Change in NWC & CapEx Assumptions

Currently at a MM IB and is doing interview with a MM PE. Received a case study with a CIM to build out a LBO model.

In the CIM, there is no CapEx figure shown in the company financials. There is only one balance sheet so I'm only able to calculate the NWC (Current Asset - Current Liability) and not the Change in NWC given there's only one period shown. Any idea how I should approach the assumptions for Change in NWC & CapEx so I can arrive at FCF? Thanks.    

Comments (8)

 
Oct 15, 2020 - 6:56pm

A few ideas.

1) What do your growth assumptions assume. I don't know the industry, but if its industrials for example you likely need to spend to grow. 

2) Do like you would if you are building an LBO model for a public company you cover, use research. As the company in the CIP likely doesn't have research pick five close comps (as pure play as possible) and put together a benchmark of what CapEx / NWC capital should be in periods moving forward.

3) Because you have historical current assets / current liabilities (at least for one period) assume that they just stay at a constant % of revenue. Change in NWC is typically relatively immaterial unless you have massive prepayments for some reason (you sell all your software in year 1 for 5 years and collect for the 5 years up front.. etc.)

4) Do something that makes sense and that you can easily justify that fits your overall thesis and story and you will be just fine. 

 

Remember that CapEx is very dependent on industry and how much in fixed permanent assets you need to grow. Zoom for example is going to have a lot of future CapEx not only tied to building out infrastructure, but opening more offices so that they can step up the pace on hiring very high quality talent diversified around the world like you need for a company that is trying to hit their targeted scale.

Net Working Capital adjustments at the end of the day are just there to true up cash flows and are tied to your ability to collect up front, collect cash rapidly (low accounts receivable), and delaying paying distributors (or conversely needing to pay-up front as a company itself).

 
Oct 17, 2020 - 9:32am

EnterpriseSoftwareLBO

 

 

Remember that CapEx is very dependent on industry and how much in fixed permanent assets you need to grow. Zoom for example is going to have a lot of future CapEx not only tied to building out infrastructure, but opening more offices so that they can step up the pace on hiring very high quality talent diversified around the world like you need for a company that is trying to hit their targeted scale.

I don't know anything about Zoom but I'd say tech is a terrible example of an industry that requires a lot of capex. R&D, their main "capex" driver, is actually expensed. And you think they are buying all their offices? No, they are renting them. Sure there are leasehold improvements that get capitalized but those are pretty minor.

Capex-heavy industries are ones that need to build infrastructure, plants, etc. Think heavy manufacturing, pipelines, railroads, etc...a few extra office chairs and computers is not going to be a big investment.

 

That said - the accounting treatment of R&D is something that needs to be separated from its essence. You do have to think of it as if it is capex, not a fixed operating expense. A portion of that R&D is maintenance and a portion is growth.

 
  • Analyst 2 in IB - Ind
Oct 17, 2020 - 11:42am

Good post, but one correction; a range of tech companies esp. in the software space capitalize R&D (e.g. 50%); not everything is expensed...

 

 
Oct 17, 2020 - 3:45pm

I surrender. And thank you bringing this up. It is what makes the forums great. Pushing back on people. What was clear in my though process was not clear in my answer.

Notice I never said anything about S&M, R&D, or G&A. I was more attempting to convey that even in an industry like cloud software where there is "zero marginal cost (more like 10 - 25%)" and most expenses are recognized before the line there is still CapEx (more details below). However, the CapEx matches your industry. Why I started with industrials as my main example. I am a software guy and had just finished watching Zoom's analyst day when they were discussing future growth so it was top of mind. To assume that CapEx is immaterial for any company as a general rule of thumb is a mistake.

Also I agree with the point that when looking at the value of a company R&D should often be capitalized. Investments in current periods that will yield greater returns in future periods and should be amortized over its useful life. Damodaran has a great discussion on this. However, because it is hard to match those two up GAAP calls for expensing most of your R&D spend. 

