How to Assess Capital Allocation
How to Assess Capital Allocation
Plus a few examples from each bucket
Capital allocation is unquestioned as the most important role for any CEO and topic of importance when analyzing any new investment idea. Warren Buffett describes it as the core job responsibility for every CEO:
The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.
But how do you actually analyze capital allocation?
There are a few good articles out there:
But most investors and write-ups simply take management’s capital allocation word at face value. If management says they plan to aggressively buyback stock, or make acquisitions, or whatever; then they’ll take those comments as gospel.
Nah. That’s rarely how it actually plays out. Instead, I use this tool to review capital allocation, both past and present.
Here’s an overview and a sampling of a few ideas putting it into practice.
I refer to this tool simply as Cash Flow Sources & Uses. It’s super common in banking/financing when a buyer is trying to line up funding sources to complete an acquisition but it has a really nice carryover to public markets investing too.
It’s simple, look at where the cash came from and where it went over various prior year periods, and compare that against what management says they plan to do in the future.
It’s really pretty simple:
Grab 5-10 years (ideally) worth of annual cash flow statements
Tally up cumulative amounts over several time periods — I recommend 3, 5, and 10 years
Look for trends and large one-time inflows or outflows… consistency is great from an operating cash flow standpoint but it’s not necessarily a good thing when it comes to deploying capital
Compare to what management said they planned to do — usually referenced in a past investor day presentation
Compare to what management says they plan to do in the future — usually referenced in a recent earnings call or investor presentation
A few thoughts and comments on capital allocation before jumping into some samples…
Capital allocation starts with actually generating operating cash flow. Without that precursor, this is a moot exercise. Sometimes I’ll come across a company with negative operating cash flow and I’ll do a quick 5 minute scan of annual cash flows just to see how on earth they might be funding regular activity (spoiler: it’s usually more debt or equity). Companies that bounce between positive and negative operating cash flow are harder to evaluate but it doesn’t make them uninvestable so long as you understand the drivers of that. Also, COVID and supply chain impacts have shown us the importance of understanding working capital.
Once we have operating cash flow, then we can determine whether the business is generating free cash flow (i.e. cash flow net of all capital expenditures). You can argue that maintenance capex and growth capex differ widely but I find the limited information as a minority outside investor makes it near impossible to truly discern maintenance capex (even if management tells you what it is). After a company has FCF, we can evaluate how they’re allocating that excess cash into various buckets (i.e. capital allocation).
Capital allocation consists of 5 possible choices…
Acquisitions — Many businesses use acquisitions as a spending outlet to grow sales/earnings/cash flow… success varies widely but we’ll look at what I consider a success story in this camp. Some companies take the nibble approach where they acquire lots of little businesses very frequently (like Constellation Software or J2 Global, now Ziff Davis); while others do “transformational” acquisitions that constitute more than a few years’ worth of FCF (Berry Global).
Repay debt — Deleveraging. Plenty of companies get into situations where they’re forced to allocate all cash flow to repaying debt in order to get down to reasonable leverage targets. Unfortunately, I think most companies that have a large allocation to repaying debt find themselves in that situation from past missteps like an expensive buyback or acquisition. A company that spends years allocating 80-100% of FCF to repaying debt might eventually find themselves in a position to shift to other more attractive avenues like M&A or shareholder returns; those inflections can be very lucrative investment opportunities.
Dividends — Quick rant: most (all?) businesses use dividends improperly. A token dividend solely for index inclusion sounds like idiocy to me; consider that a decision completely detached from fundamentals or ROI-based analysis. More companies (especially secular decliners) would be better suited with variable dividend policies. If there isn’t good use for the cash and the buyback valuation isn’t legitimately attractive, then send it back to shareholders. COVID was a time where plenty of businesses generated ecess profits and spent it on buybacks at lofty extrapolated valuations… tisk tisk, these would have made great special dividends. There’s no rule that states a dividend must be continuous except for those nut-job dividend aristocrat investors.
Buybacks — Again, lots of improper use in this bucket. “Share cannibals” are the holy grail here — a company that habitually repurchases so much stock that the share count plummets significantly over long periods of time.
The gold standard is AutoZone (AZO) which took share count from ~153m in 1998 to ~17m today (a 9-10% CAGR) but they were lucky to experience consistent revenue/earnings growth along with it (stemming from good industry dynamics).
Charter (CHTR) has been adding debt to buyback lots of stock each and every year for many years right as cash flow is stagnating. Share count down from 271m to 148m since June 2016.
