“I am not uncertain”

This was only my second investment committee as CFO.

The first didn’t go so well, especially for Nathan (you heard about that last week).

This one was certainly going better. I had sat through seven investment proposals from five different VPs.

The message had got through about the quality of proposals needing to change. They were working much harder to justify their investment cases.

But there was still a big problem.

I noticed something about the language each of the presenters used. It didn’t sit right with me.

They were all so certain.

Certain about the sales their R&D project was going to generate.

Certain about the market growth rate.

Certain about the cost to build a new factory.

Certain about the sales their untested TV ad would generate.

Call me miserable and old-fashioned. But nothing in life is certain. I think in ranges and probabilities.

They included sensitivity analysis in their business cases, but they were paid lip service. Nothing more.

I’ve never been much of a fan of sensitivity analysis anyway. Sure, they talk to the impact of something happening, but not its probability. It’s hard to make them real.

I needed to introduce a different way of talking about outcomes within the business. Not just in investment appraisal. But in everything.

If there is one thing I’ve learned in my career above anything else, it’s this:

No one knows anything for sure.

Everyone is winging it.

The great executors aren't great because they know what’s going to happen. They are great because they understand risk, monitor relentlessly, and react at the speed of light.

That's not to say forecasts in investment appraisal are useless. The opposite. They are vital.

You do need a basis for making a decision.

But...

In any scenario, there is a range of possible outcomes. And each of those outcomes are determined by assumptions. And have probabilities attached.

This is called probabilistic thinking.

If we were going to make better investment decisions. And reduce the debt of this business. It was going to start with probabilistic thinking.

This is the second part of a 4 part series on corporate capital allocation. See the first post here. It also borrows heavily from the MFCF post of last year. This post will make more sense if you have read them both previously.

How to Fund Growth (& when not to)

Last week, we saw that capital allocation decisions are complicated. With layers.

But there is one straightforward question in the middle of it all…

“Is this $ better re-invested in the business, or given back to shareholders?”

And the short answer is equally straightforward…

Spare $ should be returned to shareholders, unless there is a compelling reason not to.

Those ‘reasons’ need to be investments in the business that generate a better per $ return for shareholders, than they can get elsewhere.

Now, of course, this is where it does get complicated:

• What are the investment opportunities?

• What is the risk and return profile?

• What are shareholders’ alternatives?

• How do you value all of this?

This quickly becomes a game of 4D chess to solve.

Last week, we simplified it a little. With some hard rules linked to the strategy in the Financial Policy.

This week we will talk about how to allocate capital towards growing a business. And how to make those investment decisions:

There are four ways capital can be applied to growing a business:

1. Growth capex

2. Discretionary growth opex

3. Working Capital

4. M&A

I have written extensively about 3 & 4 in the past (each got a whole 8 part series last year). So we will touch on them briefly in the context of capital allocation. But will spend most time this week on 1 & 2.

Let’s get into it.

1) Growth Capex

There are two types of capex:

• Maintenance capex (any capital required to maintain current profitability)

• Growth capex (any capex that is not maintenance capex)

We covered this distinction in detail in the MFCF post.

Growth capex refers to any capital expenditure that leads to an expected future improvement in EBITDA. Not just revenue/capacity growth, as the name suggests.

Let’s use McDonald's as an example (from the perspective of a franchisee).

• Replacing the burger grill at the end of its 5 year life span = Maintenance Capex

• Opening a new store = Growth Capex

These are simple examples. But what about the self-service kiosks that McDonald's have forced us to use for the last decade?

This investment was reputed at $5bn across the US alone between 2015 & 2020. One of the biggest capital allocation decisions in McDonald's history.

The business case for this program was built on labor cost savings. Material EBITDA improvements through cost reduction.

This should be treated as growth capex.

A discretionary investment, structurally improving the cost base of the business. Regardless of whether it’s expected to increase sales/capacity or not. This makes it a capital allocation decision, rather than a ‘cost of doing business'.’

Everyone has their favorite measure for evaluating capital investments. It’s a huge topic. And one that will get a full series in the future.

But as a teaser, there are two measures I like:

1. Payback period (How fast do I get my money back?)

2. Net Present Value Per $ Invested

There are other measures; IRR, NPV, discounted payback, etc. We’ll talk about those another time.

But here’s why I like those two measures.

Payback period is great in a cash-constrained businesses. Where capital rationing needs to be most careful, and downside protection is important. Plus, everyone understands it: how fast do you get your money back?

And NPV Per $ Invested helps compare different options for capital allocation. All with a common denominator.

