deriving free cash flow for sgn

Stefanis,

Your reference to the need for "historical perspective to get a base line for a level of capex necessary to maintain competitiveness" is right on the mark

Apart from straightforward quizzing the CFO or CEO of a company what its Stay-in-Business (SiB) Capex is (if they are a management team worth their sale, 7 times out of 10 they would have a good grasp of this figure, and should have little commercial sensitivity in sharing it with you), the determination of SiB Capex is a mix of experiential observation and science.

One method I use is to look at the ratio of Capex-to-Sales over time. In the event that expansions, upgrades or refurbishments have been known to have been undertaken and the capital cost of those expansions, upgrades or refurbishments have been quantified, then the Capex/Sales ratio can be normalised by the stripping out of this figure.

I often then cross-check my findings with Capex-to-Sales ratios for other companies operating in the same industry segment.

After a while, one gets an intuitive "feel" for what is an appropriate level of capex needed to support a different level of revenue in for different business models operating in different industries.

The other important thing - almost more important in getting the SiB value right, especially in non-capital businesses (where I typically look to invest) - is to get a grip on how much Working Capital is required to support a given level of revenue. Often, the companies in which I invest have SiB capex-to-Revenue of less than 1%, yet Working Capital-to-Sales of 15%, or similar disproportionality. So changes in WC are often the bigger driver of Operating Cash Flow, and hence Free Cash Flow, than SiB capex. So I spend a great deal of time looking a working capital performance during the growth cycle of a business in order to understand how much of EBITDA converts to OCF, and then FCF. Working Cap-to-Sales is therefore a very important metric that I monitor over time.

And yes, any determination of FCF excludes almost all acquisitions, because acquisitions, like expansionary capex, are really growth initiatives that needed to be evaluated on their own merit.

The elements from Cash Flow from Investing Activities should be included in SiB Capex are Payments for Intangibles, for example, when those intangibles are essential to the continued operating of the business, things such as licence renewals, software upgrades etc.

But remember, like all things, a chain is only as strong as its weakest link, and the investing game is an inexact science, so getting the PRECISE value for SiB capex or WC-to-Sales is not critical given the margins of error inherent in forecasting future revenues and margins. A good approximation is good enough. (As an aside, I suppose I am at fault for quoting FCF yields to 2 decimal places given my assumptions and forecasts cannot support that level of accuracy, but that's the subject of another academic debate altogether.)

Looking at SGN specifically, the analysis is clouded somewhat by the significant profit share that SGN derives from its associate companies, although this has become less of an issue in recent years as SGN has been buying out the minority interests in many of these companies.

For context, pre-2007 SGN derived the bulk of its OCF (up to 80% in some years) from dividends received from Associate companies. But in recent years, with the consolidation of the revenues and profits of the entities SGN has been acquiring, the dividend receipts have fallen to about 10% of OCF. This is all perfectly intuitive. At the same time capex levels have risen nominally, which is what one would expect given that capex that would have appeared "off balance sheet" under the Associate interest status, is now reflected fully for SGN's account.

However, the funny thing is that capex-to-sales for SGN has fallen from roughly 3%, to less than 2% as SGN has been mopping up the minorities in the Associate companies. In forecasting future FCF, I have assumed, in the interests of conservativeness, that 3% is the appropriate Capex-to-Sales ratio. But really, here's where materiality comes in, SGN typically generates $70m in OCF from some $300m of sales revenue, meaning that whether SiB Capex-to-Sales is assumed to be 2% or 3% or even 5%, it makes little difference given OCF is a very significant multiple of SiB Capex. That's the beauty of highly cash-generative, capex-light businesses, it's not that important to get SiB capex 100% right.

Two asides:
1) About one quarter of SGN's Revenue converts to FCF, which is a ratio that is in the top decile of companies
2) SGN has spent about $80m since 2006 in acquiring the minority stakes in Associate companies. Over that time, OCF has risen from $30m pa to $70m pa. I know it's a crude exercise, but I'm tempted to believe that SGN has paid around 2 times OCF for the interests it has acquired ($80m divided by ($70m less $30m)). And remember that those are good quality cash flows given the fact that they do not need to be supported by much incremental capital.

Hope this of some assistance.

Regards

Cameron

PS. I suspect the transitioning of the 452 Capital stake in SGN has now run most of its course.