In terms of capitalizing software, it is governed by two principles: ASC 985

For external delivery, until a technology has reached technological feasibility, all cost incurred up to that point will need to be expensed when incurred

And ASC 350

If a company is developing software internally solely to meet the company's internal needs, then costs can begin to be capitalized once the product has passed its preliminary project stage and into the application development stage

Because of the barrier is so much higher in developing for external use (sold to customers) we often see more of these expenses expensed in R&D at a point-in-time than internal-use software which is typically more generously capitalized. It is a bit of a toss-up but most of the leading public tech companies recognize their expenses this way: MSFT, CRM, WDAY, ORCL etc. Further often what see capitalized in external facing costs are the implementation costs that can be easily analyzed on the time period for which they are to be amortized.

For reference the MD&A from one cloud company relating to their capitalized delivery costs.

We capitalize certain implementation costs incurred in a cloud computing arrangement during the application development stage. Costs incurred in the preliminary stages of development are analogous to research and development activities and are expensed as incurred. The preliminary stage includes activities such as formulation and evaluation of alternatives, determination of existence of needed technology, and final selection of alternatives. Once the application development stage is reached, internal and external costs are capitalized until the hosted software is ready for its intended use. Capitalized implementation costs are recorded as deferred costs, and are included in prepaid expenses and other current assets and other assets, noncurrent in the condensed consolidated balance sheets. Maintenance, minor upgrades, and training costs are expensed as incurred. Capitalized implementation costs are amortized over the term of the hosting arrangement on a straight-line basis, and are recorded under operating expenses in the same line item in the condensed consolidated statements of operations as the expense for fees for the associated hosting arrangement. The capitalized implementation costs were not material during the three months ended April 30, 2020.

However, for sake of discussion as these are not what we would all consider "traditional capital expenditures" and GAAP doesn't always match with Damodaran we will ignore capitalized software for the sake of the below analysis.

 

Turning back to Zoom what my post should have read to be more clear was:

Remember that CapEx is very dependent on industry and how much in fixed permanent assets you need to grow. While Zoom expenses most of their delivery costs, they will have a lot of future CapEx (as compared to their peers) not only tied to building out infrastructure, but opening more offices so that they can step up the pace on hiring very high quality talent diversified around the world like you need for a company that is trying to hit their targeted scale.

Turning to Zoom's MD&A

Future capital requirements will depend on many factors, including our revenue growth rate, subscription renewal activity, billing frequency, the timing and extent of spending to support further sales and marketing and research and development efforts, as well as expenses associated with our international expansion, and the timing and extent of additional capital expenditures to invest in existing and new office spaces

 

Looking ahead, we expect to increase capital expenditures for additional data center infrastructure

To conclude most types of businesses require some form of fixed investment. It may not be as material as an industrial or healthcare firm, but they do need to be examined. Just because I have don't have to build factories or Hospitals doesn't mean the investments into the computers, office space renovations, furniture, displays, kitchens, servers etc. needed to support my growth are free and depreciated over time.

At the end of the day, it still remains a tool to help true up EBIT or Net Income to cash flows.

 

Hopefully that clears my writing up a bit. Thanks for pushing back and calling me out.

 
Oct 19, 2020 - 2:58pm

EnterpriseSoftwareLBO

I surrender. And thank you bringing this up. It is what makes the forums great. Pushing back on people. What was clear in my though process was not clear in my answer.

Notice I never said anything about S&M, R&D, or G&A. I was more attempting to convey that even in an industry like cloud software where there is "zero marginal cost (more like 10 - 25%)" and most expenses are recognized before the line there is still CapEx (more details below). However, the CapEx matches your industry. Why I started with industrials as my main example. I am a software guy and had just finished watching Zoom's analyst day when they were discussing future growth so it was top of mind. To assume that CapEx is immaterial for any company as a general rule of thumb is a mistake.