Growth capex — I include this because technically it’s a legitimate option. I just don’t believe minority investors in public companies truly have a good look at the data/efficacy of this category. If capex jumps substantially (in absolute dollars or as a % of sales) you can’t automatically assume it will drive higher cash flows or that it was growth-related, even or especially if management calls it out as growth capex. Deferred maintenance is common in businesses large and small, public or private. Arguably more dangerous than deferred maintenance is a management team that spends heavily to chase after fleeting industry supply/demand imbalances (common in cyclicals, commodities, and faddish products).
As a reference point, here’s how Morningstar assesses each of these areas. They define them as balance sheet (i.e. need for debt repayment), investment (capex + M&A), and shareholder distributions (dividends + buybacks).
What to look for when evaluating capital allocation…
Inflection points — Hard shifts from one plan to another. These can be positive or negative. Positive could be a shift from repaying debt to kickstarting a buyback program. Negative could be aggressive buybacks leading to an overleveraged balance sheet and the need to focus entirely on repaying debt. Another inflection I’ve seen recently is a serial acquirer that stopped buying companies and initiated buybacks for the first time in 15+ years; hard to say whether that’s a positive or negative signal.
Cash flow constraints — Dividends are the biggest culprit here. When big companies prioritize increased payouts or dividend growth, it can quickly consume most or all of annual FCF which limits the ability to take other actions. A stagnating business with a large dividend payout is very risky. Management teams are slow to make changes with these policies. Same can be said for debt schedules; understand how those fit into the capital allocation picture over the next 3-5 years.
Small bets or large bets — In an individual year, is management allocating: a) the cash they have or produced in that year; or b) many multiples of the cash produced in that year? Maybe there’s some empirical data on this but in my experience, the larger the multiple of operating cash flow deployed into a single years’ bet (whether acquisition, dividend, or buyback) usually ends poorly — Teva, outlined below, spent 7.6x their previous year’s operating cash flow on an acquisition in 2016 and that nearly blew up the company. This exercise will help you recognize which type of management team you’re dealing with.
Consistencies — Consistency is great in the operating cash flow line… but it’s not always a good thing when it comes to where cash is used. A stable amount of spend in any line item each year can indicate a management team that feels constrained to stay in a box with capital allocation. Same goes for allocating small amounts across every bucket; while that can be successful, it can also indicate a management unwilling to take advantage of major opportunities as they pop up.
Incongruencies — Management tells you they plan to be a heavy acquirer and no acquisitions have been made in 3-5 years? Red flag. Or they announce a big buyback program but only repurchase shares in tiny amounts? Another red flag. Look for alignment in how cash is actually being spent with what management is telling you they’ll do.
Let’s walk through a few examples…
Serial Acquirers…
Berry Global (BERY)
Berry is a manufacturer of plastic containers, lids, packaging materials found in everyday items. This is my go-to example for stable cash generation supplemented by periodic large acquisitions.
It’s a really fascinating cash flow statement too… there are several distinct periods in here.
2012-2015 — Berry had just come public and spent 4 years repaying acquisition debt from $1bn+ deals made pre-IPO… that pre-IPO acquisition spend was ~10x annual cash flow at the time so these were big bets!
2016-2019— Berry cranked out 2 mega-deals within a 4 year period followed by intense deleveraging in the years following. The 2016 acquisition was ~5x 2015 FCF and the 2019 deal was close to 9x! So this was a period of levering up, growing cash flow, and making splashy acquisitions. (Hint: the stock price suffered during this stretch.)
2020-2021— Every last penny went to repaying debt. This allocation bucket amounted to >100% of FCF and was supplemented by asset sales and other minor cash inflows.
2022-2023 — Another stark turn in capital allocation… Debt paydown now a minor allocation ($395m out of $1.8bn cumulative FCF). Buybacks and dividends are coming into the picture totaling >$1.4bn which is roughly 78% of total FCF.
The takeaway with this example is that it’s critical to dissect the annual cash flows into sub-groups and look for inflection points. I wouldn’t have thought the 2016-2019 releveraging for M&A was attractive without the pre-IPO and 2012-2015 periods highlighting a near identical approach. So after the last large deal in 2019 and management’s plan for aggressive repayment, it was no surprise that 2020-2021 looked the way it did.
