You’re Only as Good as Your Tools
Depreciation-related risks for machinery and equipment makers
In our last report, Running It into the Ground, we discussed how Aerospace and Defense companies using older equipment were enjoying an earnings boost from lower depreciation which will give way as the companies are forced to boost their capital spending back to historical levels. This piece will examine the same theme for companies that make industrial machinery and parts.
ITT Inc. (ITT) is a good example. 22% of its sales are generated from products utilized in harsh and demanding applications for aerospace and defense. The average age of its PP&E is 14.8 years which is up from 11.8 years in 2018.
Machinery and Equipment are 73% of the gross PP&E and are depreciated over 2-10 years. The problem is that based on gross machinery and equipment assets using ITT’s maximum life of 10 years indicates that depreciation for just machinery would be $137.8 million per year. However, ITT only reported $84 million in total depreciation in 2023. This tells us that ITT is clearly using some much older assets that are fully depreciated. The 10-K even states that fully depreciated assets are in its PP&E table.
Capital spending only recently started to exceed depreciation and ITT was spending more in 2017 on capital equipment than it is now. Each unit likely costs more now than in 2017 so the investment isn’t going as far.
If we use the maximum depreciable life on all of ITT’s fixed assets, depreciation would have been $157.3 million last year. That is $73.1 million above what it reported, and it amounts to 70 cents in EPS vs the adjusted EPS of $5.21 it reported.
It would take years of much higher capital spending to update all the equipment and would push depreciation higher the whole time creating a significant headwind to EPS growth.
The wide range of equipment ages, depreciation policies, and level of capital spending make this topic particularly relevant to the industrial machinery group. Consider that:
The average capital spending for this group is 2.6% of sales but many fall below that level
The typical average age of equipment for companies in the group is 9-11 years, but some are using equipment that is older than 14 years
Some of these use much longer depreciation lives than their peers
All of this creates a situation where the profitability and earnings of certain companies in the group are enjoying an artificial advantage from scrimping on capex and utilizing more aggressive accounting assumptions. However, this benefit will fade as those companies are forced to ramp up capital spending or risk falling behind competitors with younger equipment. Therefore, we believe it is a very worthwhile exercise for investors with interest in this space to identify those companies at risk as well as companies that have kept up with capital spending and utilize more conservative accounting policies.
Companies mentioned in this report include RBC Bearings (RBC), Timken (TKR), Flowserve (FLS), Mueller Industries (MRI), and Otis (OTIS).
If you didn’t see our last report, we recommend you review the introduction (linked above) for a primer discussing factors to consider when analyzing depreciation/capex trends.
Let’s get behind the numbers…