CAPEX - THOUGHTS ON UNDERSTANDING MACHINERY
I'm looking at some higher-CAPEX business - specifically, companies in the packaging and plastics industries - and one make-or-break question is the useful life of the machinery. I thought I'd share some ideas I've had for any searcher bucking the low-CAPEX trend in the hopes that other searchers have some thoughts (especially if you know anything about plastics or packaging!).
1. Find out what the current machinery can and cannot produce. I was influenced by the experience of A.J. Gordon at Gordon Aluminum in episode 34 of Think Like an Owner (https://alexbridgeman.com/podcasts/a-j-gordon-running-a-3rd-generation-family-business-ep-34/). In 1989, Gordon Aluminum wanted to expand from doing residential and commercial window sections to doing larger shaped products for architectural markets. They already had a 7 inch extrusion press but those larger shapes required a 10in, $5MM extrusion press.
2. Determine the repair and customization situation with current hardware. Can everything be serviced in-house? Could the machines run indefinitely with proper service? Are there any restrictions on customization e.g. like John Deere tractors which prohibit farmers from customizing software? Are parts available or are they getting harder to find for older machines? What's the lead time to get parts?
3. What's the threat of obsolescence? Machinery with a remaining life of 50 years isn't valuable if customers are switching to a component that can't be manufactured with the existing machines. Ideally, you want to buying the equivalent of a B-52 in 1966 with decades of service life ahead of it, not a Concorde in 2000.
4. As you might imagine, historical EBITDA or SDE aren't particularly important here even if you have no problem with the seller's add-backs. A better, but by no means perfect, number is EBITDA - "maintenance CAPEX." Maintenance CAPEX is just the average annual CAPEX you need to keep the business operating as-is, as opposed to growth CAPEX which is used for expansion. There are a couple ways to estimate this and I'll point you to Bruce Greenwald of Columbia University's value investing program for examples on how to calculate it. The gist is: if you have a business with EBITDA of $500k that requires a $1MM machine to be replaced every 20 years to keep sales/profits stable, your maintenance CAPEX is $50k ($1MM/20) so your EBITDA-maintenance CAPEX = $450k a year. Just because a seller hasn't invested in machinery in the last five or ten years doesn't mean they're a low CAPEX business either!
5. How easy is it to finance large CAPEX purchases? If you're taking on debt to finance an acquisition, how would that debt affect the CAPEX-related debt?
6. What's the maximum output of the existing machinery? I like to think of 3D printers as an example. Maybe the technology has advanced now, but when I was last checking them out, most desktop versions took a few hours to create small parts. If I had a business selling 3D-printed parts, even if I could have the printers operating autonomously, I'd be limited by the number of hours in a day. More realistically, an industrial business will also be limited by staff: maybe there's only one eight hour shift and the machines run only during those 8 hours. At best, you could triple production but you'd probably experience lower margins as your labor cost would more than triple (e.g. by having to compensate more for overtime or night shifts).
7. What kind of regulatory, liability, and worker safety challenges are there with the machinery? It's good to find out if there have been any injuries, OSHA violations, etc. at the business. If even an MBA like me could safely and legally operate machinery, you're in good shape. If years of training and special certifications are required, and the only employee who has them is nearing retirement, you're in less good shape.