Also I agree with the point that when looking at the value of a company R&D should often be capitalized. Investments in current periods that will yield greater returns in future periods and should be amortized over its useful life. Damodaran has a great discussion on this. However, because it is hard to match those two up GAAP calls for expensing most of your R&D spend. 

In terms of capitalizing software, it is governed by two principles: ASC 985

For external delivery, until a technology has reached technological feasibility, all cost incurred up to that point will need to be expensed when incurred

And ASC 350

If a company is developing software internally solely to meet the company's internal needs, then costs can begin to be capitalized once the product has passed its preliminary project stage and into the application development stage

Because of the barrier is so much higher in developing for external use (sold to customers) we often see more of these expenses expensed in R&D at a point-in-time than internal-use software which is typically more generously capitalized. It is a bit of a toss-up but most of the leading public tech companies recognize their expenses this way: MSFT, CRM, WDAY, ORCL etc. Further often what see capitalized in external facing costs are the implementation costs that can be easily analyzed on the time period for which they are to be amortized.

For reference the MD&A from one cloud company relating to their capitalized delivery costs.

We capitalize certain implementation costs incurred in a cloud computing arrangement during the application development stage. Costs incurred in the preliminary stages of development are analogous to research and development activities and are expensed as incurred. The preliminary stage includes activities such as formulation and evaluation of alternatives, determination of existence of needed technology, and final selection of alternatives. Once the application development stage is reached, internal and external costs are capitalized until the hosted software is ready for its intended use. Capitalized implementation costs are recorded as deferred costs, and are included in prepaid expenses and other current assets and other assets, noncurrent in the condensed consolidated balance sheets. Maintenance, minor upgrades, and training costs are expensed as incurred. Capitalized implementation costs are amortized over the term of the hosting arrangement on a straight-line basis, and are recorded under operating expenses in the same line item in the condensed consolidated statements of operations as the expense for fees for the associated hosting arrangement. The capitalized implementation costs were not material during the three months ended April 30, 2020.

- expand -

However, for sake of discussion as these are not what we would all consider "traditional capital expenditures" and GAAP doesn't always match with Damodaran we will ignore capitalized software for the sake of the below analysis.

 

Turning back to Zoom what my post should have read to be more clear was:

Remember that CapEx is very dependent on industry and how much in fixed permanent assets you need to grow. While Zoom expenses most of their delivery costs, they will have a lot of future CapEx (as compared to their peers) not only tied to building out infrastructure, but opening more offices so that they can step up the pace on hiring very high quality talent diversified around the world like you need for a company that is trying to hit their targeted scale.

Turning to Zoom's MD&A

Future capital requirements will depend on many factors, including our revenue growth rate, subscription renewal activity, billing frequency, the timing and extent of spending to support further sales and marketing and research and development efforts, as well as expenses associated with our international expansion, and the timing and extent of additional capital expenditures to invest in existing and new office spaces

 

Looking ahead, we expect to increase capital expenditures for additional data center infrastructure

To conclude most types of businesses require some form of fixed investment. It may not be as material as an industrial or healthcare firm, but they do need to be examined. Just because I have don't have to build factories or Hospitals doesn't mean the investments into the computers, office space renovations, furniture, displays, kitchens, servers etc. needed to support my growth are free and depreciated over time.

At the end of the day, it still remains a tool to help true up EBIT or Net Income to cash flows.

 

Hopefully that clears my writing up a bit. Thanks for pushing back and calling me out.

Good stuff. Appreciate the detailed response.

 
Oct 16, 2020 - 12:56am

Tough to say without knowing the industry, but a common approach in case studies is to set capex equal to D&A. Implicit assumption is that you are "maintaining" the business. If your company is in a growth industry, then you will want to have higher capex (i.e., growth capex vs maintenance capex). Growth capex should yield some sort of return in the form of higher top line growth.
 

On NWC, calculate the usual ratios (DSO, DIO, DPO, % revenue) for the period you have. Hold those flat throughout the projection period unless you have a reason to believe they change.

 

Nailing the revenue build is probably a better use of your time than NWC / capex.

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