Fast forward to today and the company has stated their inability to find attractive large-scale acquisitions and a turn to shareholder returns through both dividends and buybacks. This is clearly a large inflection from the past 10+ years. Certainly a worthy candidate of a closer look given the undemanding valuation and clear change in capital allocation…
Deleveraging Stories
Teva Pharmaceuticals (TEVA)
In 2016, pharmaceutical maker Teva levered up massively to purchase Allergan’s generic drug business for nearly $40bn. That was a disastrous acquisition both in terms of price paid (high multiple) and the nearly immediate downturn in generics fundamentals.
From 2017 to today, Teva has been directing >100% of cash flow to repaying debt while shutting down every single line item previously at their disposal. This is what a “constrained” company looks like when it comes to deploying capital.
You don’t even need to see a balance sheet to know this company will be repaying debt for a long time coming… average FCF was $4.5bn in 2014-2015 and fell to $2bn average in 2019-2022 (i.e. a 55% decline from one period to the next). That was after spending $36bn cash on an acquisition!
Fortunately, new investors don’t always pay for the sins of the past. As of today, we’re staring at 5 straight years (2019-2022) of stable cash flows at a $2bn average rate; and a debt balance that has paid down by more than $15bn. In short, they’re grinding down the debt balance while cash flow is already stable.
If or when leverage comes down to a reasonable level, they’ll have a lot of cash to put toward other uses. Management hasn’t yet signaled a change in plans but this one looks ripe for an inflecting capital allocation story… [for fun, go look at the market cap on this one]
Lumen Technologies (LUMN)
Formerly CenturyLink (CTL), this slowly declining business carried a large debt balance and paid out a hefty dividend to shareholders.
Management stubbornly clung to that dividend for years, even in the face of very obvious declines in cash flow.
Again, most deleveraging situations get into that position from either an expensive acquisition gone bad or a dividend constraint from bad capital allocation policies.
The markers on this one are very obvious. Declining cash flow (2014-2016) leading up to a levered acquisition (2017) representing <2x annual cash flow, continued cash flow declines from 2018-2022, and only at the last minute when bankruptcy looks imminent do they eliminate the dividend entirely (2023).
Civeo (CVEO)
One last name in the deleveraging bucket. A favorite of mine as they successfully made it through the “journey.” Civeo provides worker accommodations (lodging) to oil, coal, and forestry companies in remote areas of Canada/Australia. It’s tied to oil prices which contributed to the need for deleveraging (along with a high starting debt level).
While it doesn’t look like a straight line or low volatility, this is a remarkably stable business. Excluding 2 acquisitions in 2018-2019, Civeo dedicated >100% of cumulative FCF toward repaying debt from 2015-2022.
And suddenly they didn’t need to anymore! In 2022, that capital allocation bucket dropped to 50% of FCF. Alas, another capital allocation inflection story. Buybacks and a token dividend are entering the picture in 2023. Maybe even an acquisition on the offensive?
Business Transformation
Brunswick Corp (BC)
Brunswick makes boat engines, sells parts and accessories, and entire boats. They also used to sell various consumer products in bowling/billiards. Here’s a look at a complete remake of a business via capital allocation.
Instead of the traditional cash flow statement format (operating, investing, financing sections), I’ve laid this out with the traditional definition of FCF — operating cash flow less capex = FCF. From there, I looked at how Brunswick was allocating that FCF annually among the 4 remaining deployment options (M&A, buybacks, dividends, debt).
On the micro level, I see:
2 individual years (2018 and 2021) with large acquisitions,
A brief period of deleveraging in 2019-2020.
A handful of periods with ramping buybacks (>2x individual years FCF) in 2019 and again in 2022.
Last is a big divestiture (sale of an entire business unit) in 2019.
There’s a lot of activity beneath the surface with priorities shifting several times over this 7+ year stretch.
On the macro level over this entire 7 year period we see cumulative $2bn FCF generated. Total cash uses were — $2.5bn spent on M&A, $1.5bn spent on buybacks, and $540m or so on dividends = $4.5bn. Total cash sources to fund that? Additional $2bn in borrowings, $2bn FCF, and ~$500m from an asset sale. At the end of the day this was a fairly balanced allocation plan with $2.5bn M&A (55%) and $2bn shareholder returns (45%).
What makes this a “transformation” in my view? Starting point FCF was ~$236m (average 2016-2017) but in the ensuing years they added $2.5bn in acquisitions (>10x average starting FCF) and sold $500m of business (>2x average starting FCF). That means today’s FCF is coming from very different sources (products and services), than it was in 2016.
