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Monday, January 25, 1999

An Investment Opinion
by Alex Schay

"Discretionary" Capital Expenditures

Invariably, one of the largest "discretionary" expenditures on a company's Statement of Cash Flows is capital spending. Since cash returns on capital spending often don't make an appearance on the financials until many years after they are performed, financial statement users normally fumble around in the dark when attempting get a handle on the economic justification for these outlays -- beyond the guidance offered by management.

One method that attempts to estimate the "required level" of capital expenditures over any period -- thus asserting by way of hindsight what was truly the discretionary portion of the spending -- relies on a comparison between the growth rate in cost of goods sold (COGS) and the growth rate of capital expenditures. The logic is clear. Absent any physical measure of output that can be matched with a growth in inputs, cost of sales can serve as a proxy because it constitutes all the necessary components needed to capture fluctuating product costs.

Since I've been looking at Clorox Co. (NYSE: CLX) today, thanks in part to fellow Fool Warren Gump who wrote a "refreshing" piece on the firm not too long ago, I'll use it to try out the "method." Here's some data for the last four years:

Year          6/98    6/97    6/96   6/95
Cap. Ex. 98.9 95.1 84.8 62.9
Growth 16% 18% 3% -25%
COGs 1192.5 1123.4 1007.2 892.1
Growth 10% 11% 11% 7%
Excess 6% 7% 0% 0%
Discretionary 5.93 6.65 0 0
(Numbers in $000,000)

First of all, we determine the compound annual growth rate in capital expenditures on a three year, rolling basis. We then do the same thing in order to calculate the growth rate in cost of goods sold. The next step is to take the growth rate in capital expenditures and subtract it from the growth rate that was calculated for cost of goods sold. This excess growth rate of capital expenditures is then multiplied by the total capital expenditures for the year to get a dollar figure representing the "discretionary" capital expenditures for the period. If this is taken as gospel, then these amounts can be added back to the free cash flow equation (after total capital expenditures are subtracted from net operating cash flows). The question becomes, are these sums ever significant?

Taking a look at some Clorox data provided by Cash Flow & Security Analysis author Kenneth S. Hackel, it would seem that the results don't follow a clearly discernable pattern.

Year           6/94   6/93   6/92   6/91   6/90   6/89   6/88
Discretionary 0 0 7.9 0 48.5 3.6 80
Free Cash 210.2 167.8 189.8 137.6 59.1 73.9 98.0
Discretionary - - 2.94% 0 45% 4.65% 44%
as % of total
Cap Ex. 56.6 77.6 124.7 109.1 155.9 87.8 153.3
(Numbers in $000.000)

According to research performed with the help of the CompuStat database, fewer than 20% of all firms have discretionary capital expenditures in any given year (using this method), and fewer than 2% of all firms had discretionary capital expenditures that exceeded 10% of the firm's market value.

When attempting to figure out what analytical techniques have merit and which ones can be utilized for future analysis, it's sometimes heartening to be able to eliminate candidates as well. In this case, estimates of free cash flow are not going to be dramatically affected by attempting to figure out discretionary totals in the manner outlined. However, when performed in conjunction with other techniques for identifying expenses that are ultimately discretionary, a case can probably be made. That's the subject of a future column though, Fool On!

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