Thread by @Sanjay__Bakshi

Ok, @rohitchauhan you have done it again. LOL!

https://twitter.com/rohitchauhan/status/1324782333224984577

Total Capex = Growth Capex + Maintenance Capex

We know the total capex. We can get it from the fixed asset schedule in the balance sheet. We can also get it from the cash flow statement as net investment in fixed assets.

We should do this over a BLOCK of years and not just one year because one-year data has noise. Also, why should the time taken by a planet to circle the sun synchronize precisely for time taken for business actions to pay off? (Buffett)

Ok, so now, we have a TOTAL capex figure. How to split it between GROWTH and MAINTENANCE capex? Well, one thing we know is that we have to do this on our own. The accounting statements may give us clues, but no one will split the growth and maintenance capex for us...

... even though that distinction is very important for answering two questions: (1) How good or bad is this business? (2) What are the true economic earnings to be used for valuing this business?

So how do we do this on our own? We have to use our JUDGMENT. It makes sense to think of FACTORS which influences the split between growth and maintenance. What are those factors? There are at least three that I can think of.

The FIRST factor is The NATURE of the business. Some businesses which, by their very nature, require huge outlays of cash for MAINTENANCE capex. Take, for example, consumer electronics or microprocessors.

The pace of technological change in these industries is so rapid that the need to upgrade your technology just to keep up with the competition is huge.

In such situations which can also be understood by using the phrase “HIGH DEGREE OF OBSOLESCENCE - the accounting depreciation is much less than ECONOMIC DEPRECIATION(which is another useful term to use for MAINTENANCE capex).

And some businesses, by their very NATURE, require very LITTLE outlays of cash over a block of years as compared to accounting depreciation to maintain their current level of operations and competitive position.

For example, hydroelectric power stations, toll bridges and roads, and commercial buildings. The ACCOUNTING depreciation in these situations is way MORE than ECONOMIC depreciation.

So whenever the PACE OF CHANGE in the industry is LESS and the OBSOLESCENCE risk is LOW, the MAINTENANCE capex should be less than ACCOUNTING depreciation.

This is why Charlie Munger once said, "We make bricks (BRK owns a bricks manufacturing company) using the same technology used in Mesopotamia."

The SECOND factor is INFLATION. To understand this, we should answer this question: Why do businesses charge depreciation to arrive at “profit” in the first place? The reason is that by reducing profits, from which dividends are paid, the businesses CONSERVE cash.

This cash can be invested in fixed income securities and by the time the asset has to be replaced, it is expected that sufficient funds will be in place to replace the asset which has come to the end of its useful life. So far so good.

But INFLATION can play spoilsport with these plans. If by the time one has to replace the dying asset, the REPLACEMENT cost of the asset has increased in nominal dollars to such a level that. . .

. . . there won’t be sufficient funds in the business to replace the asset after taking into account the treasury income on funds conserved by not paying them out as dividends, we will have a situation where MAINTENANCE capex is MORE than ACCOUNTING depreciation.

That's because to replace the asset, now we will have to spend more in nominal dollars than the money available on the balance sheet for its replacement.

The THIRD factor is PRODUCTIVITY GAINS. We live in a world where even if there is inflation, we also have huge productivity gains. That is, in many industries, a NEW asset, which replaces an OLD one is often a far BETTER asset. It can do MORE with LESS.

For example, it can produce MORE widgets with LESS wastage or can operate with LESS electricity consumption. These PRODUCTIVITY GAIN have an effect that works in the OPPOSITE direction of the effect of INFLATION.

So we have these THREE key factors — THE NATURE of the business, INFLATION, and PRODUCTIVITY GAINS — which can help think about the PROBABLE quantum of MAINTENANCE capex in a business as opposed to the ACCOUNTING depreciation charged in its books.

Let’s go back to the equation: Total Capex = Growth Capex + Maintenance Capex.

Sometimes to estimate MAINTENANCE capex, all we have to is to deduct GROWTH capex from MAINTENANCE capex. But how do we know how much is GROWTH capex?

Well, management announcements (interviews, commentary in the annual report, conference calls) relating to EXPANSION plans give clues. In fact, as @rohitchauhan has pointed out, sometimes we get clues about MAINTENANCE capex from management commentary. He cites BKT's example.

So, there are TWO methods for thinking about maintenance CAPEX. #1: Use it as a balancing figure in the equation Total Capex = Growth Capex + Maintenance Capex. AND #2: Use your JUDGMENT.

I think it’s probably a good idea to use BOTH methods.

One final thought. I wrote about INFLATION. But in many parts of the world, we are now experiencing DEFLATION. So we have to adjust our thinking about MAINTENANCE capex based on this…

Sorry. This one should read Sometimes to estimate MAINTENANCE capex, all we have to is to deduct GROWTH capex from TOTAL capex. But how do we know how much is GROWTH capex?