Stanley Black & Decker (SWK)
Tool maker Stanley is a really great example of a dramatically changing company driven by capital allocation decisions… we have everything in here: significant acquisitions, significant divestitures of entire business units, large one-time buybacks, and steady (constraining) dividends.
I’ve highlighted 2 distinct time periods of activity off to the right with cumulative cash flows and the individual year 2022.
So much M&A has taken place ($6.3bn acquired and $4bn divested) since 2016 that historic cash flows are almost entirely unreliable in predicting the future state of this business. Total M&A activity of $10bn+ is 17x larger than average FCF from 2016-2017 (starting point). With that level of change, it seems a bit foolish (in hindsight) that management opted to drop such a large buyback in 2022 of >$2bn at a time when cash flow was hampered and the portfolio changes relatively unseasoned.
Without digging into any of the other financial statements, I can see that this company — has likely taken on a lot of debt, is constrained by a medium sized dividend relative to operating cash flow, mis-timed a large buyback, and is a completely different company in 2023 than it was in 2016-2022.
Both of these “business transformation” examples are pretty recent so I don’t know that we have enough information to adequately evaluate their success (or lack of). Generally, these large scale transitions make me nervous unless they fit within a theme or plan laid out by management. In Brunswick’s case, they’ve shed some retail operations to get heavier into making engines and selling parts. Alternatively, for Stanley, they exited a few good businesses like locks and opted to double down on consumer/retail driven businesses.
Share Cannibals…
The dark side of excessive buybacks — Viacom is now part of Paramount (PARA) but it was spun off from CBS in the early 2000’s and experienced a period of excellent fundamentals riding the content wave of Nickelodeon, MTV, Comedy Central, etc.
They plowed nearly all of their cash flow into buybacks while using debt to repurchase more shares than cash flow would allow. I’m not going to stitch together all of those cash flow statements but let’s look at the 2011-2018 time period here:
2011-2015 — Share count fell 32% from 594m to 406m (9% CAGR just like AutoZone!) and the dividend jumped from $0.80/share to $1.46/share. That’s an amazing shareholder return story! But fundamentals didn’t back it up… revenue/earnings were flat to down and debt was increasing rapidly.
2015-2018 — The result? Buybacks stopped, the dividend reversed entirely, revenue/earnings continued to drift, and the company had to shift capital allocation to repaying debt.
You can guess how the share price reacted…
Watch for these changes or inflections… As fundamentals shift, ask yourself (or management) how the company may need to change their approach to spending cash. If revenue is stagnating and leverage is increasing while management is still pitching heavy buybacks; then you might want to reconsider…
My point with share cannibals is that they’re really hard to identify at the outset (or even in middle innings). How many once perceived repurchasers ultimately turn into a Viacom or Charter Communications?
HP Inc (HPQ)
Last example and a fascinating one too. HP Inc has long been viewed as a low growth (or declining) business making PCs, laptops, printers, cartridges, and accessories.
Since 2016 (8 years), they’ve repurchased >40% of diluted shares for a 7.6% annual reduction in share count. Cumulatively, repurchases represent 70% of the 8 year capital allocation plan; with dividends as a distant 2nd at 25%.
So this is a very cash generative business giving 95% of cash flow back to shareholders.
Drilling down a bit we can see a major acquisition in 2022 totaling $2.8bn and a subsequent dip in FCF during 2023. Perhaps some integration challenges? Also, it appears this company benefitted from some COVID-era supernormal cash flows in 2021; although they plowed most or all of those excess earnings into buying back stock.
I’ve seen a lot of shortcut capital allocation or FCF analysis (admittedly I’m guilty of this on occasion too) but it’s imperative to spend the time looking at long stretches of cash flow data. COVID had such an anomalistic impact on so many businesses that it makes the 3-year period from 2020-2023 really hard to rely on from a cash generation / deployment standpoint; making this an even more important area of focus.
Go back in time and understand the business you’re reviewing. How have they been spending cash??
It’s not enough to look at annual cash flows by year for 5-10 years. Break it apart into key time periods, line it up against changing management teams or strategic plans, tally up cumulative inflows and outflows.
Find a way to score or rate each company’s approach to capital allocation… it doesn’t need to be a formal metric or measurement; I like to line up rational capital allocation or inflecting capital allocation against a stagnant share price to get a sense for potential “coiled spring” effects in the future!
Very good article