04-22-2014, 08:11 AM
(This post was last modified: 04-24-2014, 09:23 AM by Dividend Watcher.)
I'm glad some of you got something out of it. I have to add that I'm not a CPA nor a tax expert. All I know is self-taught with lots of reading and testing of the numbers. Actually, the more I re-read what I wrote, the more I could expound on what I had written and hoped it wasn't too simplified to explain what I was trying to say. That being said, let's see if I can explain your further questions:
First off, they (or any capital items) are usually placed in service and depreciated over a staggered time frame. Using the FedEx example, if they needed 1,000 trucks, they might purchase 100 every few months. This can spread out the cash outlay over several years and when the oldest are worn out, they start over again. This can produce a level and predictable use of capital that management can plan for. Smart management. Remember, these would be expensed using depreciation and, being productive assets, provide a steady stream of income greater than the depreciation expense covering those costs (cash or non-cash).
No, I can't explain your perception nor have I analyzed pipeline companies in particular nor the majors in such detail. Probably the pipeline depreciation is also including things like site prep, permitting & approval costs, site-specific insurance above general business insurance, etc. These are all things generally required to be amortized (depreciated) along with the actual costs of a physical asset.
Since I brought up a new term, I probably should explain it. Amortization is the proper term to use when depreciating non-tangible assets; patents, intellectualy property, digging the trenches for the pipe (afterall, once the pipe is buried, where is the hole?), etc. Depreciation is generally reserved for tangible items; trucks, factories, office furniture, etc. They are generally treated the same way as far as financial statements are concerned though each may have their own line item.
So, it may not be "excessive". The IRS and the SEC frown upon using depreciation/amortization that isn't justified. That's called cooking the books.
CFO and FCF are important. They can tell you whether there is enough cash to cover the dividend today. Keep in mind, though, that as Buffet said, those depreciation costs represent real money whether it's cash spent today or a couple years ago. They may have to spend it again.
You are generally correct in your first sentence. I don't know where you're hearing all these reports of earnings off because of one-time capex, I hardly ever hear it. If it's 'talking heads', consider it bullsh*t or else management is trying to cover their a$$ for gross mismanagement. There are exceptions but it's few and far between in larger corporations.
There is a section of the tax law that allows you to deduct most or all of the allowable depreciation in the year it is placed in service. Section 179 of the tax code addresses this. I hardly ever hear large corporations taking advantage of it except for small capital purchases. The office furniture is an example. Large corporations have other ways to manage capex and depreciation that are much more flexible. Small businesses often use it extensively -- especially those that replace things like computers regularly -- or want to shield a particularly good income year to lower their tax bracket.
For things like lawsuits, they are generally "reserved" over the period of time the lawsuit is going on (this can be years) and at the amount that managment and their lawyers estimate it's going to cost them. They add some every quarter to lessen the blow or all at once. This is how management can "manage the earnings" and also applies to depreciation. So, in essence it's expensed over time. Dig into BP's financials and you'll find this information.
Using my formulas above (since it's easiest to follow that way), liabilities are increased in a separate account. To keep the equation in balance, either assets have to go up or equity goes down. We know assets didn't go up (they're being sued) so equity had to go down. Using my relation of profits=equity to tie them together, then expenses had to go up for equity to go down. Using $1000 for the lawsuit as an example:
Assets (same) = Liabilities (up $1000) + Equity (down $1000)
Profits (down $1000) = Income (same) - Expenses (up $1000)
They may do this every quarter for several years
As for CVA, repairs are expensed when incurred. Upgrades are capitalized.
It wouldn't show up in earnings until the factory was placed in service. During the construction phase, costs actually paid may be placed in an asset reserve account. Once it is placed in service, all the associated costs are totaled up and placed in the asset list. There is no appraisal. You can only deduct actual costs which can include a lot beside building materials just as in the pipeline I mentioned above. Then it's depreciated over its useful life.
No, if you add back depreciation, you'll have a good idea what cash management has available to pay the dividend. EBITDA includes (correction: EXcludes - before) taxes which is a cash expense so I wouldn't ignore that. When you bring debt into the equation, you've now changed what we're talking about. Debt is a separate issue from the depreciation.
The principal part of the debt payments is a Balance Sheet transaction only. You're taking your cash (asset) to pay the bank or bondholder loan principal. This lowers your liability (loan balance) and increasing your equity (you now own a bigger portion of your asset). Interest on the debt is deductible when paid. Both P&I are cash transactions but have nothing to do with depreciation and the book value of your asset. You need to keep the two separate in your accounting mind.
