The Over the Hill Gang
Building products companies that are still utilizing older PP&E
The analysis of any industrial company should include an assessment of the age of the company’s PP&E base. We often come across companies that are delaying refreshing their equipment, as evidenced by lagging capital expenditures, an unusually high and rising average age of PP&E, and depreciation expense that is lower than what it should be given the company’s accounting assumptions. While keeping older machines working past their prime may temporarily inflate a company’s free cash flow and earnings, the company will inevitably have to upgrade its equipment or risk sacrificing profitability due to obsolete equipment and excessive downtime, When the upgrade begins, both capex and depreciation will begin to jump which may not be anticipated by the market.
Below we will examine what to look for when evaluating a company’s equipment base before giving examples of five companies that appear to be on the brink of seeing the financial reporting benefits from using older equipment reverse.
Calculating average age
The average age of a company’s PP&E can be estimated by dividing accumulated depreciation by depreciation expense. One or both of these components are often only reported on an annual basis in the 10-K although some companies may report them quarterly. Another potential complication that can arise when calculating average age is that some companies do not break out depreciation expense separately in the 10-K. In these cases, we estimate deprecation expense by subtracting the amortization of intangible assets from the depreciation and amortization figure disclosed on the cash flow statement.
Analysts should note the trend in average age as well as how it compares to similar companies in the industry. Also, recent large acquisitions should be taken into account as they can skew the company’s average age if the PP&E booked in the deal is significantly older or newer than that of the acquiring company.
Table 1 below shows Allegion’s (ALLE) average age over the last five years:
Unexpectedly low depreciation expense
We often see companies whose depreciation expense figures do not match what we would expect given the assumptions the company utilizes in calculating depreciation. For example, consider Allegion’s (ALLE) disclosure of the breakdown of its PP&E in its 10-K filing:
Also, consider the company’s estimated useful lives it uses for each property type also disclosed in the 10-K:
There are several things to note from the above. First, ALLE’s estimated useful lives are on the high end of the industry group which is a potential indication of understated depreciation expense right off the bat.
Second, from the above information, we can calculate that the average age of the company’s PP&E base is 12.5 years. However, Machinery and Equipment comprises 50% of the asset base and has an average estimated useful life of 7 years. This alone is an indication that a sizeable part of the company’s equipment base is fully depreciated and deserves further attention. Table 2 below shows ALLE’s annual depreciation expense for the last six fiscal years:
We know from Table 1 that gross PP&E has been rising from $749 million to $961 million. But the table above shows that depreciation expense is basically flat despite a larger asset base.
Where is the missing depreciation expense?
A closer look at the above disclosure also shows that if the entire gross software balance of $183.8 million was being depreciated over the high end of its range of estimated useful life of 7 years (an unusually high level) then just Software would be generating depreciation expense of over $26 million. However, the above disclosure tells us that Software generated only $12.9 million in depreciation last year. This is a dead giveaway that a sizeable portion of the company’s software is still in service but has no depreciation expense being recorded against it. This spread alone is worth 13 cps in EPS annually.
Buildings and Improvements should be a small part of depreciation – over 40 years it would be only $4.6 million. Five years +/- is only a $0.5 million change for that. We know the total depreciation was $47.3 milion. Less $12.9 million for software and $4.6 million for buildings – the plug figure for machinery & equipment is $29.8 million. That would indicate a 16.4-year age for machinery & equipment. With ALLE saying the useful life is 2-12 years, that is another indication that some of those assets are fully depreciated.
Finally, if Machinery and Equipment was being depreciated over an average of 10 years, it should generate $48.9 million in annual depreciation expense. That is $19.1 million higher than the depreciation being recorded. This difference amounts to as much as another 19 cps in annual EPS. If you want to estimate some of the buildings and improvements are fully depreciated, then additional depreciation would be part of machinery. Don’t get too focused on every last penny.
ALLE generates almost $7 in annual EPS, so it is not as if the roughly 30 cps benefit from using older equipment makes its profits disappear. However, capital spending is already starting to increase which will eventually result in an acceleration in depreciation expense which could be a meaningful drag on the company’s earnigns growth in the future. New software could turn this from an EPS driver to an EPS drag very quickly.
We will dig further into ALLE’s numbers below along with four other companies we believe are getting a meaningful boost from using fully depreciated equipment.
Let’s get behind the numbers…