Once you have an analysis of these projects by measure, they make for a great bubble chart, where the size of the bubble is the size of the investment:

In theorty the best projects are in the bottom right (highest NPV return per $, and faster payback). The weakest in the top left.

So you might think it’s just a case of allocating capital from the bottom right up and left until you run out of ideas or money.

No.

There are two things to think about beyond where the business case places an investment on the bubble chart:

1) Fit to strategy

That project in the bottom right could be very compelling financially. But could also be a disaster strategically. Destroying long-term equity value. The strategy must be the true north.

LVMH would be able to improve margins in the short term by outsourcing all production. It would also destroy their business overnight.

Likewise, there could be projects in the top left, that are ‘meh’ on the numbers, but vital for the strategic plan.

It’s about numbers, but it not all about numbers.

2) Probabilistic thinking

The above shows the expected performance of investments on a static ‘base case’. But as we learned in the opening anecdote, it’s the range of outcomes and probabilities attached to them that matters.

This, again, is more art than science. There is one simple way you can think about this for capex. Most capexs can be categorized as either:

• Hard return - proven payback (automation and cost removal investment, proven rollout programs)

• Soft return - speculative payback (unproven demand, or untested payback)

One is not better than the other, but the bet is different. With a ‘hard return,’ you can be more confident in the outcome. The distribution is tighter.

With a soft return project, the outcome distribution is wider. But often the upside is greater too i.e. a breakthrough into a new market which could 10x NPV.

Soft return projects are harder to appraise. So I tend to look at the cashflow profile of a base case and reasonable worst case. Then ask myself what is the likelihood of each scenario.

The gap between the base case and the reasonable worst case is the execution risk. This is a simple way of bringing probabilistic thinking in. All without having to consider an infinite range of possibilities.

If a project stacks up even on its reasonable worst case (or downside is capped), it’s easier to approve.

2. Discretionary Growth Opex

This refers to any expenditure not necessary for supporting the current scale of the business i.e. investments to deliver breakthroughs in product and scale.

This came into sharp focus 18 months ago, when the big tech businesses all ripped 30% of their headcount out without missing a beat. It proved there was huge discretionary opex buried in the P&L. 

Once the market realized just how lean these businesses could be if they needed to, the stocks ripped.

However, the real question was how the management of the largest businesses in the world let that cost in, in the first place.

This is precisely why discretionary growth opex is a capital allocation decision.

These investments sit primarily in one of two areas of the P&L:

• Research & Development

• Marketing

The principles are very similar to the maintenance vs growth capex point. Is it an investment, or is it a cost of doing business.

Two examples:

• R&D costs to improve the Tesla Model 3 Software: Cost of doing business. Not discretionary growth opex (cost of maintaining current EBITDA structure)

• R&D costs to develop AI-powered humanoids: Investment in growth. Discretionary growth opex

• Marketing costs to replace churned customers: Cost of doing business

• Incremental marketing costs to grow the business: Investment in growth

This is alien to most businesses which have a process for ‘approving marketing spend’ via the budget cycle and cost center management processes.

By default they assess all marketing spend against the other; regardless of its purpose.

Rather than assessing discretionary growth expenditure against other capital allocation decisions. Stuff like growth capex, paying down debt, or paying dividends.

Remember: when making decisions, accounting classification is almost totally irrelevant. Focus on the nature of the cashflows and the behaviors they drive. Then build processes to manage them.

The art of great discretionary spend management is to use the budget cycle, and chart of accounts to ensure these investments can be separately identified.

Once identified they can be planned for, approved, coded, and reported upon separately. Through a separate stream to the rest of the P&L expenditure.

This is the best argument for Zero Based Budgeting. And there are a lot of great arguments for Zero Based Budgeting.

The right metrics will depend on the nature of the cost. But it does help if they can be reduced to the same metrics you use for assessing capex.

You can then make NPV Per $ trade-off decisions between the P&L and Capex.

Powerful stuff.

R&D is particularly difficult to budget, because we, in finance, aren’t really qualified to determine the probability of success of a breakthrough.

What we can do, though is break projects into a stage and gate process. Clear milestones and hurdles.

So the capital committed is commensurate with confidence in return on capital. So that by the time you are placing the big bet, it has become more of a ‘hard return’ case.

I think of it a bit like the way VC funding rounds work (or at least the way they should work).

A good example would be in a big pharma company. Choosing which drugs to speculate R&D on is a crucial exercise in capital allocation in this industry.

It will have different stages and gates for each approval step for the drug. Discovery, pre-clinical trials, clinical trials, FDA approval etc. As the project passes each gate meeting the required metrics, it can unlock a new round of larger funding.

If you want to make great decisions on opex investment, link them to the FP&A cycle.

