depreciation is a warning sign of insufficient investment in capital equipment.
Depreciation expense that consistently falls below capital spending could be a sign of an unrealistic depreciation policy
Depreciable lives
The schedule of depreciable lives utilized to depreciate each type of equipment is typically presented in the 10-K.
A shorter useful life results in higher depreciation expense. It also means the asset must be replaced more quickly or the company may find itself behind technologically compared to peers. Computers and software are typically depreciated over 3-5 years. Companies using a 10-year period are likely underreporting depreciation. Likewise, a company depreciating its machinery over 20 years is underreporting depreciation when its peers all utilize 7-10 years.
It is important to compare the average age of equipment to the depreciation schedule. Consider a company that depreciates computers over 3-5 years and equipment over 5-12 years and those two asset groups comprise 75% of PP&E. If the average age of the company’s total PP&E is 15, then it clearly has a large amount of fully-depreciated assets in service that may be obsolete.
Any announcement of extending depreciable lives should be viewed with skepticism, especially if the company was already near the high-end compared to its peers.
Depreciation method
Most companies depreciate assets using the straight-line method which pro-rates depreciation evenly over the estimated life of the asset.
However, some companies may utilize accelerated depreciation methods where a larger percentage of an asset’s cost is recognized upfront. These companies will experience higher depreciation and lower earnings earlier in their capital investment cycles relative to their peers.
This disadvantage will reverse over time as these assets become fully deprecated earlier.
The average age of equipment
An estimate of the average age of a company’s equipment can be determined by dividing accumulated depreciation by the current year’s depreciation expense.
A noticeably rising age is a sign that the company may be underspending on new capital equipment.
This figure should also be compared to peers for evidence the company is competing with outdated equipment which may lead to rising expenses
History of acquisitions
The property, plant, and equipment balance must be viewed not only relative to the company’s capital spending activity but also its acquisition history.
Analysts should look at past deals to see how much of the acquisition price was allocated to PP&E and how much was allocated to goodwill and intangibles.
If possible, compare the depreciation policy of the company being acquired to that of the acquiring company.
Salvage Value
Let’s go through a simplistic example of how depreciation expense can be significantly impacted by just a slight change in salvage value and estimated useful lives. For this exercise, we will assume the straight-line depreciation method, which calculates depreciation expense by spreading the cost of the fixed asset evenly over the life of the asset. A maintenance truck is purchased by XYZ Company for $60,000 and the original expected life is 10 years with no salvage value. We calculate the annual depreciation expense for this asset using the equation:
(Cost – Salvage Value) / Estimated Useful Life
For our example, this works to = $6,000 ($60,000 - $0 / 10). Thus, XYZ Company would expense $6,000 each year for 10 years. At the end of 10 years, the book value of the truck would be zero.
Now, let’s suppose that the company quickly revises its depreciation policy following this purchase and decides to depreciate the vehicle over 12 years and assumes a salvage value of $6,000 at the end of the period. Using the same equation, we get:
($60,000 - $6,000) / 12 = $4,500
In this scenario, XYZ would expense just $4,500 each year for 12 years. At the end of 12 years, the book value of the truck would be $6,000. As a result, XYZ can lower its annual depreciation expense for its truck by $1,500, or 25%, over the first 10 years by making this subtle depreciation policy change.
The Aerospace Industry
As always, we believe it is informative to make such comparisons by industry and highlight the outliers. For this report, we examined the Aerospace industry and highlighted three companies that we believe have underinvested in recent years. While they have enjoyed flat or declining depreciation expense, they are now at risk of earnings growth being depressed as depreciation now rises from an inevitable ramp-up in capital spending. In addition, we also give an example of a company that has been more consistent in its spending trends, has a low average age of equipment, and could enjoy an earnings tailwind from moderating depreciation expense relative to peers.
.Let’s get behind the numbers…