Now, if you need that loan to purchase that asset, smart management will structure the debt to approximate the useful life of the asset. This way, when the asset is worn out and you want to get rid of it, the loan is paid off and you can sell it outright. If you still need that truck, wash, rinse and repeat the whole process. REITs are pretty transparent about trying to do this.
Don't base your investment decisions solely on EV:EBITDA. You're ignoring a big part of what management uses to engineer their financial position. It's a nice benchmark to add to the analysis but isn't a full picture of the business just as P/E, FCF and debt/equity don't tell the whole picture.
Am I forgetting anything? Yeah, lots. Hope this gives you a little more understanding.
(04-21-2014, 08:21 PM)Concasto Wrote: Depreciation may be a non-cash cost at the time earnings are reported, but if an entire fleet of trucks is wearing out, that non-cash cost turns into a real one(as they have to replace the trucks), so its good that the accounting takes this into consideration along the way.
First off, they (or any capital items) are usually placed in service and depreciated over a staggered time frame. Using the FedEx example, if they needed 1,000 trucks, they might purchase 100 every few months. This can spread out the cash outlay over several years and when the oldest are worn out, they start over again. This can produce a level and predictable use of capital that management can plan for. Smart management. Remember, these would be expensed using depreciation and, being productive assets, provide a steady stream of income greater than the depreciation expense covering those costs (cash or non-cash).
(04-21-2014, 08:21 PM)Concasto Wrote: I am not expert, but pipelines seems to be allowed excessive depreciation on their assets. DW, can you comment?
No, I can't explain your perception nor have I analyzed pipeline companies in particular nor the majors in such detail. Probably the pipeline depreciation is also including things like site prep, permitting & approval costs, site-specific insurance above general business insurance, etc. These are all things generally required to be amortized (depreciated) along with the actual costs of a physical asset.
Since I brought up a new term, I probably should explain it. Amortization is the proper term to use when depreciating non-tangible assets; patents, intellectualy property, digging the trenches for the pipe (afterall, once the pipe is buried, where is the hole?), etc. Depreciation is generally reserved for tangible items; trucks, factories, office furniture, etc. They are generally treated the same way as far as financial statements are concerned though each may have their own line item.
So, it may not be "excessive". The IRS and the SEC frown upon using depreciation/amortization that isn't justified. That's called cooking the books.
(04-21-2014, 08:21 PM)Concasto Wrote: I am a fan cash flow from operations and free cash flow, which is the cash flow from operations minus the capital expenditures. Unfortunately all these metrics have hundreds of possible variables, so listening to conference calls and going over company presentations and of course watching dividend growth are all important.
CFO and FCF are important. They can tell you whether there is enough cash to cover the dividend today. Keep in mind, though, that as Buffet said, those depreciation costs represent real money whether it's cash spent today or a couple years ago. They may have to spend it again.
(04-21-2014, 09:31 PM)earthtodan Wrote: So to pull the main point that addresses my confusion, the purchase of a new fleet would not be counted against earnings for the quarter in which it was purchased? That's surprising because I keep hearing about EPS figures being thrown off by one-time capex. But it sounds like what you're saying is that only the balance sheet gets affected by a large expenditure, regardless of whether it's purchased with cash or debt.
You are generally correct in your first sentence. I don't know where you're hearing all these reports of earnings off because of one-time capex, I hardly ever hear it. If it's 'talking heads', consider it bullsh*t or else management is trying to cover their a$$ for gross mismanagement. There are exceptions but it's few and far between in larger corporations.
There is a section of the tax law that allows you to deduct most or all of the allowable depreciation in the year it is placed in service. Section 179 of the tax code addresses this. I hardly ever hear large corporations taking advantage of it except for small capital purchases. The office furniture is an example. Large corporations have other ways to manage capex and depreciation that are much more flexible. Small businesses often use it extensively -- especially those that replace things like computers regularly -- or want to shield a particularly good income year to lower their tax bracket.
(04-21-2014, 09:31 PM)earthtodan Wrote: I guess not all capex is spent on assets that depreciate. When SBUX had to pay a big legal settlement, or when CVA had to pay for unplanned repairs to a waste-to-energy facility, they didn't get anything for their money, and it couldn't be counted as depreciation in the future, so it had to be recognized immediately?
