<img src="Weissenrieder-Asset-strategy-capex-management-businessmen-with-paper-1.jpg" alt="How tactical capex decisions run company strategy">

This is a part of a three piece article series. This is part two.
If you want to start to read the beginning of the series, click here for part one.

2.0 The Tail Wags The Dog – How Tactical Decisions Run Company Strategy

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2.1 Competitiveness over a lifecycle

An industry always improves, in the sense that it is always better at what it is doing today than it was 10 years ago, because of technology development (the industry doesn’t, however, make more money due to the real price decline). We illustrate this point with the red line in Figure 2-1.

The red line is the industry average, so half of the industry’s capacity is above the red line and half is below at every point in time.

At some point, a company will build a new mill, either a Brownfield or a Greenfield. Or it will add a new production line in an existing mill. We illustrate that with the blue line starting at point A, where the mill is new and state of the art. It is clearly above the red line. Over time, the mill will be improved (the blue line goes up) but it can never follow industry average. At some point, it will cut across the red line and become less competitive than the industry average. Decades later, the company will come to the conclusion that it is better to shut down the mill because the gap between it and the industry average has become too large. This is a simple illustration of a life cycle of a mill.

A mill will slowly travel along the blue line to the right. Most mill investments will, at best, slow down the loss in relative competitiveness, not improve it. Only a few investments will take it to the left (improve mill competitiveness), and then in almost all cases it will only be a small shift. For example, a company makes a really large replacement capex in a mill. It replaces 10% of the mill with state of the art technology (like a so-called recovery boiler in a pulp mill). The time from the decision to invest in the mill to turn key (completion of investment) is often 1-3 years. Replacing 10% of the asset base shifts the mill to the left, but 90% of the mill ages another 1-3 years in the process. The net effect for the mill from the point of decision to turn key is not very large.

2.2 How capital and other resources are allocated in a system of mills

We will use Figure 2-2 (p.17) for our discussion about allocation of capital. Let’s say we run a business with 10 mills. They are all making more or less the same type of product aiming at a certain market. We assume that our port-folio of 10 mills, on average, is exactly on the industry average (i.e. we have half of our capacity in mills that perform better than the industry average, and half of our capacity in mills that perform below industry average).

Therefore, it is not unlikely that we would have three mills (making up 50% of our capacity) that are the more competitive mills, and seven that are less competitive. Let’s categorize the 10 mills. We have our Category C mill, the mill we understand we will close in 1-3 years since it isn’t performing well at all. We have our three close to state of the art Category A mills. Finally, we have our six Category B mills, good providers of our product mix, etc., but to different degrees less competitive.

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How would a company within the capital-intensive industry today act in these categories with its resources? Having worked with dozens of companies within the capital-intensive industry we have an opinion on this. To understand how companies today allocate resources we ask three questions:

Question #1: “In a normal year, how would your company invest in those 10 assets?” Most companies do not have relevant information to make the categorization, but let’s give this a try. We exclude possible investments in Brownfields/Greenfields, we just look at those 10 assets.

If we begin with Category C, it contains the mill that we know we will not keep for very long. We would prefer to spend 0% of capexes on this mill, but we need to spend some capital in that mill for it to stay open another quarter, another year. Most companies spend 3-5% of their capital on this category of mills.

How about Category A?
That category is relatively close to state of the art technology. They “need” less capital. Additionally, the opportunities for this category are perceived to be not that many (since they already are relatively good). They have less environmental issues, fewer safety issues, etc. On the other hand, they represent 50% of the capacity – clearly the need to invest here exists. Most companies would invest 20%, sometimes up to 25% in this category.

Finally, we have Category B.
Six mills (twice as many as in Category A) with an increasing technology gap (aging assets). Often these are relatively complex mills – two or three of everything instead of one – and not always a “linear” layout. There are usually environmental and safety issues. Category B gets 75% of the capital.

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The percent split between the categories should not surprise anyone (Figure 2-3). Category A doesn’t really need money. The desire might not be there, but some investment must be put into Category C. Category B definitely requires capital. Some companies say they don’t invest like this. A few of those companies might not, but in our experience, the vast majority of companies do invest this way. However, it is common for companies to get the categories of the mills mixed up, they think a Category B mill is a Category A mill, etc. We even came across a company who thought one of their Category A mills was a Category C mill. Question #2: “How much of the next 10 years’ cash flow do you expect to receive from each category?” While the split of capital spent between the categories is similar between companies, the split of future cash flow between the three categories isn’t, since it depends on what type of assets a company actually has.
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If lucky, Category C will generate 0% of future cash flow. Category A’s mills have a higher EBITDA and margin than Category B (and C) as well as lower capexes. So, this category will clearly provide the company with the highest cash flow (if not, they have been assigned to the wrong category. This is the common mistake, mentioned above). In our experience, Category A generates about 80% of future total cash flow. We have seen anything from 60% to 300% for Category A (please do the math on Categories B and C in the latter case). Category B will provide an average of 20%, after capexes. Question #3: “Pick your 100 most important/valuable resources in the company. Exclude hours spent on budgets, reports, etc. and only look at their quality time. How much of their quality time goes into each of the three categories A, B, and C?”
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Category C gets a shocking 30%.

