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A perfect example of bad management at work

Dec 15, 2009

Some businesses have all the luck in the world while some others don't. We are referring to a type of classification of businesses. And in this classification, just two categories exist. Capital intensive businesses and non-capital intensive businesses. Now, there is no hard and fast rule that separates the two. At least not to our knowledge. In other words, we cannot draw a line thick enough between the two. So, how do we classify them? As with other things in investing, let us use part art and part science here. Common sense suggests that businesses exist in order to increase their revenues. And how do they increase their revenues? Simple. They do so by building new plants and investing more in working capital.

Well, that nails it then. Capital intensive businesses are those businesses where in order to increase revenues, substantial capital investments need to be made. The other half of the classification answers itself. Non capital intensive businesses would then be those businesses where growth is not as much dependent on capital investments as on other things.

Let us illustrate with examples. Consider the steel industry. It is a highly capital intensive industry in every sense of the word. Leaving realizations aside, if you want to double your revenues, simply pour in more capital and double the capacity. Let us go to the other end of the spectrum. Here, let us take the example of the IT industry. Tomorrow, if Infosys come out with a plan to double its revenues, it simply has to double the headcount and invest a tiny-winy amount as a proportion of its revenues in making a building that could accommodate all the new employees.

Here, the capital investment gone towards the construction of new building has hardly made any dent to the capital structure of Infosys. This is in sharp contrast to the capex incurred during the capacity doubling of the steel company. Thus, it follows from these examples that while the steel company is capital intensive, IT companies like Infosys are not.

Infact, the capital for IT companies and other such companies that rely mostly on intangible assets could be things like human capital and brand equity. And as long as these companies try and preserve the intangible assets, they have an advantage over the capital intensive industries in that they can generate huge amounts of surplus cash.

Thus, the question that arises is what should these companies do with the surplus cash? If it is a sensible management, it could give it all back to shareholders in the form of dividends or some such arrangement.

However, there are some management that find silly reasons to not give it back to shareholders. Instead, they take the excess capital and put it into capital intensive industries. There can't be a worse use of excess profits than this, could there be? And there could never be a better example of bad management at work. For investing in a cash generating machine only to see the cash being evaporated in a capital intensive business is perhaps the most surefire way to get a ticket to the poorhouse.

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1 Responses to "A perfect example of bad management at work"


Dec 15, 2009

there are a few considerations that should weigh on managements when making capital allocation and capital enhancement decisions
- the cost of (incremental) capital vs. the (incremental) return on (incremental) capital employed. If this is negative, this leads to negative "value added"
- the gestation period of capital employed - some projects take a long time to start giving returns, even if the projected returns are excellent

In your example (of an IT company), ahidden factor is the time it takes to make the new employees productive. With a huge scarcity of good IT people, IT companies hire (good) people from any discipline and then spend considerable time and energy in training them, so even in their case, the returns are not really immediate, even if the incremental capital is (as you say) small.

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