Depreciation and Capex

The purpose of this thread is to allow value investors to understand NWH's depreciation and Capex. I have not thoroughly investigated the topic, but I'll toss in initial thoughts that are relevant to the cryptic words in the Euroz-Hartley Presentation that read, “Lower Capex run rate – maintenance and replacement circa $70M pa. Likely to continue through FY22, FY23 – compared to depreciation of $150M – generates FCF (Net of AASB lease cash outflows) of circa $65M.” It requires a great deal more work to be able to guesstimate what the EPS may be for FY21, FY22 and FY23, and target SPs.

New Accounting Standards for Leases

Operating leases (rental agreements) are now treated like finance leases (purchases made with borrowed funds). Rental expense now ceases to exist, and hence straight-line expensing of rentals vanishes. In loose terms, the right-to-use assets is capitalised as “property, plant and equipment” (PPE) at the present value of the lease payments discounted by the implied rate of interest for each lease. There are other considerations that I'll ignore, which are mentioned in https://www.bdo.com.au/en-au/accounting-news/accounting-news-february-2016/new-leases-standard.

All leases will incur a front-end loaded expense, comprising depreciation on the right-of-use asset, and interest on the lease liability. I plagiarised the previous sentence, but I am wary of the semantics of using the adjective “front-end”. What I think happens is that for each accounting period the asset value is reduced to account for the future period of use becoming shorter, and that reduction of the PPE asset is expensed in part as depreciation, and in part as interest. Consequently, the demise of rental as an expense is replaced by these two components, and so historical comparisons are misleading.

Right-of-use assets must be disclosed separately in the balance sheet from other assets, and lease liabilities must be disclosed separately from other liabilities. I am uncertain if the term Capex in the cryptic quote in the first paragraph of this post includes financial leases (now dressed up as operating leases), or not. If the asset side of the accounting is included in Capex, and the liability side too, then in effect the net up-front balance sheet postings would remain nearly as low as would have been the case historically when rental agreements were not capitalised.

For plant and equipment actually purchased via finance leases, things do not change, so the ratio of what used to be called finance leases (purchases that were capitalised) and operating leases (rentals that were expensed, not capitalised) is relevant to the issue of why NWH's depreciation seems abnormally high relative to the past.

The Cash Flow Perspective

The words, “Likely to continue through FY22, FY23 – compared to depreciation of $150M – generates FCF (Net of AASB lease cash outflows) of circa $65M” suggest that for FY21, FY22 and FY23 we are going to see free cash flow that the statutory NPAT is not going to reflect, and that would tend to delay tax due to be paid. As a long-term holder, I am happy to have that happen, but it would probably be viewed as a negative by short-term holders.

EPS times PER Valuations
EPS x PER is a handy shortcut to drive a guesstimated SP, but if there is hidden value in the balance sheet due to generous expensing, then the PER should be uplifted to recognise that. The market tends not to understand that, but long-term holders can afford to bide their time for the wellbeing of the stock to manifest itself.

In my view, Jules runs NWH to optimise its long-term financial wellbeing – he does not window-dress short-term EPS to benefit share traders in the near-immediate term. That being said, whether Jules wants to or not, NWH must Announce relevant contract wins, and there are words in the Eurox-Hartley Presentation that should lead to a spate of positive Announcements in FY21 to fire up Mr Market. Do a Ctrl F search for “22” in the Euroz-Hartley Presentation report, and you will find that the general tone for new contracts is positive, and those that are expected to commence in FY22 are likely to be contracted in FY21, or early FY22. As an example, I'll mention one in respect to MET, “RCRMT and DIAB had a very strong start to the year with results ahead of expectations and a strong outlook for FY21 and FY22.”

It has stopped raining, so I'll now do something more useful than posting to HC – namely, scrounge rubble for an outdoor wall that I am building.