Run down on 'capex-led' growth! - Views on News from Equitymaster

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Run down on 'capex-led' growth!

Aug 24, 2006

Abundant cash flows, burgeoning demand for products, need for economies of scale and easy availability of capital, prompted Indian corporates to go on a capex binge over the last couple of years. Resultantly, we found many companies including 'capex-led growth' to their statements of intent and growth plans. In fact, this was also used as a pretext for lack of accretion to margins or as ballpark signs of future visibility. So far...
The turnaround in corporate investment, which began in FY03, peaked in FY06 and if the Reserve Bank of India (RBI) projections are to be believed, will sustain in the current fiscal. The total project cost as well as the average cost of projects was significantly higher in FY06 as compared to the previous fiscal - reflecting increased investment opportunities. The sharp increase in production of capital goods, import of capital goods and other non-oil imports, improved corporate profitability and robust GDP growth in manufacturing over the quarters of FY06 continued the momentum in fixed capital investment.

Not to be left behind, the aggregate capital expenditure of services industry also multiplied by nearly 3 times due to the initiation of large projects pertaining to airlines, shipping and entertainment industries. Improved capacity utilisation and conducive investment climate (backed by adequate liquidity) accelerated capital spending, particularly in industries such as infrastructure, construction, textiles and iron & steel. It may also be noteworthy to point out that while investments in greenfield projects grew by 102% YoY in FY06, growth in brownfield projects was a mere 7% YoY. It thus reveals the mindset of companies to explore opportunities in new areas and capitalise on the prospects lying therein.

Escalating capex…
  FY05 FY06
  No. of Project cost No. of Project cost
  projects Rs bn % of total capex projects Rs bn % of total capex
Greenfield projects 343 395 42.1 396 796 59.3
Brownfield projects 285 456 48.5 364 486 36.2
Modernisation 45 633 6.7 15 9 0.7
Total 673 1,484 97.3 775 1,291 96.2
Source: RBI Bulletin August 2006

Where to spot it?
For investors, the easiest way to reckon how much a company had incurred on capital spending during the fiscal is to scan a component of its cash flow statement. 'Cash flow from investing activities' lists all the cash used by the company for purchase of assets or investment in subsidiaries and that garnered through the sale of assets. A comparison of the same with the 'cash flow from financing activities' will also enlighten the investor as to whether the capex was funded by additional debt or equity or neither (internal accruals).

How to evaluate it?
Since cash returns on capital spending often do not make an appearance in the company's financials until many years after they are executed, investors often do not get a justification for these outlays - beyond the guidance offered by management. One method that attempts to estimate the 'required level' of capital expenditures over a period - thus asserting by way of hindsight as to what was the 'discretionary' portion of the spending - is the comparison between the growth rate in cost of goods sold (COGS) and the growth rate of capital expenditure. The logic is clear. Absence of any physical measure of output can be matched with a growth in cost of inputs. Also, cost of sales can serve as a proxy because it constitutes all the necessary components needed to capture fluctuating product costs.

It is also pertinent to evaluate the impact of the capex funding on the company's balance sheet and bottomline going forward. While infusion of additional equity will lead to capital dilution, the debt funding must be necessarily accessed at feasible rates. While most textile companies embarked on capex plans over the last couple of years, it was only those, which availed of the benefit of TUF (Technology Upgradation Fund - offering 6% interest subsidy) that have accessed the funds at attractive rates.

What lies ahead?
Going forward, we expect the momentum of capacity expansion (in terms of growth) to get moderated on account of the uncertainties about oil prices and primary commodities prices, which have risen significantly in recent years. Global interest rates have also firmed up along with the rise in domestic interest rates, thus chocking the liquidity flow. Nevertheless, the prevailing interest rates levels being relatively lower than the historical highs - are yet to have an impact on corporate borrowing. While the higher capacities may give Indian corporates the scale required to compete with global peers, investors must keep in mind that the capex must be 'well timed'. Else, overcapacity may adversely impact realisations. Not to mention the execution risks involved!

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