Capital Allocation – Why it matters?
There are a number of frameworks one can use for shortlisting and selecting companies for investments. One such framework is to see how the company allocates capital over a period of time. The cash flow generated can be used in multiple ways namely:
- Dividends or Buyback
- Investing in the current business
- Investing in a new line of business
- Cash hoarding
How a company allocates capital is extremely important. As Buffett said – “After ten years in the job, a CEO whose company retains earnings equal to 10% of net worth, will have been responsible for the deployment of more than 60% of all capital at work in the business.”
The value of a company is essentially the discounted value of future cash flows and the terminal value. The capital allocation has immense bearing on both. For example, a company growing at 25% and trading at a P/E of 20 will have 30% of its value coming from Cash Flows of next 5 year (assuming net profit = cash flow, Cost of capital = 10%). The remaining 70% value is the NPV of cash flows after 5 years and the terminal value. As the P/E ratio increases, the market-implied value for far out cash flows and terminal value increases substantially. At a 50 P/E, NPV of cash flows after 5 years and terminal value is as high as 88%. Growth and good capital allocation is valued very highly by the market.
ITC is often sighted as an example of a company, which takes cash flow from a high RoCE business (Cigarettes) and keeps investing that capital in relatively poor RoCE businesses (Hotels and Packaging). It has also invested in the FMCG business (which usually is a high RoCE) but so far ITC has not been able to achieve industry level profitability on that.
|2019 / Rs Cr||Sales||EBIT||Capital Emp||RoCE (Pre Tax)|
|Paperboards & Packaging||4,230||1,239||6,205||20.0%|
ITC has generated around Rs. 86,000 cr cash flow from operations since 2010, out of which it’s has invested Rs. 25,000 cr mostly in segments other than cigarettes and paid out Rs. 55,000 cr in dividends (including dividend tax).
There are also numerous examples of PSUs/ State government companies with a dismal record of capital allocation. (But to be fair, I think any investor who expects government owned companies to do right capital allocation has his expectation misplaced).
One way to simplify capital allocation is using the following framework:
|Sales Growth||RoCE||Capital Allocation||Reason|
|High||High||Reinvest||Value creation due to RoCE being higher than cost of capital and investing in growth|
|High||Low||Value destruction||Not earning enough to cover cost of capital so growth destroys value faster|
|Low||High||Payout||High RoCE without growth would not require much capital, hoarding it will lower RoCE and might tempt poor allocation later|
|Low||Low||Payout||Payout to shareholders is better|
Of course, not all growth is equal. Growth in existing line of business is often the best. Growth in complementary/ adjacent line of business comes next. The base rate of success in growth in totally new line of business is very low.
A recent example of how much the market values Capital Allocation is what happened with Endurance Technologies. The stock hit a 20% lower circuit when the company announced that it was looking to setup a Tyre manufacturing unit with Rs. 175 cr investment. The company does Rs. 500 cr of annual net profit so it would not have been a major investment for them but the market reaction reduced more than Rs. 2000 cr off the market cap. Next day, the company shelved its plans to get into Tyre manufacturing.
We have seen two companies, where the capital allocation framework seems interesting. (This is not an investment recommendation. Capital allocation is only one framework and there are many other factors, which go into making an investment decision). The purpose of writing about these companies is to highlight the capital allocation framework in particular.
Gujarat Ambuja Exports Limited (GAEL)
GAEL is involved in Agro-processing (Soya and Maize derivatives) and it also has a legacy Cotton Yarn division.
In the last 9 years (2010 – 2019), the company has generated about Rs. 1800 cr of cash. Let’s quickly go through the business segments of GAEL before we go further. The company has 3 segments:
- Agro processing – They mainly process soyabeans and it’s a commodity business. They are among the companies with largest crushing capacities in India. Margins (operating margins range from 0 – 5%) are higly volatile in this segment (dependent on many factors like international soya oil prices, feed prices, currency etc.)
- Maize processing – They process mazie into starch and other value added derivatives. Mostly stable margins (last 10 years operating margins have ranged between 9-15%)
- Cotton Yarn – They have an old cotton yarn unit. Volatile margins – mostly loss making.
Now coming to capital allocation. Out of the Rs. 1800 cr generated in last 9 years, the company has invested about Rs. 1000 cr in fixed assets. More than 90% of this is towards the Maize processing segment, which has relatively better and stable margins and a ROCE > 20%.
Another Rs. 225 cr was used in share buyback (@ 95/ share) in 2016-17. (Out of the two brothers in the promoter family, one brother sold his stake back to the company in this buyback).
In 2008, the agro segment had an EBIT of Rs. 125 cr and the maize business was very small with just Rs. 133 cr sales and Rs. 12 cr EBIT. In 2019, the maize processing segment had sales of Rs. 1900 cr and EBIT of Rs. 250 cr. From a less than 3% market share (in 2007) in maize processing, GAEL today has over 25% market share. They are the market leader by a wide margin and all this was achieved by deploying all the capital towards the better business over the last 10 years.
HIL Ltd (estwhile Hyderabad Industries)
HIL Ltd is one of the largest company in building products space. The business segments are
- Roofing products (asbestos and non asbestos roofing sheets and steel sheets)
- Building products (Dry/Wet walling products and Thermal Insulation materials)
- Polymer products (CPVC and UPVC pipes and Wall Putty)
- Flooring products (Parador – German company they recently accquired)
Historically (say 7-8 years back), the company was only in Roofing products. They had sales of Rs. 800-1000 cr and generated Rs. 50-100 cr cash from this business. Over the past 5 – 6 years, the company has used the cash generated from the Roofing business to build its polymer and building product business. While the roofing products business is a stagnant business (also has a regulatory tail risk due to use of asbestos) with not much growth and throws annual cash, the polymer product business has a long growth runway with better margins and RoCE.
Also last year, the company accquired Parador – it is a German company which designs and manufacturers floorings. To finance this acquisition, they have taken debt both at Parador and at HIL level. They plan to repay the debt in HIL from the cash flows of the roofing products business.
So here we have 2 examples – in the first one (GAEL) the company has successfully build a leadership in a better business from the cashflows of a relatively inferior business and the second one (HIL) where the company is using the cash flows from a stagnant business to build and scale up segments where they see long term growth.
Disclosure / Disclaimer: The post is for information purpose only and not to be construed as an investment advice. The author or his clients may have financial interest in the companies mentioned. Please consult your financial advisor before acting on any of it.
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