For things like lawsuits, they are generally "reserved" over the period of time the lawsuit is going on (this can be years) and at the amount that managment and their lawyers estimate it's going to cost them. They add some every quarter to lessen the blow or all at once. This is how management can "manage the earnings" and also applies to depreciation. So, in essence it's expensed over time. Dig into BP's financials and you'll find this information.
Using my formulas above (since it's easiest to follow that way), liabilities are increased in a separate account. To keep the equation in balance, either assets have to go up or equity goes down. We know assets didn't go up (they're being sued) so equity had to go down. Using my relation of profits=equity to tie them together, then expenses had to go up for equity to go down. Using $1000 for the lawsuit as an example:
Assets (same) = Liabilities (up $1000) + Equity (down $1000)
Profits (down $1000) = Income (same) - Expenses (up $1000)
They may do this every quarter for several years
As for CVA, repairs are expensed when incurred. Upgrades are capitalized.
(04-21-2014, 09:31 PM)earthtodan Wrote: If say, BA hadn't signed a contract with the union in Washington and had built a new factory in Missouri instead, when would the cost of building the factory show up in earnings? Would it not show up in the earnings statements until it was finished, appraised, and started depreciating?
It wouldn't show up in earnings until the factory was placed in service. During the construction phase, costs actually paid may be placed in an asset reserve account. Once it is placed in service, all the associated costs are totaled up and placed in the asset list. There is no appraisal. You can only deduct actual costs which can include a lot beside building materials just as in the pipeline I mentioned above. Then it's depreciated over its useful life.
(04-21-2014, 09:31 PM)earthtodan Wrote: KMI declared a $0.42 dividend on $0.28 EPS, but from $0.55 of FCF available for distribution. If I look at FCF, it's well covered, but if I decide to ignore EBITDA and count depreciation as a real cost, then I should button my wallet, I'm told. However, then I feel like I'm counting the cost of pipelines twice, through depreciation (non-cash) and interest on debt (cash).
No, if you add back depreciation, you'll have a good idea what cash management has available to pay the dividend. EBITDA includes (correction: EXcludes - before) taxes which is a cash expense so I wouldn't ignore that. When you bring debt into the equation, you've now changed what we're talking about. Debt is a separate issue from the depreciation.
The principal part of the debt payments is a Balance Sheet transaction only. You're taking your cash (asset) to pay the bank or bondholder loan principal. This lowers your liability (loan balance) and increasing your equity (you now own a bigger portion of your asset). Interest on the debt is deductible when paid. Both P&I are cash transactions but have nothing to do with depreciation and the book value of your asset. You need to keep the two separate in your accounting mind.
Now, if you need that loan to purchase that asset, smart management will structure the debt to approximate the useful life of the asset. This way, when the asset is worn out and you want to get rid of it, the loan is paid off and you can sell it outright. If you still need that truck, wash, rinse and repeat the whole process. REITs are pretty transparent about trying to do this.
(04-21-2014, 09:31 PM)earthtodan Wrote: The question is relevant to offshore drillers because they have large fleets paid for with debt, and not all the same age. SDRL has levered up to buy a large fleet of $600m+ drillships, and therefore surely has a high non-cash depreciation expense. The depreciation expense would not be the same for all drillers. Diamond Offshore (DO) has the oldest fleet in the industry (and the lowest leverage), and therefore should have a lower depreciation expense. According to Finviz, SDRL is cheaper on a P/E basis than DO. However, I'm guessing that on an EBITDA basis SDRL might actually be more expensive than DO. A comparison of EV:EBITDA on Seeking Alpha strongly confirms this theory.
Don't base your investment decisions solely on EV:EBITDA. You're ignoring a big part of what management uses to engineer their financial position. It's a nice benchmark to add to the analysis but isn't a full picture of the business just as P/E, FCF and debt/equity don't tell the whole picture.
Am I forgetting anything? Yeah, lots. Hope this gives you a little more understanding.
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“While the dividend itself is merely a rearrangement of equity, over time it's more like owning an apple tree. The tree grows the apples back again and again and again, and the theoretical value of the tree doesn't change just because of when the apples are about to fall.” - earthtodan
“While the dividend itself is merely a rearrangement of equity, over time it's more like owning an apple tree. The tree grows the apples back again and again and again, and the theoretical value of the tree doesn't change just because of when the apples are about to fall.” - earthtodan