When considering the answer to Question 3, a company must include all the discussions/analyses/etc. on, “Should we close or keep, should we make another investment?” In considering this question, include the time spent trying to fix the mill, evaluating closure costs, and eventually when the mill closes. We had a client once who hesitated over a Category C mill for a long time. Once they even had one of their senior VPs on the corporate jet going to the mill to communicate its closure. When he landed, he got the message, “We got another large order, come back home.” This can go on for years, which is why we see such a high percentage of resources allocated to Category C mills.

Category A doesn’t need resources.

Those mills are working just fine. In a project, we had a number of years ago, the project manager from the client’s side had been a mill manager for their best Category A mill for five years. He told us that the head office hadn’t contacted him even once during those years.

Category B gets 65% of the resources.

When we read the pink pages we often read about CEOs from the capital-intensive industry explaining the quarter’s poor performance with reasons such as prices not developing the way they expected, increased costs, and shaky demand. Certainly, one can explain a quarter or two with those factors, but the capital-intensive industry often fails in delivering shareholder value year in, year out. To blame the above factors for more than a couple of quarters is like saying that one lost a sailing race due to a head wind.

Prices not developing as expected, costs being up and demand being shaky is nature. It is a fact for all players in a capital-intensive industry. Technology development, even if slow, brings down prices compared to costs for existing assets – this is a fact. Companies invest in better technology in an attempt to avoid that.

Now, we cannot say that this table, for a certain company, in a certain year is “incorrect.” All we can say is that if one spends resources like this over time; one will weaken and eventually ruin the company.

We would say that all companies and all CEOs we have worked with for the last 23 years have had the ambition to do well. They want to do the right thing, to have the company make more money, but too many organizations fail.

There are several reasons for why many companies don’t deliver expected returns or fail. Why over time they don’t follow the stock market’s index, as an example. Here we show you all you need to drain a company of cash flow, and even sometimes, as shocking as it sounds, run them into the ground: All that is needed is to have the company’s future somewhere (green), but spend its resources elsewhere (red). Done year in and year out, decade after decade, results in a poor performing company. Or a company in Chapter 11.

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This is all that is required to make a company fail, even if the intentions are the best. If a company has an aggressive acquisition strategy one might make things even worse (i.e. acquiring a large set of Category B mills. Acquired Category B mills usually consume more capital than the net cash flow gain from an acquisition – we have seen this countless of times. Why do companies end up in this situation, where resources are being allocated as in above table? They want to do the right thing, but the result is poor. For every little (and large) decision they make they do their homework, and they normally fulfill the benefits they claim in the capex request. Still, the company doesn’t succeed. How is this possible?
2.3 Why it goes wrong

We were engaged in answering this question in the late 90s. We came up with a long list of reasons but pared the list down to three basic reasons why companies fail.

The first two reasons are present in all companies, and they have to be there. They cause an extremely costly problem, but they are necessary.

The third reason is anything from somewhat present to very present in almost all companies. Although it doesn’t have to be present at all, companies can throw it out today – there is no point whatsoever in having it involved in the capital allocation process.

Reason #1: The capex process is a bottom-up process. It has to be. The mill knows the issues and how to fix them (supported by central technology/manufacturing resources). So, the mill manager will come to the head office and say “I have an issue, and now I know how to solve it.” This issue could be quality, cost, safety, environmental, etc. The head office will say, “We know. We have been discussing this now for two years.” On paper, the capex necessary to fix the issue makes sense.

Reason #2: Delta calculations are used to evaluate the benefit of a capex project, and the projects are evaluated one by one, in isolation. Going back to what we discussed in part one, basically all companies do what the textbook says, what we have been taught to do: they calculate the payback/NPV/IRR for each capex project individually, in “isolation” (we assume all data is accurate and correct).