The Long Range Planning and Budgeting cycle set guardrails for decisions on opex investments. Part of this would include the % of revenue you set aside to invest in ‘growth’.

3) Invest in Working Capital

Most businesses have positive working capital. Which means they need cash investment in order to grow.

I have written about this extensively before. As well as the virtues of negative working capital.

The important point with an increase in working capital is that it is taken intentionally as a decision to invest in capital.

That capital could have other uses, so it must be properly evaluated. It is rarely a decision in isolation. And overlays with other broader capital allocation decisions.

Building a new factory and increasing volumes will have a capital cost. But will also require a working capital investment.

The key is to understand the total cashflow profile of a business initiative including its working capital impact.

4) M&A

If you want to read the full series on M&A, it starts here.

Fundamentally, M&A should play one of two roles in capital allocation:

1. When it represents the cheapest way of growing. Accessing new capacity, products or markets i.e. buying vs building through capex and opex investment.

2. Improving value capture, by consolidating a market or a cost base. Delivering synergies.

M&A should be directly traded off against inward investment. ‘Can we build it ourselves?’

As I wrote in the M&A series, the best M&A strategies are selective about targets and price. But they are indifferent about timing. i.e. they will sit and wait for the right targets.

That means having sources of capital ‘ready to go’ when an opportunity comes along. And latent capital has an opportunity cost (as we’ve learned in this series).

That’s why companies like using their stock (especially if the price is high) or new debt for M&A.

You can solve valuations of targets into expected NPV return on $ invested. This then allows you to fluidly compare investing in capex, R&D, etc with potential M&A.

And being dynamic enough to arbitrage between the options is what makes great capital allocators.

How to select where to invest and how much

If you are a tech company growing profitably at 50% pa, it’s easy to justify investments in R&D, marketing, and capex. To capitalize on the white space in front of you.

Likewise. if you are in a mature market with no growth but want to expand cashflows, adding capacity is a risky strategy. It's much easier to justify allocating capital to opportunistic M&A.

You can’t force growth that isn’t there. But if it is there, you have a duty to try and take it.

It all starts with the strategy, the market, and the opportunity.

The distribution of capital depends on the relative strength of the growth opportunities.

And the strength and reliability of their cash profiles.

It’s art and science.

Role of CFO and Finance

We have to be careful as finance. This is where we can be growth killers.

How does Google build an NPV case for an investment in AI? If they win the space they could break through and build the first  $10tn company. If they don't, they could be left in the dust by a start-up we don’t even know exists yet.

It’s the job of strategists, marketers, and product people to see the future. They are the dominant voice. Not finance.

We have a voice, but it’s a quiet one.

It’s easy to say no to any one investment, but do that forever and your equity value will go to zero.

The role of finance is to set the rules inside which the business gets access to capital. So setting sensible hurdles and guardrails to access that capital is the job here.

And to create jumping-off points when something is not working.

You also must not get too hung up on accounting. Is it Capex, or Opex or even M&A?.

It doesn’t matter.

All investments are the same at their heart.

They have a cashflow profile. Some are more certain than others.

All cashflow profiles have four features:

• Timing

• Size

• Direction

• Certainty

Our job is to estimate these cashflows and their probability.

And then evaluate them against their most important alternative - giving cash back to shareholders.

More on that next week.

Big Ben from London, UK asked:

I have reached the top position at a small company ($5 million ARR), where I lead their strategy and helped the CEO triple revenue on a tight budget over the last few years. I feel there is no room for further progression, and my next step is to start my own company in the same market, targeting a different client segment. This would make my new venture a direct competitor.

Given the positive relationship and trust built with the CEO who promoted me, should I offer him an opportunity to invest in my new business, or is it better to cleanly part ways by leaving the company without involving them?

Thanks for your question, Big Ben (ding-dong).

That positive and trusting relationship you built with your CEO is about to change. If you are leaving to set up a direct competitor, you should assume that would be received as a declaration of war.

I would not recommend approaching your CEO to invest. Why would they do that? Even if they wanted to, an investment in a competitor would probably breach the restrictive covenants in their employment contract.

You need to assume you are going to be enemy number 1 for your current business and be confident you can build a business and a customer pipeline despite that.

Once you have a position of strength (i.e. revenue) and have proven your business is credible, then you can reach out to your former CEO and see what’s partnership is possible; peer-to-peer. But do it from a position of strength.

Good luck…

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The Secret CFO

Disclaimer: I am not your accountant, tax advisor, lawyer, CFO, director, or friend. Well, maybe I’m your friend, but I am not any of those other things. Everything I publish represents my opinions only, not advice. Running the finances for a company is serious business, and you should take the proper advice you need.