So, a mill manager comes to the head office saying, “I have an issue, and now I know how to solve it. The payback is two years.” The head office is likely to reply, “We know. We have been discussing this for three years. The payback makes sense; it even looks a bit conservative.” They respond this way because an individual analysis of the issue tells the company the manager’s solution is an appropriate and reasonable way to proceed.

Reason #3: ROCE (or ROOC, Re, EVA, or any other P&L and balance sheet based measure) is used to prove the performance of the mill. It is bad enough that companies use these measures at the group level. Some claim that the errors in these measures are canceled out when applied on the company/group level. This is incorrect, and to use any of these measures on a mill level gives totally corrupt information (it doesn’t matter how many adjustments you make in, for instance, EVA). Let us give you a relevant example:

Take the blue line from Figure 2-5. It represents the life cycle of a mill, let’s say 60 years. We lay it out as the X-axis in a graph, with the categorizations A, B and C, Figure 2-6.

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How does an EBITDA margin look for a mill over its lifecycle?

It would be very volatile, but for the purpose of our example, we can “normalize” it. Look at Figure 2-7 whose EBITDA margin development represents a mill from its Greenfield state to closure 60 years later.

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From a poor, but normal start-up, this mill is at its peak competitiveness after about 5 years. After that, the EBITDA margin will slowly but surely decline until closure. This represents lowered relative competitiveness over time. This continues to be true even if capital is spent on the mill. In fact, the mill will decline like that because capital is spent on it. If capital is not spent, the EBITDA margin will fall even quicker and the mill will be closed a lot earlier.

In reality, the EBITDA margin will jump up and down. One can work in a mill for 20 years without noticing the EBITDA margin trending downwards.

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How will the ROCE (or ROOC, Re, EVA, or any other P&L-balance sheet based measure) look for this mill? The ROCE is simply a mathematical consequence of the development of the EBITDA margin and accounting rules for depreciation. See Figure 2-8. Look at it for a while. What does it really say about “performance” according to ROCE in our three categories?

The mill carries a lot of initial capital in the first 15 years (accounting rules), but cash flow from year five is superior to any other year after that. The EBITDA margin is at its peak. Approximately at the point when it goes from being competitive to less competitive than the industry average, the mill’s accounting based performance measures will skyrocket.

**If you are ever to take the seat as a mill manager, make sure you do this a year before the initial capex has been written off in the books. Then make sure your bonus is set on ROCE or EVA; you’ll be rich. Cash flow and EBITDA margin will be down, but you’ll be just fine.

So, with “Reason #3” a mill manager comes to the head office saying: “I have an issue, and now we know how to solve it. The payback is two years. And, we still contribute well to the company’s ROCE”. Why would anyone ever say no to a capex with those attributes? No red flags anywhere in sight.

ROCE does not, in any way, indicate competitiveness. Hence it should never be involved in any capital allocation discussions.

2.4 The tail wags the dog

Any business wants to think that it sets a system-wide strategy for its assets and that its capexes follow that strategy, right? Like this:

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However, our wide experience – and anecdotal evidence – is that it is not at all like that. The capex process is a well-established and truly “powerful” process in companies. An institution. Lots of people are involved with their respective responsibilities, rules not to be messed with, there are set structures for approvals, etc.

We claim that the capex process is so strong that it actually sets the strategy for the assets, in our example, the mills. The result of the selected capexes for a mill year in and year out determines the strategy of that mill and as a result, the whole company, (however, it does not determine the fate of a mill. Even stronger external forces determine that).

So, it is not that an asset strategy determines which capexes are chosen for a mill. Companies don’t even have well-established, uniform and thorough processes for setting the asset strategy for their system of mills, (the reader may think “but we do in our company”, especially if said reader is responsible for that process – we’ll challenge that statement any day).

So, the picture actually looks like this:

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When the capex process determines the strategy, we call this “the tail wags the dog”, a common term for when something is backward. Our experience is that a company loses a value of at least 30% of its capexes every year. At least. As we discussed earlier in this paper, it is tempting to think that one’s own company’s capex management process avoids these traps. Individuals responsible for the capex process often react that way (CFO’s, VPs of Strategy, etc.). If this is the reader’s reaction, then he/she is acting defensive and not helping the company (or its CEO or owners). In that case, somebody in the company, other than the reader, will soon educate themselves from our descriptive articles and solutions, and bring the inevitable changes to the company.

All companies that invest capital in fixed assets (even if they are not necessarily capital intensive) need to fix this issue. All companies have to have an Asset Strategy that governs the capex allocation.

But the way to achieve it is not at all the way one might think it should be done.

Interested in reading article one?

“What really creates a short payback”

Interested in reading article three?

“The “creative destruction” funnel”